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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 The Dollar Has Broken Above Overhead Resistance Most central banks continue to dial up their hawkish rhetoric, led by the Fed. This is putting upward pressure on the dollar (Feature Chart). The big surprise has been resilient inflationary pressures across many economies. In our view, the market has already priced in an aggressive path for interest rates in the US, putting the onus on the Fed to deliver on these expectations. Meanwhile, other central banks that are also facing domestic inflationary pressures will play catch up. Our short USD/JPY position was triggered at 124. While there are no immediate catalysts for yen bulls, the currency is very cheap, and speculators are very short. Look to sell the DXY soon. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short DXY 102 2022-04-07 - SHORT USD/JPY 124 2022-04-05 0.02 Bottom Line: Technically, the dollar has broken above overhead resistance, putting it within striking distance of the March 2020 highs at 103. However, given stretched positioning, our bias is that incremental increases in the DXY will require much more upside surprises in US interest rates. This is not our base case. Feature The dollar performed well in the first quarter of this year. Year-to-date, the DXY index is up 3.9%.  Remarkably, this has coincided with strength in many commodity currencies such as the BRL, ZAR, COP, CLP, and AUD, that tend to be high beta plays on a falling dollar (Chart 1). Technically, the dollar has broken above overhead resistance, putting it within striking distance of the March 2020 highs of 103 (Chart 2). However, given stretched positioning, our bias is that incremental increases in the DXY will require much more upside surprises in US interest rates. This is not our base case. Chart 1The Dollar And Commodity Currencies Have Been Strong This Year Chart 2The Dollar Has Broken Above Overhead ##br##Resistance As we have highlighted in past reports, the dollar continues to face a tug of war. If rates rise substantially in the US, and that undermines the US equity market leadership (Chart 3), the dollar could suffer. If US rates rise by less than what the market expects, record high speculative positioning in the dollar will surely reverse. Chart 3Dollar Tailwinds Remain Intact This week’s Month-In Review report goes over our take on the latest G10 data releases, and the implication for currency strategy both in the near term and longer term. US Dollar: The Fed Stays Hawkish Chart 4The Case For More Tightening The dollar DXY index is up 3.9% year-to-date. The key data releases the Federal Reserve watches continue to suggest a hawkish path for interest rates going forward. Inflation remains strong in the US. Headline CPI came in at 7.9% year-on-year in February and is expected to accelerate in next week’s release. Nonfarm payrolls are still robust. The US added 431K jobs in March, nudging the unemployment rate to a cycle low of 3.6%. Wages are inflecting higher, which is pulling up unit labor costs. The Atlanta Fed Wage Growth Tracker currently sits at 6%. These developments continue to underpin market expectations for aggressive interest rate increases. The market now expects the Fed to raise rates to 2.25% by December 2022. Speculators are also very long the dollar. The mispricing in the dollar comes from the fact that markets are expecting the Fed to be more aggressive than other central banks in curtailing monetary accommodation this year (as proxied by two-year yield spreads). However, the reality is that other central banks are also ratcheting up their hawkish rhetoric. As such, we expect policy convergence to be a theme that will play out in 2022, putting downward pressure on the dollar. In conclusion, our 3-month view on the dollar is neutral, based on the risk of further escalation in the Ukrainian crisis and robust inflation prints, but our 9-month assessment will be to sell the dollar on any strength. We are revising our year-end target on the DXY to 95. The Euro: Stagflation Chart 5Euro Area Real Yields Are Too Low The euro continues to weaken, down 4.2% this year, after hitting an intraday low of 1.08 last month. Economic data in the eurozone has been soft, especially on the back of a surge in the number of new Covid-19 cases, rising energy costs driven by the military conflict between Ukraine and Russia, and a weak euro adding to upward pressure on inflation. This is pinning the euro area in a stagflationary quagmire.  More specifically: The headline HICP (harmonized index of consumer prices) index for the euro area was 7.5% for March. The hawks in the ECB are very uncomfortable with last week’s HICP release of 9.8% in Spain, 7.3% in Germany, and 7% in Italy. House prices in the euro area are accelerating on the back of very low real rates. This is increasing the unaffordability of homes across the eurozone. One of our favorite measures of economic activity, the Sentix Economic Index, tumbled in April. At -18, this is the lowest since July 2020, a negative surprise vis-à-vis the expected -9.4. Faced with a deteriorating economic backdrop, but strong inflationary pressures, the ECB has chosen a hawkish path to maintain credibility. Asset purchases will be tapered this year, and rate hikes are on the table. Forward markets are now pricing 53 bps of interest rate increases this year. In our view, while the ECB will not deliver the pace of rate hikes anticipated by markets in the near term, pricing of interest rate differentials between the eurozone and the US will narrow, as the ECB plays catch up. We are neutral on the euro over a 3-month horizon but are buyers over 9 months and beyond. Stay long EUR/GBP as a play on policy convergence between the ECB and BoE. Our year-end target for EUR/USD is 1.18.  The Japanese Yen: A Contrarian View Chart 6Too Many Yen Bears The Japanese Yen: A Contrarian View The Japanese yen is down 7% year-to-date. This pins it as the worst performing G10 currency this year. The story for Japan (and the yen) has been a very slow emergence from the latest Covid-19 wave. This has kept domestic inflation very subdued, allowing the BoJ to stay dovish, even as the external environment has done better. This has pushed interest rate differentials against the Japanese yen. The latest trigger for the selloff in the yen was the BoJ’s commitment to maintain yield curve control as global interest rates have been surging. This pushed USD/JPY above 125, the highest since 2015. On the back of this move, incoming economic data justified the BoJ’s stance. Headline inflation has picked up (still at 0.9%), but core “core” inflation remains at -1%. At 1.21, the job-to-applicant ratio is well below its pre-pandemic level of around 1.6. Ergo, the labor market is not as tight as a 2.7% unemployment rate suggests. Wage growth is improving, currently at 1.2% for February. That said, is it hard to argue that Japanese workers have bargaining power and can trigger a wage/inflation spiral that will allow the BoJ to pivot. Related Report  Foreign Exchange StrategyThe Yen In 2022 Despite these negatives, we are constructive on the yen because the downside is well priced in, while upside surprises are not. Real rates remain higher in Japan than for other G10 countries. Speculators are also very short the yen. As we highlighted last week, the yen is also extremely cheap. We went short USD/JPY at 124. Our view is that interest rate expectations for the US are overdone in the near term. As such a stabilization/retracement in global yields could be a bullish development for yen bulls. Our target is 110 with a stop at 128.  British Pound: A Hawkish BoE Chart 7The Case For A Hawkish BoE The pound is down 3.4% year-to-date. The Bank of England has been one of the more aggressive central banks, raising interest rates to 0.75% last month. Inflation continues to soar in the UK - headline CPI was at 6.2% in February while core inflation clocked in at 5.2%. This prompted the governor to send a letter to the Chancellor of the Exchequer, explaining why monetary policy has allowed inflation to deviate from the BoE’s mandate of 2%. According to the BoE’s projections, inflation will rise above 8% this year before peaking. At the same time, taxes are slated to rise in the UK this month. While the labor market continues to heal, the combination will be a hit to consumer sentiment in the near term. The SONIA curve in the UK is pricing 130 bps of price hikes this year. While the BOE must contain inflationary pressures (in accordance with their mandate), the risks of a policy mistake have risen. Tight monetary and fiscal policy in the UK could stomp out any budding economic green shoots. The pound is also very sensitive to global financial conditions, and an equity market correction, especially on the back of heightened tensions in Ukraine, will put pressure on cable. We are short sterling, via a long EUR position. In our view, the EUR/GBP cross is heavily underpricing the risks to the UK economy in the near term.    Australian Dollar: A Commodity Story Chart 8The RBA Will Stay Patient The Australian dollar is up 3% year-to-date, making it the best performing G10 currency. The Reserve Bank of Australia kept rates on hold at its April 5th meeting, but it ratcheted up its hawkish tone. The two critical measures that the RBA is focusing on, inflation and wages, have been improving. As a result, the shift in the RBA stance was justified. Since its March meeting, home prices have continued to accelerate, rising 23.7% year-on-year in Q4. Meanwhile, the unemployment rate has fallen to a cycle low of 4% in Q4. This is below many measures of NAIRU. The RBA expects inflationary pressures to remain persistent in 2022, but ultimately fall to 2.75% in 2023. This will still be at the upper bound of their 2%-3% target range. Admittedly, wages are still low by historical standards, but as Governor Philip Lowe has highlighted, the behavior of the Phillip’s Curve at these low levels of unemployment is unpredictable. The external environment is also AUD bullish. The RBA Index of Commodity prices soared by 40.9% year-on-year in March, widening the gap with a rather muted AUD (up 3.4% this year). In our view, the market is concerned about the zero-Covid policy in China (Australia’s biggest export partner), which could dim Australia’s economic outlook in the near term. On the flip side, many speculators are now short the Aussie which is bullish from a contrarian perspective. A healthy trade balance is also putting upward pressure on the currency. We are lifting our limit buy on AUD/USD to 72 cents, after being stopped out for a modest profit earlier this year.  New Zealand Dollar: Positive Catalysts, But Overvalued Chart 9Home Price Inflation In New Zealand Is Rolling Over The New Zealand dollar is up 1% year-to-date. The Reserve Bank of New Zealand is among the most hawkish within the G10.  The cash rate is at 1%, the highest among major developed economies on the back of economic data which remains robust. Home prices, a metric the RBNZ monitors to calibrate monetary policy, are rising 23.4% year-on-year as of March. While we are modestly positive on the Kiwi, it has become very expensive according to most of our models. The result is that the trade balance continues to print a deficit, with the latest data point in February deteriorating to NZ$ -8.4 billion. Kiwi bonds also offer the highest yield in the G10, meaning the market has already priced a hawkish path of interest rates by the RBNZ. Given the crosscurrents mentioned above, we are neutral the kiwi versus the dollar over both a 3-month and 9-month horizon.          Canadian Dollar: The BoC Will Stay Hawkish Chart 10The BoC Will Hike Next Week The CAD is up 0.4% year-to-date. The Bank of Canada is expected to raise interest rates by 50bps to 1% at next week’s meeting. This is not a surprise, since all the measures the BoC looks at to calibrate monetary policy are robust. Both headline and core inflation are well above the midpoint of the 1%-3% target range. The common, trim, and median inflation prints are either at or above the upper bound of the central bank’s target at 2.6%, 4.3%, and 3.5%, respectively. This suggests inflationary pressures in Canada are broad based. Employment in Canada is back above pre-pandemic levels, with the unemployment rate slated to come in at 5.4% with today’s release, close to estimates of NAIRU. House price inflation is raging across many cities in Canada, which argues that monetary policy is too easy and mortgage rates are too low. We have always highlighted that the key driver of the CAD remains the outlook for monetary policy and the path of energy prices. In the near term, oil prices will stay volatile as the situation in Ukraine continues to be very fluid, but the CAD has not priced in the fact that the BoC is leading the interest rate cycle vis-à-vis the US this time around.  Speculators are only neutral the CAD, an appropriate stance over the next three months. That said, we are buyers of CAD over a 9-to-12-month horizon, with a target of 0.84.   Swiss Franc: A Safe Haven Chart 11The SNB Will Lean Against Franc Strength The Swiss economy continued to fare well in the first quarter. The manufacturing PMI jumped to 64 in March. Retail sales were up 12.8% year-on-year in February. The labor market remains strong with unemployment near pre-pandemic levels. Switzerland’s direct exposure to the war appears relatively limited with little inflationary spillovers. CPI stood at 2.4% year-on-year in March, with about 1% of the increase coming from energy prices. The Swiss economy is still generating a record trade surplus, coming in at CHF 5.7bn in February. Safe-haven inflows into the franc have dampened inflationary dynamics. This leaves room for the SNB to continue easing monetary policy for longer relative to other central banks in the developed world.  In terms of monetary policy, the SNB kept interest rates unchanged at -0.75% at its Q1 meeting. The SNB has also described the franc as “highly valued” and said that it is willing to intervene in FX markets as necessary to counter the upward pressure in the currency. Sight deposits have been rising in March. We are neutral CHF on both a 3-month and 9-month horizon but will be buyers of EUR/CHF at current levels.   Norwegian Krone: Bullish On A 12-18 Month Horizon Chart 12NOK Has A Policy Tailwind The NOK is flat this year. In March, the Norges Bank raised the policy rate by 25 bps to 0.75%, in line with policymakers’ previous statements. Citing rising import prices and a tight labor market, the committee now expects to increase rates to 2.5% by the end of 2023, up from an assessment of 1.75% in December.  Inflation accelerated again in February, with headline and core CPI at 3.7% and 2.1% year-on-year respectively. Despite the removal of all Covid-19 restrictions in mid-February, consumer demand data remained soft with retail sales, household consumption, and loan growth all down in February. Still, the overall economy remains strong, and the Bank expects a rebound in demand going forward. The manufacturing PMI jumped to 59.6 in March after a three-month decline. Industrial production rose 1.6% year-on-year in February, after lackluster performance in January. The trade surplus remains robust. Registered unemployment fell to 2% in March and with rising wage expectations, the case for tighter monetary policy remains intact. The uncertainty over energy-related sanctions can keep oil prices volatile in the near time, as well as the NOK. That said, our commodity team expects oil to average $93/bbl next year, which is higher than what the forward markets are pricing. That will be bullish for the NOK.   Swedish Krona: Lower Now, Strong Later Chart 13The SEK Is Not Pricing Rate Hikes By The Riksbank SEK is down 4% year-to-date. The Riksbank remains one of the most dovish central banks in the G10, keeping the repo rate at 0% at its February meeting, with no hikes projected until 2024. Since then, inflation data has come in well above expectations and several board members have spoken out on the need to reevaluate monetary policy. The OIS curve is now pricing about two hikes by the end of the year. CPIF was 4.5% year-on-year in February and the measure excluding energy jumped to 3.4%, up from 2.5% in January. With fears that the conflict in Ukraine will exacerbate this trend, a survey of 12-month inflation expectations stood at a record 10.2% in March. While inflation is surprising to the upside, underlying economic data has been on the weaker side. The Swedish new orders-to-inventory ratio has fallen sharply. Consumer confidence also dipped in March, to the lowest point since the Global Financial Crisis. Sweden remains highly sensitive to eurozone economic conditions. As such, it is also in the direct firing range of any economic turbulence in the euro area, though it will also benefit from growth stabilization later this year, should macroeconomic risks abate. SEK is the second most undervalued currency based on our Purchasing Power Parity models and is likely positioned for a coiled spring rebound when the Riksbank eventually turns more hawkish. We are neutral SEK over a 3-month horizon but are bullish longer term.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary Ebbing Stagflation Fear Will Prompt Rerating European inflation will rise further before peaking this summer. Core CPI will reach between 2.8% and 3.2% by year-end before receding. The combination of stabilizing growth and the eventual peak in inflation will cause stagflation fears to recede. European assets have greater upside. Cyclicals, small-caps, and financials will be major beneficiaries of declining stagflation fears. The underperformance of UK small-cap stocks is nearing its end. UK large-cap equities are a tactical sell against Eurozone and Swedish shares. TACTICAL INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT EQUITIES Buy European & Swedish Equities / Sell UK Large Caps Stocks 03/21/2022     Bottom Line: Stagflation fears are near an apex as commodity inflation recedes. A peak in these fears will allow European asset prices to perform strongly over the coming quarters.     Despite a glimmer of hope that Ukraine and Russia may find a diplomatic end to the war, the reality on the ground is that the conflict has intensified. Although the hostilities are worsening and the European Central Bank (ECB) surprised the markets with its hawkish tone, European assets have begun to catch a bid. The crucial question for investors is whether this rebound constitutes a new trend or a counter-trend move? Our view about Europe is optimistic right now. The path is not a direct line upward. The recent optimism about the outcome of the Russia-Ukraine talks is premature; however, we are getting to the point when markets are becoming desensitized to the war and energy prices are losing steam. Moreover, the increasing number of statements by Chinese economic authorities pointing toward greater stimulus and support to alleviate the pain created by China’s stringent zero-COVID policy are another positive omen. Higher Inflation For Some Time European headline inflation is set to exceed 7% this summer and core CPI will increase between 2.8% and 3.2% by the end of 2022. Related Report  European Investment StrategySpring Stagflation The main force that will push inflation higher in Europe remains commodity prices. Energy inflation is extremely strong at already 32% per annum (Chart 1). It will increase further because of both the recent jump in Brent prices to EUR122/bbl on March 8 and the upsurge in natural gas prices, which were as high as EUR212/MWh on the same day before settling to EUR106/MWh last Friday. The impact of energy prices will not be limited to headline inflation and will filter through to core CPI (Chart 1, bottom panel). The average monthly percentage change in the Eurozone core CPI inflation stands at 0.25% for the past six months (compared to an average of 0.09% over the past ten years), or the period when energy-prices inflation has been the strongest. Assuming monthly inflation remains at such an elevated level, annual core CPI will hit 3.3% in the Eurozone by the end of 2022 (Chart 2). Chart 2Core CPI to Rise Further Chart 1Energy Inflation: Alive And Well The picture is not entirely bleak. Many forces suggest that these inflationary forces will recede before year-end in Europe. Energy prices are peaking, which is consistent with a diminishing inflationary impulse from that space. We showed two weeks ago that the massive backwardation of oil curves, the heavy bullish sentiment, and the high level of risk-reversals were consistent with a severe but transitory adjustment in the energy market. Oil markets will experience further volatility, as uncertainty around peace/ceasefire negotiations continues to evolve in Ukraine. Nonetheless, the peak in energy prices has most likely been reached. BCA’s energy strategists expect Brent to average $93/bbl in 2022 and in 2023. The potential for a decline in headline CPI after the summer is not limited to energy prices. Dramatic moves in the commodity market, from metals to agricultural resources, have made headlines. Yet, the rate of change of commodity prices is decelerating, hence, the commodity impulse to inflation is slowing sharply. As Chart 3 shows, this is a harbinger of a slowdown in European headline CPI. Related Report  European Investment StrategyFallout From Ukraine Looking beyond commodity markets, the recent deceleration in European economic activity also suggests weaker inflation in the latter half of 2022. Germany will likely suffer a recession because it already registered a negative GDP growth in Q4 2021. Q1 2022 growth will be even worse because of the country’s high exposure to both China and fossil fuel prices. More broadly, the recent deceleration in the rate of change of both the manufacturing and services PMIs is consistent with an imminent peak in the second derivative of goods and services CPI (Chart 4). Chart 3Commodity Impulse Is Peaking Chart 4Inflation's Maximum Momentum Is Now Underlying drivers of inflation also remain tame in Europe. European negotiated wages are only expanding at a 1.5% annual rate, which translates into unit labor costs growth of 1% (Chart 5). This contrast with the US, where wages are expanding at a 4.3% annual rate. A peak in inflation, however, does not mean that CPI readings will fall below the ECB’s 2% threshold anytime soon. The European economy continues to face supply shortages that the Ukrainian conflict exacerbates (Chart 6). Moreover, the recent wave of COVID-19 in China increases the risk of disruptions in supply chains, as highlighted by the closure of Foxconn factories in Shenzhen. Finally, inflation has yet to peak; mathematically, it will take a long time before it falls back below levels targeted by Frankfurt. Chart 5The European Labor Market Is Not Inflationary Chart 6Not Blemish-Free Bottom Line: European headline inflation will peak this summer, probably above 7%. Additionally, core CPI is likely to reach between 2.8% and 3.2% in the second half of 2022. As a result of a decline in the commodity impulse, inflation will decelerate afterward, but it will remain above the ECB’s 2% target for most of 2023. Hopes For Growth Two weeks ago, we wrote that Europe was facing a stagflation episode in the coming one to two quarters, but that, ultimately, economic activity will recover well. Recent evidence confirms that assessment. Chart 7A Coming Chinese Tailwind? The tone of Chinese policymakers is becoming more aggressive, in favor of supporting the economy. On March 16, Vice-Premier Liu He highlighted that Beijing was readying to support property and tech shares and that it will do more to stimulate the economy. True, this response was made in part to address the need to close cities affected by the sudden spike of Omicron cases around China. Nonetheless, the global experience with Omicron demonstrates that, as spectacular and violent the surge in cases may be, it is short-lived. Meanwhile, the impact of stimulus filters through the economy over many months. As a result, Europe will experience the impact of China’s Omicron-induced slowdown, while it also suffers from the growth-sapping effects of the Ukrainian conflict; however, it will also enjoy the positive effect on growth of a rising credit impulse over several subsequent quarters (Chart 7). Beyond China, the other themes we have discussed in recent weeks remain valid. First, European fiscal policy will become looser, as governments prepare to fight the slowdown caused by the war, while also increasing infrastructure spending to wean Europe off Russian energy. Moreover, European military spending is well below NATO’s 2% objective. This will not remain the case, as military expenditure may leap from less than EUR100bn per year to nearly EUR400bn per year over the coming decade. Second, European spending on consumer durable goods still lags well behind the trajectory of the US. With the energy drag at its apex today, consumer spending on durable goods will be able to catch up in the latter half of the year, especially with the household savings rate standing at 15% or 2.5 percentage points above its pre-COVID level. Bottom Line: European growth will be very low in the coming quarters. Germany is likely to face a technical recession as Q1 2022 data filters in. Nonetheless, Chinese stimulus, European fiscal support, pent-up demand, and a declining energy drag will allow growth to recover in the latter half of the year. As a result, we agree with the European Commission estimates that European growth will slow markedly this year. Market Implications In the context of a transitory shock to European economic activity and a coming peak in inflation, European stock prices have likely bottomed. Chart 8Depressed Sentiment To Help Beta Sentiment has reached levels normally linked with a durable market floor. The NAAIM Exposure Index has fallen to a point from which global markets often recover. Europe’s high beta nature increases the odds that European equities will greatly benefit in that context (Chart 8). Valuations confirm that sentiment toward European assets has reached a capitulation stage. The annual rate of change of the earnings yields in the earnings yields has hit 73%, which is consistent with a market bottom (Chart 9). More importantly, the change in European forward P/E tracks closely our European Stagflation Sentiment Proxy (ESSP), based on the difference between the Growth and Inflation Expectations’ components of the ZEW survey (Chart 10). For now, our ESSP indicates that stagflation fears in Europe have never been so widespread, but these fears will likely dissipate as energy inflation declines. This process will lift European earnings multiples. Chart 9Bad News Discounted? Chart 10Ebbing Stagflation Fear Will Prompt Rerating Earnings revisions will likely bottom soon as well. The ESSP is currently consistent with a dramatic decline in European net earnings revisions (Chart 10, bottom panel). It will take a few more weeks for lower earnings revisions to be fully reflected. However, they follow market moves and, as such, the 17% decline in the MSCI Europe Index that took place earlier this year already anticipates their fall. Consequently, as stagflation fears recede, earnings revisions will rise in tandem with equity prices. Chart 11Maximum Pressure On Corporate Spreads A decline in stagflation fears is also consistent with a decrease in European credit spreads in the coming months (Chart 11). This observation corroborates the analysis from the Special Report we published jointly with BCA’s Global Fixed-Income Strategy team last week.  In terms of sectoral implications, a decline in stagflation fears is often associated with a rebound in the performance of small-cap equities relative to large-cap ones (Chart 12, top panel). This reflects the greater sensitivity of small-cap equities to domestic economic conditions compared to large-cap stocks. Moreover, small-cap equities had been oversold relative to their large-cap counterparts but now, momentum is improving (Chart 12). As a result, it is time to buy these equities. Similarly, financials have suffered greatly from the recent events associated with the Ukrainian conflict. European financial institutions have not only been penalized for their modest exposure to Russia, they have also historically declined when stagflation fears are prevalent (Chart 13). This relationship reflects poor lending activity when the economy weakens, and the risk of a policy-induced recession caused by high inflation. Financials will continue their sharp rebound as stagflation fears dissipate. Chart 13Financials Have Suffered Enough Chart 12Small-Caps Time To Shine The dynamics in inflation alone are very important. As Table 1 highlights, in periods of elevated inflation over the past 20 years, financials underperform the broad market by 11.3% on average. It is also a period of pain for small-cap equities and cyclicals. Logically, exiting the current environment will offer opportunities in European cyclical equities and for financials in particular. Table 1Who Suffers From High Inflation? Chart 14Long Industrials & Materials / Short Energy Finally, a pair trade buying industrials and materials at the expense of energy makes sense today. Materials and industrials suffer relative to energy equities when stagflation rises, especially in periods when these fears reflect rising energy pressures (Chart 14). A reversal in relative earnings revisions in favor of materials and industrials will propel this position higher. Bottom Line: Sentiment toward European assets reached a selling climax in recent weeks. Stagflation fears in Europe have reached an apex, and their reversal will lift both multiples and earnings revisions in the subsequent quarters. Diminishing stagflation fears will also boost the appeal of European corporate credit, contributing to an easing in financial conditions. Small-cap stocks, cyclicals, and financials will reap the greatest benefits from this adjustment. Going long materials and industrials at the expense of energy stocks is an attractive pair trade. Key Risk: A Policy Mistake The view above is not without risks. The number one threat to European growth and assets is a policy mistake from the ECB. On March 10, 2022, the ECB’s policy statement and President Christine Lagarde’s press conference showed that the Governing Council (GC) will decrease asset purchases faster than anticipated. Chart 15Will The ECB Repeat It Past Mistakes? It is important to keep in mind the dynamics of 2011. Back then, the ECB opted to increase interest rates as European headline CPI was drifting toward 2.6% on the back of rising energy prices. According to our ESSP, the April 2011 interest rates hike took place at the greatest level of stagflation fears recorded until the current moment (Chart 15). Lured by rising inflation, the ECB ignored underlying weaknesses in European economic activity, which wreaked havoc on European financial markets and growth. If the ECB were to increase rates as growth remains soft, a similar outcome would take place. For now, the ECB’s communications continue to de-emphasize the need for rate hikes in the near term, which suggests that the GC is cognizant of the risk created by weak growth over the coming months. Waiting until next year, when activity will be stronger and the output gap will be closed, will offer the ECB a better avenue to lift rates durably. This risk warrants close monitoring of the ECB’s communication over the coming months. If headline inflation does not peak by the summer, the ECB is likely to repeat its past error, which will substantially hurt European assets. Our optimism is tempered by this threat. UK Outperformance Long In The Tooth? Last week, the Bank of England (BoE) increased the Bank Rate by 25bps to 0.75%, in a move that was widely expected. Yet, the pound fell 0.7% against the euro and gilt yields fell 6 bps. This market reaction reflected the BoE’s choice to temper its forward guidance. The central bank is now expected to increase interest rates to 2.2% next year, before they decline in 2024. The dovish projection of the BoE shows the MPC’s concerns over the impact of higher energy costs and rising National Insurance contributions on household spending. In the BoE’s opinion, the economy is very inflationary right now, but it will slow, which will mitigate the inflationary impact down the road. We share the BoE’s worries about the UK’s near-term economic outlook. The combination of higher taxes, higher interest rates, and rising energy costs will have an impact on growth. However, the rapid decline in small-cap stocks, which have massively underperformed their large cap-counterparts, already discounts considerable bad news (Chart 16). Additionally, small-cap equities relative to EPS have begun to stabilize, while relative P/E and price-to-book ratios have also corrected their overvaluations. In this context, UK small-cap equities are becoming attractive. Chart 17UK vs Eurozone: A Stagflation Bet Chart 16UK Small-Cap Stocks Have Purged Their Excesses In contrast to small-cap stocks, UK large-cap equities have greatly benefited from the global stagflation scare. The UK large-cap benchmark had the right sector mix for the current environment, overweighting defensive names as well as energy and resources. It is likely that when stagflation fears recede, UK equities will undo their outperformance (Chart 17). Technically, UK equities are massively overbought against Euro Area and Swedish stocks, both of which have been greatly impacted by stagflation fears and their pro-cyclical biases (Chart 18 & 19). An attractive tactical bet will be to sell UK large-cap stocks while buying Eurozone and Swedish equities, as energy inflation declines and as China’s stimulus boosts global industrial activity in the latter half of 2022 Bottom Line: Move to overweight UK small-cap stocks within UK equity portfolios. Go long Euro Area and Swedish equities relative to UK large-cap stocks as a tactical bet. Chart 18UK Overbought Relative To Euro Area... Chart 19… And Sweden   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades

Dear client, In addition to this weekly report, we sent you a Special Report from our Geopolitical Strategy service, highlighting the risk from the Russo-Ukrainian conflict. Kind regards, Chester Executive Summary The Ukraine crisis will lead to a period of strength for the DXY. Countries requiring foreign capital will be most at risk from an escalation in tensions. Portfolio flows have reaccelerated into the US, on the back of a rise in Treasury yields. This will be sustained in the near term. The euro area on the other hand has already witnessed significant portfolio outflows, on the back of Russo-Ukrainian tensions and an energy crisis. Countries with balance of payment surpluses like Switzerland and Australia are good havens amidst the carnage. Oil-producing countries such as Norway and Canada have also seen an improvement in their balance of payments, on the back of a strong terms-of-trade tailwind. This will be sustained in the near term. Balance Of Payments Across The G10 Bottom Line: The dollar is king in a risk-off environment. That said, the US and the UK sport the worst balance of payments backdrops, while Norway, Switzerland, and Sweden have the best. This underpins our long-term preference for Scandinavian currencies in an FX portfolio. In the near term, we think the DXY will peak near 98-100, but volatility will swamp fundamental biases. Feature Chart 1The US Runs A Sizeable Deficit The Russia-Ukraine conflict continues to dictate near-term FX movements. With Russia’s invasion of Ukraine, the risk of escalation and/or a miscalculation has risen. FX volatility is increasing sharply, and with it, the risk of a further selloff in currencies dependent on foreign capital inflows. As a reserve currency, the dollar has also been strong. It is difficult to ascertain how this imbroglio will end. However, in this week’s report, we look at which currencies are most vulnerable (and likely to stay vulnerable) from a balance of payments standpoint. Chart 1 plots the basic balance – the sum of the current account balance and foreign investment – across G10 countries. It shows that at first blush, Norway, Switzerland, Sweden, and Australia are the most resilient from a funding standpoint, while New Zealand, the UK, and the US are the most vulnerable. In Chart 2, we rank G10 currencies on eight different criteria: The basic balance, which we highlighted above. Real interest rate differentials, using the 10-year tenor and headline inflation. Relative growth fundamentals, as measured by the Markit manufacturing PMI. Three fair value models which we use in-house. The first is our Purchasing Power Parity model, which adjusts consumption basket weights across the G10 to reflect a more apples-to-apples comparison. The second is our long-term fair value model (LTFV), which adjusts for productivity differentials between countries; and the final is our intermediate-term timing model (ITTM), which separates procyclical from safe-haven currencies by including a risk factor such as corporate spreads. All three models are equally weighted in our rankings. The net international investment position (NIIP), which highlights currencies that are most likely to witness either repatriation flows or a positive income balance in the current account. Finally, net speculative positioning, which tells us which currencies have crowded long positions, and which ones sport a consensus sell. Chart 2The Scandinavian Currencies Are Attractive The conclusions from this chart are similar to our basic balance scenario – NOK, SEK, AUD, CHF, and JPY stand out as winners while GBP, NZD, and USD are the least attractive. The US dollar is a special case given its reserve currency status, with a persistent balance of payments deficit. The rise in the greenback amidst market volatility is a case in point. However, portfolio flows into the dollar also tend to be cyclical, so a resolution in the Ukraine/Russia conflict will put a cap on inflows. Equity portfolio flows had dominated financing of the US current account deficit but are relapsing (Chart 3). Bond portfolio flows have rebounded on the back of rising US yields, but US TIPS yields remain very low by historical standards (Chart 4). If they do not improve much further, specifically relative to other developed markets, it will be tough to justify further inflows into US Treasurys. Chart 3Equity Portfolio Flows Into The US Are Relapsing Chart 4Bond Portfolio Flows Into The US Are Strong In this week’s report, we look at the key drivers of balance of payments dynamics across the G10, starting with the US, especially amidst a scenario where the forfeit of foreign capital could come to the fore. United States Chart 5US Balance Of Payments The US trade deficit continues to hit record lows at -$80.7 billion for the month of December. Over the last few years, it has become increasingly difficult to fund this widening trade deficit via foreign purchases of US Treasurys. A positive net income balance has allowed a slower deterioration in the US current account balance, though at -$214.8 billion for Q3, it remains close to record lows. The overall picture for both the trade and current account balance is more benign as a share of GDP, given robust GDP growth (Chart 5). That said, as a share of GDP, the trade balance stands at -3.5%, the worst in over a decade. Foreign direct investment into the US has been improving of late. This probably reflects an onshoring of manufacturing, triggered by the Covid-19 crisis. That said, despite this improvement, the US still sports a negative net FDI backdrop. In a nutshell, the basic balance in the US (the sum of the current account and foreign direct investment) is still deteriorating. The dollar tends to decline on a multi-year basis when the basic balance peaks and starts worsening.       Euro Area Chart 6Euro Area Balance Of Payments The trade balance in the euro area has significantly deteriorated in recent quarters, on the back of an escalating energy crisis. Russia’s invasion of Ukraine marks the cherry on top. On a rolling 12-month basis, the trade surplus has fallen to 1% of GDP (Chart 6). This is particularly telling since for the month of December, the trade balance came in at €-4.6 billion, the worst since the euro area debt crisis. The current account continues to post a surplus of 2.6% of GDP, on the back of a positive income balance. However, FDI inflows are relapsing. After about two decades of underinvestment in the euro area, FDI inflows were at their highest level, to the tune of about 2% of GDP in 2021. Those have now completely reversed on the back of uncertainty. The combination of an energy crisis and dwindling FDI is crushing the euro area’s basic balance surplus. A rising basic balance surplus has been one of the key pillars underpinning a bullish euro thesis. Should the deterioration continue, it will undermine our longer-term bullish stance on the euro. It is encouraging that portfolio investments have turned less negative in recent quarters, as bond yields in the euro area are rising. Should this continue, it will be a good offset to the deterioration in FDI.   Japan Chart 7Japan Balance Of Payments Like the euro area, the trade balance in Japan continues to be severely hampered by rising energy imports. The trade deficit in January deteriorated to a near record of ¥2.2 trillion, even though export growth remained very robust. Income receipts from Japan’s large investment positions abroad continue to buffer the current account, but a resolution to the energy crisis will be necessary to stem Japan’s basic balance from deteriorating (Chart 7). The process of offshoring has sharply reversed since the Covid-19 crisis. While FDI is still deteriorating, it now stands at -2.4% of GDP, compared to -4.3% just before the pandemic. Net portfolio investments are also accelerating, especially given the rise in long-term interest rates in Japan, positive real rates, and the value bias of Japanese equities. We are buyers of the yen over the long term, but a further rise in global yields and energy prices are key risks to our view.             United Kingdom Chart 8UK Balance Of Payments The UK has the worst trade balance in the G10, and the picture has not improved much since the pandemic (currently at -6.7% of GDP). Similar to both the euro area and Japan, much of the drag on the trade balance has been due to rising import costs from energy and fuels. This puts the UK at risk of an escalation in the conflict between Ukraine and Russia. Meanwhile, the improvement in the income balance over the last few years has started to deteriorate, as transfer payments under the Brexit withdrawal agreement kick in. As a result, the current account balance is deteriorating anew (Chart 8). Both portfolio and direct investment in the UK were robust in the post-Brexit environment but have started to deteriorate. This is critical since significant foreign investment is necessary to boost productivity in the UK and prevent the pound from adjusting much lower. With bond yields in the UK rising, and the FTSE heavy in cyclical stocks, this should limit further deterioration in the UK’s financial account. A significant drop in the estimated path of settlement payments for Brexit will also boost the income balance. The key for the pound over the coming years remains how fast the UK can improve productivity, which will convince foreign investors that the return on capital for UK assets will increase. Canada Chart 9Canada Balance Of Payments Canada’s domestic economy has been relatively insulated from the geopolitical shock in Europe, but its export sector is benefiting tremendously from it. Rising oil prices are boosting Canadian terms of trade. As a result, the current account has turned into a surplus for the first time since 2009, in part driven by an improving trade balance (Chart 9). Outside of trade, part of the improvement in the Canadian current account balance is specifically driven by income receipts from Canada’s positive net international investment position. At C$1.5 trillion, income receipts are becoming an important component of the current account balance. Foreign direct investment into Canada continues to remain robust, given strong commodity prices. This is boosting our basic balance measure, which today sits at a surplus of 2.4% of GDP and should continue to improve. Finally, because of Canada’s improving balance-of-payments backdrop, it is no longer reliant on foreign capital as it had been in the past, which supports the loonie.         Australia Chart 10Australia Balance Of Payments Australia continues to sport the best improvement in both its trade and current account balances over the last few years. As a result, the basic balance has eclipsed 4% of GDP for the first time since we have been measuring this series (Chart 10). The story for Australia remains improving terms of trade, specifically in the most desirable commodities – copper, high-grade iron ore, liquefied natural gas, and to a certain extent, high-grade coal. Foreign direct investment in Australia has eased significantly. Investment in projects in the resource space are now bearing fruit, easing the external funding constraint. Meanwhile, domestic savings can now be easily recycled for sustaining capital investment. In fact, foreign direct investment turned negative in Q4 2021. This also explains the drop in net portfolio investment since Australians now need to build a positive net international investment position. We have a limit buy on the Aussie dollar at 70 cents, as we are bullish the currency over a medium-term horizon.         New Zealand Chart 11New Zealand Balance Of Payments For the third quarter of 2021, New Zealand’s current account balance hit record lows, despite robust commodity (agricultural) prices. Imports of fertilizers, crude oil, and vaccines have led to a widening trade deficit. A drop in the exports of wood also affected the balance. With a negative net international investment position of about 48% of GDP, the income balance also subtracted from the current account total (Chart 11). From a bigger-picture perspective, New Zealand’s basic balance has been negative for many years, as coupon and dividend payments to foreign investors, as well as valuation adjustments from net foreign liabilities, have kept the current account in structural deficit. However, as the prices of key agricultural goods head higher, New Zealand can begin to benefit from a terms-of-trade boom that will limit its external funding requirement. In that respect, portfolio investments are also improving. New Zealand has the highest bond yield in the G10, on the back of the highest policy rate so far (the RBNZ raised interest rates again this week). New Zealand’s defensive equity market has also corrected sharply amidst the general market riot. As such, foreign investors could begin to favor this market again based on high yields and a reset in valuations. Going forward, New Zealand should continue to see further improvement in its basic balance relative to the US, supporting the kiwi. Switzerland Chart 12Switzerland Balance Of Payments The Swiss trade balance remains in a structural surplus, with a post Covid-19 boom that has led a new high as a share of   GDP (Chart 12). Global trade has been rather resilient due to high demand for goods. While Switzerland has a large net international investment position, income flows this quarter were hampered by servicing costs for foreign direct investments. The net international investment position did improve by CHF27 billion on a quarter-over-quarter basis in Q3, on the back of a net increase in foreign asset purchases. Currency movements also had little impact on the portfolio in Q3, which is atypical. The SNB will always have to contend with a structural trade surplus that puts upward pressure on the currency. This will keep the Swiss franc well bid, especially in times of crisis when the positive balance-of-payments backdrop makes the CHF a safe haven.             Norway Chart 13Norway Balance Of Payments Q3 2021 saw a strong recovery in Norway’s trade account that is likely to carry over to this year. A recovery in crude oil and natural gas prices was a welcome boon. The lack of tourism also boosted the services account (Norwegians travel and spend less abroad than foreigners visiting Norway). The ongoing electricity crisis in Europe was also an opportune export channel for Norway, which for the first time, opened its 450-mile-long, 1400-megawatt North Sea cable link to the UK. Positive income flows also benefit the current account and the krone (Chart 13). With one of the largest NIIPs in the world heavily skewed towards equity dividends, the NOK benefits when yields rise, even though the domestic fixed-income market is highly illiquid. While a resolution of the Russian-Ukrainian crisis could sap the geopolitical risk premium from oil, the reopening of the global economy will benefit Norwegian exports of oil and gas. Tepid investment in global oil and gas exploration will also ensure Norway’s terms of trade remain robust.       Sweden Chart 14Sweden Balance Of Payments The Swedish current account balance has deteriorated slightly in the last few quarters, on the back of supply-side bottlenecks. Particularly, exports of cars have been hampered amidst a semiconductor shortage. That said, the primary income surplus remains a key pillar of the current account, keeping the basic balance at a healthy surplus of about 6% of GDP (Chart 14). Portfolio inflows into Sweden have dwindled, like most other European economies. If this has been due to geopolitical tensions in Europe, it will eventually prove to be fleeting. That said, the Riksbank remains one of the most dovish in the G10 and the OMX is also one of the most cyclical stock markets, which may have spooked short-term foreign investments. The Swedish krona has been the weakest G10 currency year-to-date. Given that we expect most of the headwinds to be temporary, and the basic balance backdrop remains solid, we will go long SEK versus both the euro and the US dollar.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Special Report

Feature Over the past months, we have seen a potent bout of volatility in developed government bond markets, as investors have tried to assess the “lift-off” dates for central bank hiking cycles and the speed and cumulative degree of eventual monetary tightening. Record inflation prints have also created a communication challenge for central banks, with investors demanding more certainty in relation to the preconditions that need to be met in the data for central banks to raise rates. Adding to the uncertainty are the new frameworks adopted by the US Federal Reserve and the European Central Bank (ECB) that allow for overshoots of the 2% inflation target to make up for historical undershoots. However, it remains to be seen how committed policymakers will be to these new frameworks. Even the historically dovish European Central Bank has been forced to talk down market pricing, with overnight swap markets eyeing a rate hike as early as next year. Across the English Channel, the Bank Of England, which initially baffled investors by failing to deliver a rate hike during its November meeting, now appears to have embarked on a new path, with Governor Andrew Bailey calling into question the very efficacy of forward guidance itself and possibly returning to making decisions on a meeting-by-meeting basis. Chief Economist Huw Pill has recently talked about “training” people to “think the right way about monetary policy,” but it remains to be seen if market participants will be receptive students. In any case, it is clear that the uniformly dovish period of extraordinary monetary accommodation induced by the pandemic is at an end. To navigate the uncertainty as central banks shift gears toward tighter policy on the margin, we are introducing revised versions of our BCA European Central Bank monitors this week. These indicators use economic and financial market data to gauge whether the current stance of monetary policy lines up with current conditions. Our revisions focus on making the monitors more dynamic and responsive to shifts in central bank reaction functions. Overall, the message from our new monitors is clear—rebounding growth and inflation data mean that all our indicators are moving in a direction more consistent with tighter policy even after Friday's market action (Chart 1). In the following sections of this report, we cover in greater detail the methodological changes to our indicators, followed by region-level assessments of the five new monitors introduced in this report for the Euro Area, UK, Sweden, Norway, and Switzerland. Chart 1The New BCA European Central Bank Monitors What’s New? We have made three major improvements to our central bank monitors: First, the sub-components—economic growth, inflation, and financial conditions—are no longer calculated as a simple average of their constituent data series. Instead, each data series is now weighted according to the degree that it moves in conjunction with other data series over a 60-month rolling window. In other words, data series that are highly correlated with other series receive a greater weight. There are two benefits to this approach: (i) it makes the monitors more dynamic and (ii) it adjusts for changes in correlations over time. Second, the weights of each of the three sub-components in the overall monitor are now determined so as to minimize the sum of squared residuals (SSR) of a regression of the 12-month change in policy rate (the dependent variable) with the readings from our monitors (the independent variable). We have imposed two constraints: each sub-component must have a minimum weight of 15% and may not weigh more than 70%. More importantly, the weights are now re-calculated every 60 months. In doing so, there is no assumption that central bankers’ reaction function is constant over time, and it avoids look-ahead bias. There is also the natural question of how to optimize the weights of our sub-components when policy rates remain flat for extended periods at, or near, the Zero Lower Bound (ZLB). While we did consider calculating a different set of weights targeting the annual change in assets held by the Central Bank during ZLB periods, we eschewed this approach for two reasons: these periods are neither frequent nor sufficiently prolonged to provide an appropriate sample. As a result, the weights currently applied to the monitors are based on the 60 months preceding policy rates reaching the Zero Lower Bound. Table 1 shows the weights currently being used for each monitor. Table 1European Central Bank Monitors' Weights Third, all of the data series included in our monitors are now standardized over 60-month rolling time horizons. Like the changes made to the weight calculation above, it ensures the monitor does not rely too heavily on either past or future data. Although central banks’ mandates do not change often—if at all—their reaction functions do. Take inflation, for instance. Our monitors should not factor in the level of price changes experienced in the 1970s as a benchmark to determine whether a central bank should be more or less accommodative based on what inflation is today. We also took this opportunity to make changes to the data series included in the monitors, with a focus on including higher-frequency series to improve the timeliness of the indicator. All in all, clients should note that these improvements do not change the interpretation of the monitors. A rising trend is still consistent with fundamentals that would have caused central banks to tighten in the past and vice versa. ECB Monitor: Stay Put Chart 2Euro Area: ECB Monitor Our European Central Bank (ECB) Monitor is currently in positive territory, suggesting that the ECB should be removing accommodation (Chart 2). However, the ECB did not sound any more hawkish at the close of its last meeting held at the beginning of the month. The latest surge of COVID-19 cases in Europe and subsequent governments’ responses will weigh on economic growth and give reason to the ECB not to rush into a new tightening cycle. It will also be interesting to see how the renewed energy crisis affects President Christine Lagarde's stance on the transitory aspects of inflation. The components of our ECB Monitor are consistent with these two forces (Chart 2, panel 2). Strong economic data prints have been losing steam this year, which weighed on the economic growth component. Nonetheless, this indicator now tries to move back up. Meanwhile, the inflation component is surging, driven by both the rapid acceleration in European realized inflation and CPI swaps. We have argued that energy, taxes, and base effects account for the bulk of the price increases in the Euro Area, and that, as such, the ECB was correct in looking past them. Market participants do not agree with the ECB. The Euro Overnight Index Average (EONIA) curve is now pricing 15bps of tightening by the end of 2022 (Chart 2, bottom panel), which is unlikely to happen considering the ECB’s dovish communication and its adoption of AIT. In this context, we lean against the EONIA pricing and expect the ECB to increase rates in 2024, at the earliest. We also continue to recommend an overweight stance on European government bonds within global fixed income portfolios. BoE Monitor: Tightening On The Way Chart 3UK: BoE Monitor Our Bank of England (BoE) monitor has continued its sharp rebound into positive territory since its trough in 2020 (Chart 3). While the BoE’s communication has been questionable, the Bank has done nothing to reverse its recent hawkish turn. This makes sense given economic data that is showing signs of an overheating economy. Consumer price inflation came in at 4.2% year-over-year in October, a ten-year high. And as we discussed in a recent BCA Research Global Fixed Income Strategy report, there are signs that rising inflation is having a dampening effect on consumer confidence, imperiling growth in 2022. Turning to the individual components of our BoE monitor, we see broad-based pressure to tighten policy, with all three components in solidly positive territory and rising quickly (Chart 3, middle panel). Inflationary pressures are being driven not only by strong CPI prints, but also by rising input prices and inflation expectations that are becoming unmoored from the BoE’s target. Meanwhile, capacity utilization scores from the BoE’s Agents’ Summary are at the highest level since 2007, creating scope for further inflation down the road. Growth is ebullient as well, with both manufacturing and services PMIs significantly above the 50 advance/decline line. Rising house prices and consumer lending are creating stability risks captured in the financial subcomponent of the monitor. Market anticipations for tightening over the next year have continued to increase, notwithstanding the muddled messaging from the BoE, with 111bps of tightening expected over the coming year (Chart 3, bottom panel). With the BoE set to be one of the more hawkish developed market central banks in 2022, we are comfortable maintaining an underweight stance on Gilts within global government bond portfolios. Riksbank Monitor: On Hold, But Not For Long Chart 4Sweden: Riksbank Monitor Our Riksbank Monitor is now close to neutral, after reaching all-time highs earlier this year (Chart 4). For now, the Riksbank seems content to continue to hold the repo rate at 0%, while expanding the size of its balance sheet. Taking a closer look at the breakdown in the Riksbank Monitor, we can see that the earlier surge was mostly driven by the financial conditions component, which is still solidly in positive territory (Chart 4, panel 2). The inflation component confirms that inflation is still not a concern for the Riksbank. In fact, core CPI stands at 1.82% annually, below the 2% target and far from what other developed economies are currently experiencing. We expect the ongoing robust economic recovery to continue lifting the economic growth component, which, at some point in the future, should place more pressure on the Riksbank to remove accommodation. Market participants have only started pricing in some rate hikes from the Riksbank recently (Chart 4, bottom panel). Still, we view this 35bps of expected tightening as too modest relative to the actual pressure on the Riksbank to tighten policy. The positive outlook for the Swedish economy,1 as well as rising house prices and household indebtedness, will force the Riksbank to tighten policy before the ECB—all of which may happen sooner if inflation starts to accelerate. Consequently, Swedish sovereign debt does not appear as an attractive underweight candidate in global government bond portfolios. Norges Bank Monitor: More Hikes To Come Chart 5Norway: Norges Bank Monitor Our Norges Bank Monitor is well into positive territory and continues to increase, signaling pressure for tighter policy (Chart 5). In September, the Norges Bank became the first of the G10 central banks to deliver a rate hike, which it paired with forward guidance suggesting hikes at its coming December, January, and March meetings. We believe such an outcome is supported by the data, which show pressure to tighten on a growth and inflation basis (Chart 5, middle panel). The growth subcomponent of our indicator has been driven by rebounding business and consumer sentiment. Meanwhile, inflationary pressures have been driven by rising capacity utilization and producer prices, which grew at an unbelievable 60.8% year-over-year in October, the highest annual growth rate that has ever been recorded for the series. The reading from the financial subcomponent is more neutral, hovering above the zero level. This slight decline this year may largely be explained by slowing house price growth and falling debt service ratios. However, the NOK remains undervalued on a PPP-basis, which, at the margin, creates pressure on the Norges Bank to tighten. Overnight index swap curves are currently discounting 136bps of tightening in Norway over the coming year. We believe this is a realistic outcome, given the Norges Bank’s uniquely hawkish reaction function and pressures to tighten, which are not likely to dissipate any time soon. We remain bearish on Norwegian government debt. SNB Monitor: Still About The Swiss Franc Chart 6Switzerland: SNB Monitor Our Swiss National Bank (SNB) Monitor has decreased somewhat after peaking earlier this year, but remains solidly in positive territory, which suggests that the SNB should remove accommodation (Chart 6). This is unlikely to happen anytime soon. At the Central Bank leadership’s annual meeting with the Swiss government last month, the SNB emphasized the need to maintain accommodative monetary policy. In so doing, it kept policy rate and interest on sight deposits at the SNB at −0.75%, while remaining willing to intervene in the foreign exchange market as necessary, in order to counter upward pressure on the Swiss franc. After all, the currency remains the main determinant of Swiss monetary conditions. Therefore, the SNB will continue to try to cap the upside in the CHF vis-à-vis the EUR, because it considers the Swiss franc "highly valued". Meanwhile, inflation does not seem to be an imminent concern for the SNB. Headline inflation and core inflation stand at 1.25% and 0.58%, respectively. All three components of our SNB Monitor appear to send the same message at the moment (Chart 6, panel 2). Markets largely seem to believe the SNB’s unwillingness to tighten monetary policy (Chart 6, bottom panel). Only 16 bps of tightening are priced over the next 12 months, and 54bps over the next 24 months. We maintain our neutral stance on Swiss bonds within global portfolios, given low liquidity. Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com   Footnotes 1      Please see BCA Research European Income Strategy Report, "Take A Chance On Sweden", dated May 3, 2021, available at eis.bcareseach.com.

Highlights Monetary Policy: Last week’s numerous central bank meetings across the world confirmed that the overall direction for global monetary policy is shifting in a more hawkish direction. The main reason: growing fears that elevated inflation will persist for much longer than expected, even with global growth having lost some momentum. Country Allocation: The relative degrees of central banker hawkishness support our current government bond country allocation strategy. Stay underweight the US, UK, Canada, New Zealand and Norway where markets are discounting a path for future policy rates over the next two years that is too flat. Remain overweight countries where there is less need for a more aggressive tightening response: the euro area (both the core and periphery), Australia, Sweden and Japan. Still The Only Game In Town Last week was a busy one for global bond markets, with no fewer than 14 central banks within both the developed markets (DM) and emerging markets (EM) holding policy meetings. The results were eventful: Within EM, Brazil and Hungary lifted policy rates. Norway followed suit to become the first G-10 central bank to hike during the COVID era. The Fed teed up a formal announcement on tapering asset purchases at the next FOMC meeting in November. The Bank of England (BoE) gave strong hints that rate hikes could come sooner than expected, perhaps even before year-end. Chart of the WeekMonetary Policy Backdrop Turning More Bond-Bearish Global bond yields in the developed markets took notice of the change in central bank guidance, especially from the Fed and BoE. The benchmark 10-year US Treasury yield rose from a pre-FOMC low of 1.30% to an intraday high of 1.57% yesterday – a level last seen late June. Longer-dated yields in the UK also rose significantly, with the 30-year Gilt yield rising from a pre-BoE meeting low of 1.11% to an intraday high of 1.40% yesterday – also the highest level since June. The pull on yields extended to other countries, as well, with 10-year yields in Germany, Canada and Australia climbing to three-month highs. The overall message from all of those policy meetings was one of an incremental shift toward less accommodative policies, even as the pace of global economic growth has slowed in recent months. Policymakers are growing more concerned that higher inflation could linger for longer (Chart of the Week). At the same time, loose policy settings have fueled a boom in asset markets that supports growth through easy financial conditions, but also raises future stability risks that worry the central banks. The number of countries seeing actual rate hikes is growing. Our Global Monetary Policy Tightening Indicator shows that just over one-quarter of G-10 and EM central banks have lifted rates over the past three months (Chart 2). All but one (Norway) are in EM, where policymakers have had to act more mechanistically in response to high inflation, even with softening economic growth momentum. While the slower pace of growth is more visible in EM relative to DM, when looking at cyclical indicators like manufacturing PMIs, inflation rates are simply too high around the world for inflation-targeting central banks to ignore (Chart 3). Chart 2Our Global Monetary Policy Indicator Shows A More Hawkish Turn Chart 3Global CBs Growing More Worried About Inflation Risks Within the major DM countries, there has been a notable shift in interest rate expectations in a more hawkish direction. Interest rate markets are, for the most part, still underestimating the potential for tighter monetary policies over the next couple of years. This is the main reason why we continue to recommend an overall below-benchmark strategic stance on global duration exposure. However, the relative expected pace of rate hikes also informs our views on country allocation. In Table 1, we show expectations for the timing of the next rate hike, as well as the cumulative amount of rate increases to the end of 2024, that are currently discounted in DM overnight index swap (OIS) curves. We present the latest level for both, as well as the reading from earlier this month to see how expectations have changed. Table 1Markets Still Pricing Very Modest Tightening Cycles The so-called “liftoff date” for the first rate hike has been most notably pulled forward in the UK from January 2023 to May 2022, while other countries have seen more modest shifts in the timing of the next rate increase. More importantly, the discounted pace of rate hikes to end-2024 for all countries shown in the table has increased since early September (including Norway, factoring in last week’s tightening move by the Norges Bank). In our view, the biggest driver of relative government bond market yield movements and returns over the next 6-12 months will be the relative adjustments in the expected pace of rate hikes. On that front, the biggest shift higher in cumulative tightening has occurred in countries where we are more pessimistic on government bond performance on a relative basis to the global benchmark: the US, Canada, the UK and Norway. The smaller increases in the pace of hikes have occurred in our more preferred markets – Australia, Sweden, the euro area, and Japan. Assessing Our Two Biggest Government Bond Underweights: The US & UK For last week’s Fed meeting, a new set of economic and interest rate projections from the FOMC members (“the dots”) were presented (Chart 4). Compared to the forecasts from the June meeting, US real GDP growth expectations for 2021 were revised down (5.9% vs 7.6%) but were boosted for 2022 (3.8% vs 3.3%) and 2023 (2.5% vs 2.4%). A new forecast for 2024 was added, coming in at 2.0%. Importantly, none of those growth forecasts was below the median FOMC estimate of the longer-run real GDP growth rate of 1.8% (top panel). In other words, the Fed is not anticipating below-trend growth anytime in the next three years. Chart 4The Fed’s Rate Projections Look Too Low The same conclusion goes for the US unemployment rate (second panel), with the median FOMC projection for 2022 (3.8%), 2023 (3.5%) and 2024 (3.5%) all below the median longer-run “full employment” estimate of 4.0%. The forecasts for US inflation (third panel) reflect that persistent low level of unemployment. Headline PCE inflation is expected to end 2021 at 4.2%, to be followed by a somewhat slower pace – but still above the 2% Fed inflation target – in 2022 (2.2%), 2023 (2.2%) and 2024 (2.1%). Yet despite these forecasts that show US growth and inflation exceeding its longer-run estimates for the next few years, the FOMC is projecting a relatively slow upward path for interest rates. The median dot now calls for the Fed to hike the funds rate once in 2022 and three more times in both 2023 and 2024. This would bring the funds rate to 1.75% by the end of 2024 – still 75bps below the Fed’s estimate of the longer-run “neutral” funds rate of 2.5% (bottom panel). That projected path for the funds rate is higher than the June dots, which only called for 75bps of cumulative hikes to the end of 2023. There is a wide divergence of opinions on the future path of rates within the FOMC, but the hawks appear to be winning the internal battle (Chart 5). There is now a 9-9 split of FOMC members who are calling for a rate hike in 2022, compared to a 7-11 split back in June, while the number of those projecting a funds rate above 1% in 2023 rose from 5 to 9. Chart 5A Wide Dispersion Of FOMC Interest Rate Views For 2023/24 One area where there does appear to be a consensus is on the timing and pace of tapering. Fed Chair Powell noted at his post-FOMC press conference that an announcement on the reduction of Fed asset purchases could come as soon as the next FOMC meeting on November 6. Powell also signaled that there was general agreement on the FOMC that the taper should end by mid-2022, barring any economic setbacks. That would likely open the door to a rate hike in the latter half of next year, given the Fed’s longstanding view that lifting the funds rate should only occur after tapering is complete, to avoid sending conflicting signals about the Fed’s policy bias. It is clear that the Fed’s policy guidance has shifted incrementally in a more hawkish direction, and confirms our long-held expectation that tapering would be announced by year-end, with rate hikes to begin in late 2022. This dovetails with our recommended investment positioning in the US Treasury market for the next 12-18 months. Maintain a below-benchmark US duration exposure, with a curve-flattening bias, while staying underweight US Treasuries in global (USD-hedged) fixed income portfolios (Chart 6). Our other high-conviction underweight government bond call is in the UK. The BoE’s recent messaging has turned more hawkish in a very short period of time, justifying our decision to downgrade our recommended UK Gilt exposure to underweight last month.1 The BoE Monetary Policy Committee had already sharply upgraded its inflation forecast for the end of 2021 to just above 4% at the last policy meeting in August. That was categorized as just a temporary surge due to rising energy prices and goods prices elevated by shorter-term global supply chain bottlenecks. At last week’s meeting, however, the MPC noted that +4% UK inflation could persist into Q2 2022 because of the current surge in wholesale natural gas prices that has driven many UK gas suppliers out of business (Chart 7). Chart 6Our Recommended Strategy For US Treasuries Chart 7BoE Growing More Worried About Inflation Chart 8Our Recommended Strategy For UK Gilts The official view of the BoE has been like that of other central banks, that much of the current high inflation is supply driven and, hence, will not last. Yet within the MPC, there is clearly some growing nervousness about high realized inflation becoming more embedded in longer-term inflation expectations, which are moving higher. BoE Governor Andrew Bailey has noted in recent speeches that there was a growing case for interest rate hikes because of stubbornly higher inflation. Two members of the MPC even voted last week to reduce the size of the BoE’s QE program that is already set to end in just three months. The markets have begun to heed the more hawkish signals from the BoE. Our 24-month UK discounter, measuring the amount of rate hikes priced into the UK OIS curve, has jumped 24bps since September 7 (Chart 8). Over that same period, UK Gilts have underperformed the Bloomberg Barclays Global Treasury index by 108bps (on a USD-hedged and duration-matched basis). We are sticking with our underweight recommendation on UK Gilts, as there are still too few rate hikes priced into the UK curve relative to the BoE’s guidance and upside inflation risks. What About The BoJ? Same Old, Same Old Chart 9Reasons Why JGBs Will Outperform Lost amid the hawkish din from the Fed and BoE meetings last week was the Bank of Japan (BoJ) meeting. The message from policymakers in Tokyo was predictably dovish, as Japan has not seen anything resembling the high inflation that has pushed central bankers elsewhere in a more hawkish direction. Japanese growth has also not seen the same magnitude of recovery from the pandemic shock as the other major developed markets, despite suffering comparable losses during the 2020 recession (Chart 9). One of the main reasons has been that Japan’s vaccine rollouts were much slower than those of other major countries. This forced an extension of emergency lockdowns and other economic restrictions that depressed domestic demand and delayed a return to normal economic activity (second panel). COVID outbreaks even cost Japan the one-time economic windfall from hosting an Olympics, with the Tokyo Games first delayed by a year and then taking place with no fans. Japan has also not suffered any of the higher inflation rates witnessed elsewhere over the past year, despite presumably facing many of the same inflationary forces from global supply chain disruption (third panel). Both headline and core CPI inflation are now in deflation. Governor Haruhiko Kuroda stated last week that it will take longer for Japan to see inflation return back to its 2% target than other developed countries, with the official BoJ forecast calling for that level to be reached by 2023 – a forecast that appears too optimistic. We continue to view Japanese government bonds (JGBs) as a relative safe haven during the period of rising global bond yields that we expect over the next 6-12 months. The BoJ is nowhere close to seeing the conditions necessary to begin exiting its Yield Curve Control and negative interest rate policies, both of which have crushed JGB volatility and kept longer-term bond yields hovering near 0%. We continue to recommend a moderate overweight stance on Japan in global government bond portfolios, particularly on a USD-hedged basis to make the yields more attractive. The Scandinavian Policy Divergence Last week, the Norges Bank raised its benchmark interest rate from 0% to 0.25% (Chart 10), stating that a normalizing economy requires a gradual normalization in monetary policy. The bank’s decision reflects idiosyncratic factors unique to the Norwegian economy, but also some of the same broader themes that are forcing other central banks in a more hawkish direction.   As a small economy driven heavily by oil exports, both the Norwegian krone and the price of oil weigh heavily on the policy decisions of the Norges Bank. On that front, the rise in energy prices since the crisis has outpaced the appreciation in the krone (Chart 10, top panel). With this relative weakness in the krone comes higher import price inflation and increased export competitiveness, both of which mean that the Norges Bank must pull forward its path of rate hikes to compensate. As opposed to other G10 central banks, the Norges Bank clearly believes a pre-emptive move on rates is necessary to nip future inflation risk in the bud. The bank expects that increased capacity utilization and wage growth will help push up underlying inflation to approximately 1.9% by the end of 2024, with the ongoing supply chain disruptions creating additional upside risk to that forecast. Like other G10 banks, however, the Norges Bank is concerned about increasing financial imbalances. The Norwegian house price-to-disposable income ratio is now at all-time highs and the Norges Bank expects it to remain elevated to the end of its forecast horizon (Chart 10, bottom panel). With the growth in house prices substantially outpacing income growth during the pandemic, housing market vulnerabilities have increased as households have taken on greater leverage to enter the market. In contrast to the Norges Bank, the other major Scandinavian central bank, Sweden’s Riksbank, has hewed more closely to the prevailing global monetary policy orthodoxy – avoiding pre-emptive policy tightening in order to boost inflation. The central bank chose to hold its repo rate at 0% at last week’s policy meeting, even with a Swedish economy that has recovered the 2020 pandemic losses and is projected to return to pre-COVID growth rates in 2022 (Chart 11). In its decision, the Riksbank mirrored rhetoric from the Fed and ECB, citing that high inflation was driven by rising energy prices and supply logjams, both factors which are expected to subside over the coming year (Chart 11, middle panel). Both headline and core versions of the bank’s favored CPI-F (CPI with Fixed Interest Rate) measure are projected by the Riksbank to remain below target in 2022, reaching 2% only in 2024. Chart 10The Norges Bank Isn't Waiting Around... Chart 11...But The Riksbank Will Remain Patient Chart 12The Central Bank Story Will Further Widen The Norway-Sweden Spread The Riksbank is less willing than the Norges Bank to respond to temporarily higher inflation because of the former’s growing reluctance to return to negative nominal interest rates in response to an economic shock. The Riksbank would likely be more comfortable in lifting nominal rates only when real rates were significantly lower than current levels, which requires higher inflation. In contrast to the neighboring Norges Bank, the Riksbank has an additional tool which it can use to express shifts in monetary policy—the size of its balance sheet. The bank forecasts that holdings of securities will remain unchanged in 2022 (Chart 11, bottom panel), implying that purchases, net of redemptions, will be drawn down roughly to zero. However, the bank does believe that the existing stock of purchases will continue to support financial conditions. Chart 12 shows the impact of the Norges Bank’s relatively hawkish reaction function. Despite relatively similar underlying growth and inflation profiles, sovereign debt from Norway has markedly underperformed Swedish counterparts, a dynamic that has been even more obvious since the pandemic. On the currency side, the NOK/SEK cross has recovered much of the losses from 2020, and will likely rally further as Norway-Sweden rate differentials will turn even more favorable for the NOK. Relative to the global benchmark on a currency-hedged and duration-matched basis, Norwegian government debt has underperformed much more than Sweden following the pandemic. We see these tends continuing over the next 6-12 months, with the Norges Bank likely to remain far more hawkish than the Riksbank. Our bias is to favor Swedish sovereign debt over Norwegian government bonds.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy/European Investment Strategy Report, "The UK Leads The Way", dated August 11, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The Evergrande crisis is not China’s Lehman moment. Nonetheless, Chinese construction activity will decelerate further in response to this shock. Global equities are frothy enough that a weaker-than-expected Chinese construction sector will remain a near-term risk to stocks prices. European markets are more exposed to this risk than US ones. Tactically, this creates a dangerous environment for cyclicals in general and materials in particular. Healthcare and Swiss stocks would be the winners. Despite these near-term hurdles, we maintain a pro-cyclical portfolio stance, which we will protect with some temporary hedges. We will lift these hedges if the EURO STOXX corrects into the 430-420 zone. A busy week for European central banks confirms our negative stance on EUR/GBP, EUR/SEK, and EUR/NOK. While EUR/CHF has upside, Swiss stocks should outperform Euro Area defensives. Stay underweight UK Gilts in fixed-income portfolios. Feature The collapse of property developer Evergrande creates an important risk for European markets. It threatens to slow Chinese construction activity further, which affects European assets that are heavily exposed to the Chinese real estate sector, directly and indirectly. This risk is mostly frontloaded, as Chinese authorities cannot afford a complete meltdown of the domestic property sector. Moreover, this economy has slowed significantly and more policy support is bound to take place. Additionally, forces outside China create important counterweights that will allow Europe to thrive despite the near-term clouds. While we see more short-term risk for European stocks and cyclical sectors, the 18-month cyclical outlook remains bright. Similarly, European stocks will not outperform US ones when Chinese real estate activity remains a source of downside surprise; but they will afterward. China’s Construction Slowdown Is Not Over The Evergrande crisis is not China’s Lehman moment. Beijing has the resources to prevent a systemic meltdown and understands full well what is at stake. At 160% of GDP, China’s nonfinancial corporate debt towers well above that of other major emerging markets and even that of Japan in the 1980s (Chart 1). If an Evergrande bankruptcy were allowed to topple this debt mountain, China would experience the kind of debt-deflation trap that proved so disastrous in the 1930s. A further deterioration of conditions in Chinese real estate activity is nonetheless in the cards, even if the country avoids a global systemic financial shock. First, the inevitable restructuring of Evergrande will result in losses for bond holders, especially foreign ones. Consequently, risk premia in the Chinese off-shore corporate bonds market will remain wide following the resolution of the Evergrande debacle. While Chinese banks are likely to recover a large proportion of the funds they lent to the real estate giant, they too will face higher risk premia. At the margin, the rising cost of capital will curtail the number of projects real estate developers take on over the coming two to three years. Second, the eventual liquidation of Evergrande will hurt confidence among real estate developers. This process may take many forms, but, as we go to press, the most discussed outcome is a breakup and restructuring where state-owned enterprises and large local governments absorb Evergrande’s operations. Evergrande’s employees, suppliers, and clients who have deposited funds while pre-ordering properties will be made whole one way or the other. However, shareholders and management will not. Wiping out shareholders and senior management will send a message to the operators of other developers, which will negatively affect their risk taking (Chart 2). Chart 1China Cannot Afford A Lehman Moment Chart 2Downside To Chinese Construction Activity   Third, one of President Xi Jinping’s key policy objectives is to tame rampant income inequality in the Chinese economy. Rapidly rising real estate prices and elevated unaffordability only worsen this problem. Hence, Beijing wants to avoid blind stimulus that mostly pushes house prices higher but that would have also boosted construction activity. Thus, if credit growth is pushed through the system, the regulatory tightening in real estate will not end. This process is likely to result in further contraction in floor space sold and started. Bottom Line: The Evergrande crisis is unlikely to morph into China’s Lehman moment. However, its fallout on the real estate industry means that Chinese construction activity will continue to contract in the coming six to twelve months or so. Chinese Construction Matters For European Equities The risk of further contraction in Chinese construction activity implies a significant near-term risk for European equities, especially relative to US ones. Even after the volatility of the past three weeks, global equities remain vulnerable to more corrective action. Speculative activity continues to grip the bellwether US market. Our BCA Equity Speculation Index is still around two sigma. Previous instances of high readings did not necessarily herald the end of bull markets; however, they often resulted in sideways and volatile trading, until the speculative excesses dissipated (Chart 3). The case for such volatile trading is strong. The Fed is set to begin its taper at its November meeting. Moreover, an end of the QE program by the middle of next year and the upcoming rotation of regional Fed heads on the FOMC will likely result in a first rate hike by the end of 2022. Already, the growth rate of the global money supply has declined, and the real yield impulse is not as supportive as it once was. Therefore, the deterioration in our BCA Monetary Indicator should perdure (Chart 4), which will heighten the sensitivity of global stocks to bad news out of China. Chart 3Rife With Speculation Chart 4Liquidity Deterioration At The Margin Chart 5Still Too Happy Investor sentiment is also not as washed out as many news stories ascertain. The AAII survey shows that the number of equity bulls has fallen sharply, but BCA’s Complacency-Anxiety Index, Equity Capitulation Indicator and Sentiment composite are still inconsistent with durable market bottoms. Moreover, the National Association of Active Investment Managers’ Exposure Index is still very elevated. When this gauge is combined with the AAII bulls minus bears indicator, it often detects floors in the US dollar-price of the European MSCI index (Chart 5). For now, this composite sentiment measure is flashing further vulnerability for European equities, especially if China remains a source of potential bad news in the coming months. Economic linkages reinforce the tactical risk to European stocks. Chinese construction activity affects the Euro Area industrial production because machinery and transportation goods represent 50% of Europe’s export to China (Chart 6). This category is very sensitive to Chinese real estate activity. Moreover, Europe’s exports to other nations are also indirectly affected by the demand from Chinese construction. Financial markets bear this footprint. Excavator sales in China are a leading indicator of construction activity. Historically, they correlate well with both the fluctuations of EUR/USD and the performance of Eurozone stocks relative to those of the US (Chart 7). Hence, if we anticipate that the problems Evergrande faces will weigh on excavator sales in the coming months, then the euro will suffer and Euro Area stocks could continue to underperform. Chart 6Europe's Exports To China Are Sensitive To Construction Activity Chart 7A Near-Term Risk To European Assets   Similarly, the fallout from Evergrande’s problem will extend to the performance of European equity sectors. The sideways corrective episode in cyclical relative to defensive shares is likely to continue in the near term. This sector twist remains frothy, and often declines when Chinese credit origination is soft (Chart 8). Materials stocks are the most likely to suffer due to their tight correlation with Chinese excavator sales (Chart 9); meanwhile, healthcare equities will reap the greatest benefit as a result of their appealing structural growth profile and their strong defensive property. Geographically, Swiss stocks should perform best (Chart 9, bottom panel), because they strongly overweigh healthcare and consumer staple names. Moreover, as we recently argued, the SNB’s monetary policy is an advantage for Swiss stocks compared to Eurozone defensives.1 Additionally, Dutch equities, with their 50% weighting in tech and their small 12% combined allocation to industrials and materials, could also enjoy a near-term outperformance as investors digest the sectoral impact of weaker Chinese construction activity. Chart 8The Vulnerability Of Cyclicals/Defensives Remains Chart 9Responses To Weaker Construction   Bottom Line: No matter how the Evergrande story unfolds, its consequence on Chinese construction activity may still cause market tremors. Global equity benchmarks may be rebounding right now, but, ultimately, they remain vulnerable to this slowdown. Any negative surprise out of China is likely to cause Europe to underperform because of its greater exposure to Chinese construction activity. Investment Conclusion: This Too Shall Pass The risks to the European equity market and its cyclicals sectors will prove transitory and will finish by the end of the year. Beijing will tolerate some pain to the real estate sector, but the stakes are too high to let the situation fester for long. The main problem is China’s large debt. Already sequential GDP growth in the first half of 2021 was worse than the same period in 2020, and credit accumulation is just as weak as in early 2018 (Chart 10). In this context, if real estate activity deteriorates too much, aggregate profits will contract and, in turn, will hurt the corporate sector’s ability to service its debt. Employment and social tensions create another stress point that will force Beijing’s hand. At 47, the non-manufacturing PMI employment index is already well into the contraction zone (Chart 11). Weakness in construction activity will hurt the labor market further. In an environment where protests have been springing up all over China, the Communist Party does not want to see more stress applied to workers. Chart 10In The End, Stimulus Will Come Chart 11Worsening Chinese Employment Conditions   These two constraints will force Beijing to alleviate the pain caused by a weaker construction sector. As a result, we still expect the Chinese credit and fiscal impulse to re-accelerate by Q2 2022. Developments outside of China will create another important offset that will allow risk assets to thrive once their immediate froth has receded. Strong DM capex will be an important driver of global activity next year. As Chart 12 shows, capex intentions in the US and the Euro Area are rapidly expanding, which augurs well for global investments. Moreover, re-building depleted inventories (Chart 13) will be a crucial component of the solution to global supply bottlenecks. Both activities will add to global demand. As an example, ship orders are already surging. Chart 12DM Capex Intentions Are Firming Chart 13Don't Forget About Inventories     We maintain a pro-cyclical stance in European markets after weighing the near-term negatives against the underlying positive forces. For now, hedging the tactical risk still makes sense and our long telecommunication / short consumer discretionary equities remain the appropriate vehicle – so does being long Swiss stocks versus Euro Area defensives. However, we will use any correction in the EURO STOXX (Bloomberg: SXXE Index) to the 430-420 zone to unload this protection. Bottom Line: The potential market stress created by a slowdown in Chinese construction activity will be a temporary force. Beijing will not tolerate a much larger hit to the economy, especially as tensions are rising across the country. Thus, even if the stimulus response to the Evergrande crisis will not be immediate, it will eventually come, which will support Chinese economic activity. Additionally, the capex upside and inventory rebuilding in advanced economies will create an offset for slowing Chinese growth. Consequently, while we maintain a pro-cyclical bias over the medium term, we are also keeping in place our hedges in the near term, looking to shed them if SXXE hits the 430-420 zone. A Big Week For Central Banks Chart 14The BoE's Is Listening To The UK's Economic Conditions... Last week, four European central banks held their policy meetings: The Riksbank, the Swiss National Bank, the Norges Bank, and the Bank of England. No major surprises came out of these meetings, with central banks discourses and policy evolving in line with their respective economies. The BoE veered on the hawkish side, highlighting that rates could rise before its QE program is over. This implies a small possibility of a rate hike by the end of 2021. However, our base case remains that the initial hike will be in the first half of 2022. The BoE is behaving in line with the message from our UK Central Bank Monitor (Chart 14). Moreover, the combination of rapid inflation and strong house price appreciation is incentivizing the BoE to remove monetary accommodation, especially because UK financial conditions are extremely easy (Chart 14, bottom panel). One caution advanced by the MPC is the uncertainty surrounding the impact of the end of the job furlough scheme this month. However, the global economy will be strong enough next spring to mitigate the risks to the UK. The results of last week’s MPC meeting and our view on the global and UK business cycles support the short EUR/GBP recommendation of BCA’s foreign exchange strategist,2 as well as the underweight allocation to UK Gilts of our Global Fixed Income Strategy group.3 The Norges Bank is the first central bank in the G-10 to hike rates and is likely to do so again later this year. While Norwegian core inflation remains low, house prices are strong, monetary conditions are extremely accommodative, and our Norway Central Bank Monitor is surging (Chart 15). The Norwegian central bank will continue to focus on these positives, especially in light of our Commodity and Energy team’s view that Brent will average more than $80/bbl by 2023.4 In this context, we anticipate the NOK to outperform the euro over the coming 24 months. Nonetheless, the near-term outlook for Norwegian stocks remains fraught with danger. Materials account for 17% of the MSCI Norway index and are the sector most vulnerable to a deterioration in Chinese construction activity. The Riksbank continues to disregard the strength of the Swedish economy. Relative to economic conditions, it is one of the most dovish central banks in the world. The Swedish central bank is completely ignoring the message from our Sweden Central Bank Monitor, which has never been as elevated as it is today (Chart 16). Moreover, the inexpensiveness of the SEK means that Swedish financial conditions are exceptionally accommodative. At first glance, this picture is bearish for the SEK. However, easy monetary conditions will cause Sweden’s real estate bubble to expand. Expanding real estate prices and transaction volumes will boost the profits of Swedish financials, which account for 27% of the MSCI Sweden index. Moreover, Swedish industrials remain one of our favorite sectors in Europe, and they represent 38% of the same index. As a result, equity flows into Sweden should still hurt the EUR/SEK cross. Chart 15...And The Norges Bank, To Norway's Chart 16The Riksbank Is Blowing Real Estate Bubbles Chart 17The CHF Still Worries The SNB Finally, the SNB proved reliably dovish. Our Switzerland Central Bank Monitor is rising fast as inflation and house prices improve (Chart 17). However, the SNB is rightfully worried about the expensiveness of the CHF, which generates tight Swiss financial conditions (Chart 17, bottom panel). Consequently, the SNB will keep fighting off any depreciation in EUR/CHF. Thus, the SNB will be forced to expand its balance sheet because the ECB is likely to remain active in asset markets longer than many of its peers. This process will be key to the outperformance of Swiss stocks relative to other European defensive equities.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1 Please see European Investment Strategy “The ECB’s New Groove,” dated July 19, 2021, available at eis.bcarsearch.com 2 Please see Foreign Exchange Strategy “Why Are UK Interest Rates Still So Low?,” dated March 10, 2021, available at fes.bcarsearch.com 3 Please see European Investment Strategy “The UK Leads The Way,” dated August 11, 2021, available at eis.bcarsearch.com 4 Please see Commodity & Energy Strategy “Upside Price Risk Rises For Crude,” dated September 16, 2021, available at fes.bcarsearch.com   Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance