Equities

Special Report

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

Executive Summary EM Equity Sentiment Is Not Very Depressed Yet Chinese A-shares have become oversold, and authorities are determined to stabilize the market. Yet, downshifting corporate profits and a selloff in global stocks are risks to A-shares’ absolute performance. Overall, we favor A-shares relative to overall EM and Chinese investable stocks, but not in absolute terms. As to China’s internet companies, even though authorities have recently promised not to introduce new regulatory measures against platform companies, the already-enacted regulations will not be reversed, and common prosperity initiatives will continue to be rolled over in the coming months and years. Nevertheless, in response to their massive underperformance, we are upgrading Chinese investable stocks from underweight to neutral within an EM equity portfolio. Investors should stay defensive on global risk assets and continue underweighting EM equities and credit. Recommendation Inception Date Return Take Profits on Short Chinese Investable Value Stocks / Long Global Value Stocks    Nov 26/20  39% Maintain Long Chinese A-Shares / Short Chinese Investable Stocks Mar 04/21 23.2% A New Trade: Long Chinese A-Shares / Short EM Stocks            Mar 23/22   Upgrade Chinese Investable Stocks with EM from Underweight to Neutral                            Mar 23/22   Bottom Line: The risk-reward profile for Chinese stocks has improved, but does not yet justify a long position in absolute terms. The outlook for A-shares is superior to that of investable TMT and non-TMT stocks. Feature Table 1The Decline In Chinese Stocks From Their Peaks In 2021 To March 22, 2022 The last two weeks have seen massive gyrations in Chinese stocks, especially in the realm of internet companies. Chinese investable internet stocks’ year-long decline went into a tailspin early this month. But, in the last several days these stocks have rebounded sharply. The selloff earlier this year was not limited to internet companies. Chinese investable non-TMT and A-shares have also tanked. Table 1 illustrates the extent to which individual Chinese equity indexes are down from their peaks in 2021 to March 22. Chart 1Our China Relative Equity Trades The relevant question for investors is whether the events of the last several weeks represent a final capitulation in Chinese stocks, creating a buying opportunity, or at least marking an end to the underperformance of Chinese stocks versus global and EM equities. It is hard to know if an ultimate buying opportunity has emerged for Chinese stocks in absolute terms. Unless global stocks have bottomed (which is not our view, see more on this below), it will be difficult for Chinese share prices to rally on a sustainable basis. However, last week was probably a watershed event, at least for some parts of the Chinese equity markets. Thus, we are making several adjustments to our investment strategy for Chinese stocks: 1. Book profits on the short Chinese investable value stocks / long global value stocks position (Chart 1, top panel). This strategy has produced a 39% gain since its recommendation on March 4, 2021. 2. Maintain the long A-shares / short investable stocks strategy recommended on March 4, 2021 (Chart 1, bottom panel). 3. A new trade: long Chinese A-shares (onshore market) / short EM stocks. Consistently, we continue to recommend overweighting Chinese A-shares within an EM equity universe. 4. For EM equity portfolios, upgrade the allocation to the Chinese investable/offshore stock index from underweight to neutral. Chinese A-Shares (Onshore Market) The risk-reward profile for the A-share market has improved because of the following: Authorities care much more about the stability of the onshore equity market, which is dominated by domestic retail and institutional investors, than about offshore listed Chinese stocks, owned primarily by international investors. Securing onshore financial market stability is one of the main objectives of government policy this year. With the A-share price index down by 27% from its peak last year, authorities will deploy all the tools at their disposal to put a floor under share prices, including purchases by the National Team, which is a group of state-linked institutions that buy stocks to preclude larger drawdowns. Foreign investor net purchases of onshore listed stocks have become deeply negative (Chart 2, top panel). Historically, such large foreign liquidation of onshore stocks marked a bottom in A-shares (Chart 2, bottom panel). A-shares have become modestly cheap, as is evidenced by our composite valuation indicator and cyclically adjusted P/E ratio (Chart 3). Chart 2Chinese A-Shares Are Oversold Chart 3Chinese A-Shares: Improved Valuation Chart 4China: Fiscal Stimulus Is At Work Importantly, the government will ramp up stimulus and the economy will recover in H2 this year. The top panel of Chart 4 demonstrates that this year the fiscal spending impulse will rise from 1% to 3.4% of GDP Special bond issuance by local governments has already accelerated in recent months and will produce a revival in traditional infrastructure spending (Chart 4, bottom panel). Finally, onshore stocks are immune to the derating of offshore Chinese stocks due to international investor concerns about potential US sanctions and delisting from US markets. The reason is that foreign investors account for a very small share of onshore stock holdings.  That said, China’s property market and COVID-19 lockdowns remain a risk to the economy and corporate profits. In fact, the improvement in the TSF impulse over the past several months has been solely due to local government (LG) bond issuance. Excluding LG bond issuance, the TSF impulse has not bottomed yet (Chart 5). This means that corporate and household credit origination have been weakening. Without a major reversal in corporate credit and the property market, a strong business cycle recovery is unlikely in China. Chart 5China: Corporate And Household Credit Has Not Improved Bottom Line: On the positive side, A-shares have become oversold, and authorities are determined to stabilize the market. On the negative side, downshifting corporate profits and a selloff in global stocks are risks to A-shares’ absolute performance. Overall, we favor A-shares in relative terms but not in absolute terms. Also, we reiterate the long A- shares / short Chinese investable stocks position initiated on March 4, 2021. A New Trade: Long Chinese A-Shares / Short EM Stocks A-share prices are set to outperform EM stocks in the coming months for the following reasons: First, domestic policy support is forthcoming for Chinese onshore stocks. Fiscal injections and an eventual improvement in credit origination will provide support to Chinese domestic demand in the second half of this year. By contrast, domestic demand in mainstream EM (excluding China, Korea, Taiwan) will remain lackluster and there will be little policy support. Latin American and EMEA countries have raised interest rates substantially and could hike them further due to surging energy and food prices. High borrowing costs will dampen their domestic demand (Chart 6). In ASEAN countries where central banks have not yet tightened policy, real interest rates remain relatively high. Also, we tactically downgraded Indian stocks to underweight last week due to potential economic growth and profit disappointments amid high energy prices and expensive equity valuations. As a whole, mainstream EM broad money growth – both in nominal and real terms – are close to record lows and will drop further (Chart 7). Chart 6Mainstream EM Domestic Demand To Weaken Chart 7Mainstream EM Broad Money Growth Chart 8Mainstream EM: The Fiscal Thrust Is Mildly Negative The fiscal thrust for mainstream EM in 2022 will be marginally negative (Chart 8). Second, at the current juncture, rising US bond yields constitute a greater risk to mainstream EM currencies and equities than to Chinese ones. The renminbi has been firm versus the US dollar, which has been appreciating over the past 15 months. This is due to China’s enormous current account surplus and lack of capital outflows. Chinese individuals and companies are reluctant to invest abroad due to fears of US sanctions amid long-term geopolitical tensions between the US and China. Meanwhile, rising US interest rates pose risks to mainstream EM currencies (Chart 9). The basis is that these mainstream EM countries still meaningfully rely on international investors (though less than in the past). The Fed’s hawkish stance and rising US interest rates will continue supporting the greenback in the near term.  Finally, the relative trend in bond yields favors Chinese onshore stocks versus the EM equity benchmark. Chinese local government bond yields have decoupled from US Treasury yields. Yet, mainstream EM domestic yields are rising along with those of the US (Chart 10). Chart 9US Dollar vs. EM And US TIPS Yields Chart 10Mainstream EM Local Yields Are Rising Rapidly Chart 11Rising Borrowing Costs Are Negative For Share Prices Falling interest rates in China will support onshore equity valuations. By contrast, rising EM local bond yields as well as EM USD corporate bond yields will suppress equity performance in mainstream EM (Chart 11). Bottom Line: We remain overweight Chinese A-shares within an EM universe. Our confidence level in this strategy has increased and, hence, we recommend a new pair trade: long Chinese A-shares / short EM equities. Investable Stocks: TMT And Non-TMT Even though authorities have recently promised not to introduce new regulatory measures against platform companies, the already-enacted regulations will not be reversed, and common prosperity initiatives will continue to be rolled out in the coming months and years. Hence, the derating/multiple compression of TMT stocks might not be over for the same reasons we have been arguing for some time: These companies are facing higher uncertainty about their business model, which entails a higher equity risk premium. Government regulation of corporate profitability like those of monopolies and oligopolies entails low equity multiples. In the government’s view, these companies should perform social duties – redistributing profits from shareholders to Chinese citizens. Beijing’s involvement in their management and the prioritization of national and geopolitical objectives over shareholder interests. Risks of delisting from US stock exchanges remain high despite some recent statements from Chinese authorities. The point is that in the long run, Chinese authorities will not accept foreign/US shareholder control of Chinese platform companies that own and manage big data. Chart 12Chinese TMT Stocks: Where Is The Technical Support? It is impossible to know at what level of share prices these risks will be properly discounted or over-discounted so a new bull market can start. When valuation indicators are not useful, we resort to technical indicators. Based on our technical work, a bear market might stop at one of very long-term moving averages. Accordingly, Chinese TMT stocks might have reached a bottom (Chart 12). As to Chinese investable non-TMT share prices (analogous to value stocks), these have fallen close to their lows of the past 12 years (Chart 13, top panel). They have also massively underperformed global and EM peers (non-TMT/value stocks) (Chart 13, middle and bottom panel). Given the potential for a revival in the Chinese economy in H2 this year, investors should avoid the temptation to become more bearish on Chinese non-TMT/value stocks as their prices fall. Their risk-reward in relative terms to other markets has improved due to the capitulation selloff, and authorities’ increased willingness to stimulate the economy more aggressively going forward. Bottom Line: The year-long bear market in Chinese investable TMT and non-TMT stocks is probably in its late innings in absolute terms. In response to their massive underperformance, we are upgrading Chinese investable stocks from underweight to neutral within an EM equity portfolio. Also, we are taking profits on our recommended position of short Chinese value stocks / long global value stocks. Overall Market Observations The selloff in global and EM equities is not over. As we argued in our March 10 report, global stocks will set a durable bottom only if oil prices drop on a sustainable basis and if the Fed backs off from tightening/US bond yields drop. Neither of these conditions have been met so far. In addition, the Ukraine crisis will intensify. Hence, the path of least resistance for global share prices is lower. The current geopolitical and macro backdrops are similar to the ones that prevailed during the Cuban missile crisis in 1962, the oil embargo of 1973 in response to the Yom Kippur War as well as the Gulf War of 1990. Based on the above three profiles, the current selloff in US stocks is not yet over (Chart 14). Chart 13Chinese Non-TMT Stocks: A Lot Of Bad News Being Discounted? Chart 14US Equity Drawdowns During Geopolitical Crises/Commodity Shocks Importantly, rapidly rising US high-yield corporate ex-energy bond yields (shown inverted in the chart) are a precursor for lower US share prices (Chart 15). All this means that non-US equities, including EM, will continue to suffer. In a nutshell, investors’ sentiment on EM equities is not very bearish to warrant a bullish stance from a contrarian perceptive (Chart 16). Chart 15Rising US Corporate Bond Yields Is A Problem For The S&P 500 Chart 16EM Equity Sentiment Is Not Very Depressed Yet   Bottom Line: Investors should stay defensive on global risk assets and continue underweighting EM equities and credit in global equity and credit portfolios, respectively. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes

Executive Summary Biden’s Low Approval On Foreign Policy   The energy shock stemming from President Biden’s foreign policy challenges could get worse, especially if US-Iran talks fail. The energy and inflation shocks condemn the Democrats to a dismal midterm election showing, even if Biden handles the Ukraine crisis reasonably well and his approval rating stabilizes. Biden’s foreign policy is still somewhat defensive, focusing on refurbishing US alliances, and as such should not force the EU to boycott Russian energy outright. Biden’s foreign policy doctrine will likely be set in stone with his imminent decision on whether to rejoin the 2015 nuclear deal with Iran. We doubt it will happen but if it does the market impact will be fleeting due to lack of implementation. Biden’s foreign policy toward China will likely grow more aggressive over time. Recommendation (Cyclical) Inception Level Initiation Date Return Long ISE Cyber-Security Index  647.53  Dec 8, 2021 -4.6% Bottom Line: President Biden foreign policy challenges are creating persistent downside risks for equity markets. Feature External risk is one of our key views for US politics in 2022. This risk includes but is not limited to the war in Ukraine. The Biden administration’s urgent foreign policy challenges are creating persistent downside risks for the global economy and financial markets in the short run – embodied in rising energy costs (Chart 1). Related Report  US Political Strategy2022 Key Views: Gridlock Begins Before The Midterms Chart 1Oil Prices And Prices At The Pump Ukraine Can Still Hurt US Stocks The Ukraine war is not on the verge of resolution – more bad news is likely to hit US equity markets. The Russian military is bombarding the port city of Mauripol, which will fall in the coming days or weeks (Map 1). Given that Mauripol is refusing to surrender, it is highly unlikely that the central government in Kiev will surrender anytime soon. Map 1Russian Invasion Of Ukraine 2022 The military situation is approaching stalemate and yet ceasefire talks are not promising. The Ukrainians do not accept Russian control of Donbas and Crimea and will need to hold a referendum on the terms of any peace agreement. Lack of progress will drive the Russians to escalate the conflict, whether by means of bombardment, troop reinforcements, or bringing the Belarussian military into the fight. The United States and its allies are increasing defense support for Ukraine while warning that Russia could use chemical, biological, or even tactical nuclear weapons. In our sister Geopolitical Strategy service we argue that the war to get worse before it gets better, with Russia determined to replace the government in Kiev. US investors should expect continued equity market volatility. US and global growth expectations are yet to be fully downgraded as a result of the global energy shortage – the Fed now expects GDP growth of 2.8% while the Atlanta Fed shows GDP clocking in at 1.3%, well below consensus expectations (Chart 2). Corporate earnings will suffer downgrades as a result of higher energy costs. The Federal Reserve just started hiking interest rates and it is not discouraged by foreign affairs. Real rates will rise. Chairman Jerome Powell sounded a hawkish tone by saying that he is willing to hike by 50 basis points at a time if required. The threat of a wage-price spiral is real. The 2-year/10-year Treasury slope is on the verge of inverting. The Fed’s new interest rate projections suggest that the interest rate will rise above the neutral rate in 2023-24. Chart 2Growth Will Take A Hit Ukraine’s Impact On The Midterm Elections A negative foreign policy and macroeconomic background will compound the Democratic Party’s woes in the midterm elections. Biden’s approval rating is languishing at Donald Trump levels, yet without Trump’s high marks on the economy (Chart 3). Biden will not be able to turn the economy around because even if inflation starts to abate, voters will react to the one-year and two-year increase in inflation rather than any month-on-month improvement. Republicans have pulled ahead of Democrats in generic congressional ballot opinion polling (Chart 4). Even if Biden’s ratings stabilize ahead of the midterms (even if he handles Ukraine well), Democrats face a shellacking. The market is rightly priced for Republicans to take over all of Congress, though the GOP’s odds of taking the Senate are lower than consensus holds (Chart 5). A Republican victory is not negative for US corporate earnings but uncertainty over the general direction of US policy will continue to weigh on the equity market this year. Chart 3Biden’s Approval Ratings Chart 4Republicans Take The Lead Biden’s foreign policy can and will get a lot more aggressive if the Democratic Party views its election odds as so dismal that foreign tensions come to be seen as a source of badly needed popular support. That is not yet the case but developments with Russia and Iran could force the administration to adopt a more offensive foreign policy, which would be negative for financial markets. Hence investors will have to worry about rising policy uncertainty over the 2022-24 political cycle. Chart 5Midterm Election Odds Biden’s Policy Toward Russia And Europe It is too soon to say precisely what is the “Biden Doctrine” of foreign policy. The withdrawal from Afghanistan and the war in Ukraine were thrust upon Biden. What will define his foreign policy is how he handles Russia, Iran, and China going forward. By the end of the year, Biden will have forged his foreign policy doctrine, for better or worse. Biden began with a defensive foreign policy. His administration’s primary intention is to refurbish US alliances in Europe and Asia to counter Russia and China. Consider: In 2021, Biden condoned Germany’s deepening economic and energy integration with Russia (i.e. the Nord Stream II pipeline). Russia’s invasion forced Germany to change its mind and join the US and other democracies in imposing harsh sanctions on Russia. Even so, the US is calibrating its actions to what the European allies can stomach. Biden is attempting to negotiate new trade deals with allies, by contrast with President Trump’s tendency to slap tariffs on allies as well as rivals.1 Biden is likely to try to revive the Transatlantic Trade and Investment Partnership (TTIP) with Europe, he is scheduled to restart talks with the UK about a post-Brexit trade deal, and he will probably attempt to rejoin the Trans-Pacific Partnership (CPTPP) in future. Now that Russia has invaded Ukraine, Biden’s foreign policy is becoming more aggressive, albeit still within certain limitations: The US is not willing to send troops to defend Ukraine or impose a no-fly zone, which would trigger direct conflict with Russia. But the US is continuing to provide Ukraine with lethal weapons, which helped precipitate the war. Congress recently voted to increase Ukraine aid by $13.6 billion, including $6.5 billion in defense support, including drones, Stinger anti-aircraft missiles, and Javelin anti-tank missiles. These are supposed to start arriving in Ukraine in a few days. The US is reportedly looking into providing Ukraine with Soviet-era SA-8 air defense, though not the S-300s missile defense.2 The US is bulking up its military presence across Europe to deter Russia from broadening its attacks beyond Ukraine. Biden has declared a red line in that he will defend “every inch” of NATO territory. This means that a single Russian attack that spills over into Poland or another NATO country will precipitate a new and bigger crisis (and financial market selloff). The risk going forward is that American policy could grow increasingly aggressive to the point that tensions with Russia escalate. Unlike Russia and Europe, the US does not have vital national interests at stake in Ukraine. American national security is not directly threatened by the war there. Hence the US can afford to take actions that its European allies would prefer not to take. As long as Biden prioritizes solidarity with the Europeans, geopolitical risks may be manageable for the markets. But if Biden attempts to lead an even bolder charge against Russia (or China), then risks will become unmanageable. So far Biden is allowing Europe to impose sanctions at its own pace and intensity. The Europeans must tread more carefully than the US, lest sanctions cause a broad energy cutoff that plunges their economy into recession along with Russia’s. This would destabilize the whole Eurasian continent and increase the chances of strategic miscalculation and a broader military conflict. Europe has opted for a medium-term strategy of energy diversification while avoiding the US’s outright boycott of Russian energy. The EU depends on Russia for 26% of its oil and 16% of its natural gas imports (Chart 6). The dependency is higher for certain countries. Germany, Italy, Hungary, and others oppose an outright boycott – and a single EU member can veto any new sanctions. Theoretically the Europeans could ban oil while still accepting natural gas. Natural gas trade routes are fixed due to physical pipelines, whereas oil is more easily rerouted, leaving Russia with alternatives if Europe stops importing oil. But Russia exports 63% of its oil to developed markets and 65% of its natural gas, with the bulk of that going to the European Union at 48% and 15% respectively (Chart 7). Russia’s economy would suffer from an oil ban and it would assume that a natural gas ban would soon follow, which could unhinge expectations that war tensions can be contained. Chart 6EU Mulls Boycott Of Russian Oil Chart 7Russian Regime Depends On O&G Given the damaged state of the Russian economy and high costs of war, Moscow will probably keep accepting energy revenues as long as Europe is buying. But if it believes Europe will cut off the flow, then it has an incentive to act first. This is a risk, not our base case. Still, as Russia targets the capital Kiev with intense shelling and civilian casualties increase, US pressure for an expansion of sanctions will increase. This is the risk that investors need to monitor. If the US brings the EU around to adopting sanctions on Russian energy then equity markets will plunge anew. And since Europe is diversifying over time anyway, Russia will have to escalate the war now to try to achieve its aims before its source of funds dries up. Biden’s Policy Toward China Biden’s foreign policy also started out defensively with regard to China. Biden intended to stabilize relations, i.e. engage in some areas like climate policy and avoid expanding President Trump’s trade war. Both the Democratic Party and the Communist Party face important political events in 2022 and their inclination is to prevent global instability from interfering. But the Ukraine war has made this goal harder. As with Europe the immediate question is whether Biden will try to force China to cooperate on Russia sanctions. But in China’s case Biden is more likely to use punitive measures – at least eventually. After a two-hour bilateral phone call on March 18, Biden “described the implications and consequences if China provides material support to Russia as it conducts brutal attacks against Ukrainian cities and civilians.”3 Biden’s threat of sanctions is a negative for Chinese exporters and banks (Chart 8). Chinese stock markets were already suffering from China’s historic confluence of internal and external political and economic risks. The Ukraine war has increased the fear of western investors that investing in China will result in stranded capital when strategic tensions rise explode, as with Russia. Chart 8Biden Threatens China With Sanctions Economically, China is much more dependent on the West than Russia. While Germany and Russia take a comparable share of Chinese exports, at 3.4%and 2.0% respectively, the EU takes up more than three times as many Chinese exports as the Commonwealth of Independent States, at 15.4% versus 3.2% (Chart 9A Chart 9B). China was never eager to commit to an exclusive economic relationship with Russia at the expense of its western markets. Strategically, however, China cannot afford to reject Russia. Chart 9AEU Wary Of Targeting China Chart 9BEU Wary Of Targeting China   Russia has now severed ties with the West and has no choice but to offer favorable deals to China on the whole range of relations. China’s greatest strategic threat is US sea power; Russia offers a strategically vital overland source of natural resources. Russia also offers intelligence and security assistance in critical regions like Central Asia and the Middle East that China needs to access. Like Russia, China fears US containment policy and views US defense relations with its immediate neighbors as a fundamental national security threat. President Biden reassured China that US policy toward the Taiwan Strait has not changed but also said that the US opposes any unilateral attempt to change the status quo. The implication is that China will segregate its EU and Russia networks of trade and finance to minimize the impact of any US secondary sanctions. China will offer Russia some assistance while making diplomatic gestures to maintain economic relations with Europe. The Europeans will lobby the Americans not to expand sanctions on China. The Biden administration will be reluctant to increase sanctions on China immediately, since it wants to maintain global stability in general, control the pace of rising global tensions, and maintain maneuverability for immediate problems with Russia and Iran. Biden’s priority is to rebuild US alliances and Europe will be averse to expanding the sanction regime to China. Therefore any sanctions on China will come only slowly and with ample warning to global investors. But sanctions are possible over the course of the year. If the Biden administration concludes that it has utterly lost domestic support, that the midterm elections are a foregone conclusion, then it can afford to get tougher in the international arena in hopes that it can improve its standing with voters. Biden’s Policy Toward Iran While Afghanistan and Ukraine were thrust upon Biden, the major foreign policy challenge in which he retains the initiative is whether to rejoin the 2015 nuclear deal with Iran. Thus it may be policy toward Iran and the Middle East that defines the Biden doctrine. The Ukraine war has not stopped the Biden administration from seeking to rejoin the 2015 Joint Comprehensive Plan of Action, which was a strategic US-Iran détente that sought to freeze Iran’s nuclear program in exchange for its economic development. The original nuclear deal occurred with Russia’s blessing after the US and EU overlooked Russia’s invasion of Crimea. Now negotiations toward rejoining that deal are reaching the critical hour. The US has supposedly offered Russia guarantees to retain Russian support. The reason for Biden to rejoin the 2015 deal is to open Iran’s oil and natural gas reserves to the global and European economy and thus mitigate the global energy shock ahead of the midterm elections. Iran could return one million barrels per day to global markets. There is also a strategic logic for normalizing relations with Iran: to maintain a balance of power in the Middle East, reduce US military commitment there, provide Europe with greater security, and free up resources to counter Russia and China. Whether the deal will fulfill these ends is debatable but the Biden administration apparently believes it will. Biden is capable of rejoining the deal because the critical concessions do not require congressional approval. Through executive action alone, Biden could meet Iran’s demands: sanctions relief, delisting the Iranian Revolutionary Guard Corps as a terrorist organization, and ensuring that Russo-Iranian trade (especially nuclear cooperation) is not exempted from the new Russia sanctions. There will be domestic political blowback for each of these concessions but not as much as there will be if gasoline prices continue to rise due to greater global instability stemming from the Middle East. The Iranians are also capable of rejoining the deal. Supreme Leader Ali Khamenei, in his Persian New Year speech, gave a green light for President Ebrahim Raisi’s administration to pursue policies that would remove US sanctions. Khamanei implied that Iran should let the West lift sanctions while continuing to fortify its economy to future US sanctions.4 While the US and Iran are clearly capable of a stop-gap deal, it will not be a durable agreement – and hence any benefits for global energy supply will be called into question. The reason is that the underlying strategic logic is suffering: Biden will appear incoherent if he alienates Saudi Arabia and the UAE while appealing to them to increase oil production – and they are more capable than Iran on this front (Chart 10). Biden will appear incoherent if he agrees to secure Russo-Iranian trade at the same time as he seeks to cut Russia off from all other trade. Biden may not achieve a reduction in regional tensions through an Iran deal, since Israel insists that it is not bound to the nuclear deal. If Iran does not comply with the nuclear freeze, Israel will ramp up military threats. The Iranians cannot trust American guarantees that the next president, in 2025, will not tear up the nuclear deal and re-impose sanctions on Iran. The Iranians need Russian and Chinese assistance so they cannot afford to embark on a special new relationship with the West. Ultimately the Iranians are highly likely to pursue deliverable nuclear weapons for the sake of regime survival, as our Geopolitical Strategy has argued. Chart 10US-Iran Deal Will Not Be Durable   Thus Biden may choose a deal with Iran but we would not bet on it. Moreover any stop-gap deal will be undermined in practice, so that the investment repercussions will be ephemeral. If Biden fails to clinch his Iran deal as expected, then the world faces an even larger energy shock due to rising tensions in the Middle East. Investment Takeaways The Biden administration’s foreign policy challenges will compound its macroeconomic challenges and weigh on the Democratic Party in the midterm elections. The war in Ukraine will hurt Biden and the Democrats primarily because of the energy shock. The energy shock will get worse if Biden fails to agree to a stop-gap deal with Iran. But we expect either the US or Iran to back out for strategic reasons. With Republicans likely to reclaim Congress this fall, US political polarization will remain at historically high levels over the course of the 2022-24 election cycle. However, Russia’s belligerence underscores our view that rising geopolitical threats will cause the US to unify and reduce polarization over the long run. The war reinforces our US Political Strategy themes of “Peak Polarization” and “Limited Big Government,” as a new bipartisan consensus is forming around the view that the federal government should take a larger role in the economy to address national challenges both at home and abroad. One of our cyclical investment ideas stemming from these themes is to buy cyber-security stocks. President Biden warned US government and corporations on March 21 that Russia could stage cyber attacks against the United States and that private businesses must be prepared. Cyber stocks have suffered amid the general rout in tech stocks but they are starting to recover. Year to date, they are outperforming the S&P 500, and the tech sector, and look to be starting to outperform defensive sectors (Chart 11). Chart 11Biden Warns Of Cyber Attacks   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com     Footnotes 1     See Yuka Hayashi, “U.S., U.K. Strike Trade Deal to End Tariffs on British Steel and American Whiskey”, Wall Street Journal, March 22, wsj.com 2     See Nancy Youssef and Michael Gordon, “U.S. Sending Soviet Air Defense Systems It Secretly Acquired to Ukraine”, Wall Street Journal, March 21, wsj.com. 3    White House, “Readout of President Joseph R. Biden Jr. Call with President Xi Jinping of the People’s Republic of China,” March 18, 2022, whitehouse.gov. 4    Ayatollah Ali Khamenei implied at his Persian New Year speech that a deal with the Americans could go forward. He emphasized the need to improve the economy and implied that some of the economic burdens will go away starting this year. He pointed to a way forward with US sanctions intact, while also saying that he did not discourage attempts to remove sanctions. “We should not tie the economy to sanctions... It is possible to make economic advances despite U.S. sanctions. It is possible to expand foreign trade, as we did, enter regional agreements and have achievements in oil and other areas … I never say to not go after sanctions relief, but I am asking you to govern the country in a way in which sanctions do not hurt us.” See “Iran's Khamenei Says Economy Should Not Be Tied to U.S. Sanctions,” Reuters, March 21, 2022, usnews.com.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets

Executive Summary Table 1Equity Capitulation Scorecard We have put together a framework to capture the extent to which recent economic and political developments have been priced in by the equity market.  It has seven criteria: Rate stabilization has not materialized yet, monetary conditions will continue to tighten Economic growth expectations do not yet reflect the deteriorating economic backdrop.  US GDP forecasts will be downgraded which will be a drag on equity performance Earnings growth expectations need to come down to reflect supply disruptions, raging input prices, and the stronger dollar Oil prices have stabilized which provides support for US equities Valuations have retraced, signaling that the market is reasonably priced Technicals signal that the market is oversold “Black swans”: The effects of the war in Ukraine will be a drag on US equities and are not yet fully priced in.  However, China’s pledge to be more investor-friendly is a positive. On balance, risks for US equities slightly outweigh the upside opportunity. Bottom Line: Although many ingredients for a sustainable rally are already in place, our analysis concludes that US equities have not hit rock bottom yet, and time is needed to resolve remaining headwinds. Feature The S&P 500 and NASDAQ are in correction territory, having pulled back 13% and 22%, respectively from their peak. Over the past few months, investors had to process a witches’ brew of staggering inflation, impending monetary tightening, and a war in the heart of Europe. Too much! Related Report  US Equity StrategyAre We There Yet? However, over the past couple of days, US equities have staged an aggressive rally: The S&P rebounded 5.5% and the NASDAQ 8%. While we are long-term investors and don’t focus on short-term market moves, we find a recent market turn a good excuse to take a close look at US equities and gauge whether this recent rally is a “dead-cat bounce” or the market has truly bottomed and is in the early stages of a recovery rally. To do so, we have put together a framework to capture the extent to which recent economic and political developments have been priced in by the equity market. “Equity Capitulation” Framework Historically, equities bottomed when bad news had been reflected in expectations, valuations had come down to reflect the new economic reality, and investors had capitulated. Here are our criteria for an equity rebound this economic cycle: Monetary tightening has been priced in and rates have stabilized Economic growth expectations have been downgraded Energy prices have normalized Earnings growth expectations have come down and earnings are unlikely to surprise on the downside Investors have capitulated and sentiment is rock-bottom Valuations have lost their “good times” froth and are attractive There are resolutions of the geopolitical factors that have contributed to market turmoil In this report, we will go through each of the criteria and do our best to gauge whether “we are there yet.” Pricing In Tighter Monetary Policy – Rate Stabilization Is Still Elusive The recent correction of US equities reflects a repricing due to tighter monetary policy. The million-dollar question is how much monetary tightening is priced in and when will rates stabilize? To our minds, this is one of the key conditions for a sustainable bull market. Last week, the Fed raised rates for the first time since 2018. This first rate hike is 0.25 - 0.50, which did not come as a surprise and was broadcast well in advance. The latest dot plot also signals that the Fed expects the target rate to reach 1.75% by the end of 2022, i.e., six more hikes are expected this year. However, a day after the announcement, the market is pricing eight to nine rate hikes (Chart 1), with the Fed rate ending the year at 2.25-2.5%. Thus, the market expects aggressive Fed action and is likely to be positively surprised when the Fed takes a more measured approach than anticipated. This is certainly positive for equities.   Chart 1The Market Is Pricing More Hikes In 2022 Then The Fed Chart 2Monetary Conditions Will Continue To Tighten However, despite the market coming to terms with an aggressive hiking schedule, monetary conditions are still easy (Chart 2), and real rates are negative. With the Fed’s emphasis on combating inflation, it is reasonable to expect that monetary conditions will continue to tighten, and real rates will rise. Also, nominal rates don’t yet show any signs of stabilization either (Chart 3). What does this mean for equities? Empirical analysis demonstrates that it takes around three months after the first hike for equities to adjust to a new monetary regime and deliver positive returns (Chart 4). Chart 3Rates Have Not Stabilized Yet Chart 4Adjusting to A Tighter Monetary Regime Takes Time Monetary conditions are likely to tighten further. Rate stabilization, which we are looking for, has not materialized just yet. On a positive note, we don’t expect any negative surprises from the Fed. Forecasts Need To Reflect Slowing Economic Growth According to the Bloomberg consensus, economic growth expectations for 2022 are still robust and have not been substantially downgraded (Chart 5). The market still expects the US economy to grow at 3.55%, compared to 3.8% in January, despite monetary tightening, falling ISM PMI readings (Chart 6), and soaring energy costs. The Fed is more realistic about the effects of its policy on economic growth, changing expectations from 4% to 2.8%. The logical conclusion is that more GDP growth downgrades are on the way. The latest reading of the Atlanta Fed stands at only 1.3%. Chart 5Economic Forecasts Do Not Yet Reflect Deteriorating Macro Backdrop Chart 6Surveys Signal Growth A Slow Down It is also important to note that both the direct and indirect effects of the war in Ukraine are yet to be reflected in US growth forecasts: Since the beginning of the war, the GSCI Commodities index has increased by 11%. One might argue that soaring commodity prices are a temporary phenomenon and forward curves signal eventual reversion to long-term averages. However, this may take months and even years, and by then, most of the stockpiles and hedges are likely to run out. Growth expectations are likely to fall, or worse yet, economic growth may surprise on the downside. Earnings Expectations Need To Come Down Similar to economic growth forecasts, bottom-up earnings growth expectations have barely budged (Chart 7): The market is still expecting about 9% earnings growth over the next 12 months. However, global supply disruptions and raging input prices are bound to cut into corporate profitability and slow earnings growth. Chart 7Earnings Expectations Have Not Budged To make things worse, the US dollar has appreciated by nearly 10% since the beginning of 2021 (Chart 8). Since companies in the S&P 500 derive 40% from abroad, the strong greenback is bound to translate into softer overseas profits, cutting into the profitability of US multinationals. The effect of a stronger currency will be further exacerbated by the withdrawal of US companies from Russia to protest the war in Ukraine. While most US companies have limited exposure to Russia, there are some that will take a hit: For example, Philip Morris derives 8% of sales from that market. McDonald’s announced that closing its restaurants in Russia will cost $50 million a month or 9% of annual sales. While it is hard to accurately gauge the effect of the war and self-sanctions on US corporate profits, on the margin it is definitely a negative. Chart 8Dollar Has Strengthened Significantly Earnings growth expectations have barely budged, and do not reflect a surge in commodity prices, a war, and slowing economic growth. We posit that downgrades are highly likely, and will be a drag on US equity performance. Oil Prices Have Stabilized The key channel for the war in Ukraine to affect the rest of the world is through the supply of energy. High energy prices present an economic danger because they touch every facet of the economy. Goldman Sachs estimates that spiraling electricity prices have already taken down 900,000 tonnes of aluminum capacity and 700,000 tonnes of zinc capacity in Europe. Certainly, in the past, a jump in the oil price has often been associated with recessions and negative equity returns (Chart 9). Therefore, we consider it a major shot in the arm that the WTI has come down from $130 to $105 on the back of lockdowns in China. This hiatus gives policymakers and oil producers time to negotiate deals and restart production – the onus is on US shale producers and Gulf nations. However, the long-term resolution is yet to be seen. Chart 9Oil Price Increases Have Been Associated With Negative Equity Returns Oil price stabilization provides solid support for US equity performance. Valuations – No Longer An Excuse Not To Buy The correction in US equity markets has taken the froth off valuations: The S&P 500 forward multiple has come down from roughly 23x to 19x earnings (Chart 10), with all of the change attributable to multiple contraction. The BCA S&P 500 Valuation Indicator shows that the index is no longer “overvalued” (Chart 11). Outright cheap? No. But valuations can no longer be an excuse not to buy. Also, there are multiple corners of the market that are outright cheap – lots of bottom fishing is already taking place. Chart 10Valuations Have Moderated Chart 11The S&P 500 Is No Longer Overvalued...   Valuations have moderated and the market is reasonably priced. Technicals – The Market Is Oversold While valuation multiples may contract further, most technical and sentiment indicators are flashing capitulation. The AAII Investor Bull/Bear Sentiment Indicator is below its March 2020 reading while the BCA Technical Indicator has shifted towards the oversold zone (Chart 12). It is important to note that this indicator is driven primarily by momentum components – its reading is oblivious to the top-heavy index composition and reflects prospects for large caps. A useful way to look under the index’s hood is to consider the number of stocks that retraced from their highs, currently over 95% of NASDAQ stocks have retraced  (Chart 13). This high a reading flashes that the market is oversold, and there are lots of bargains to be had. Chart 12...Or Overbought Chart 13Majority Of Stocks Are Oversold   Technicals indicate an oversold market. Black Swans Have Landed The war in Ukraine: Optimism about a potential peace deal between Russia and Ukraine seems premature – the conflict is just getting started and neither side will be backing off until it has to surrender unconditionally. However, while the war is contained in Ukraine, and Russian gas is flowing to Europe, any crisis in the equity market would be averted. The war in Ukraine will remain a headwind to global equities for a while. And while the US equity market is insulated from the direct consequences of the crisis, indirect effects will continue to reverberate through its economy for now. The direct and indirect effects of the war in Ukraine will be a drag on US equities and are not yet fully priced in. China pledged to keep capital markets stable and vowed to support overseas stock listings, indicating that regulation of Big Tech will end soon. In addition, it promised to offer support for property developers to minimize their risks. And China’s pledge to be more investor-friendly is believable as in its current stage of economy and with the onset of COVID, the government is in dire need of propping up both the economy and the stock market. Of course, China still presents great uncertainty associated with lockdowns. This is a positive for the US market as there are a number of Chinese companies listed on the US stock exchanges. Putting It All Together Our Equity Capitulation scorecard has seven different criteria, as discussed above. According to our assessment of the economic and market environments, there are two factors that signal near-term equity rebound: Investor capitulation or Technicals, and Energy prices. However, there are still headwinds: Monetary conditions will continue to tighten, economic and earnings growth expectations will be downgraded, and the war in Ukraine is unlikely to end soon. On balance, risks for US equities slightly outweigh the opportunity. The final score is -1, which indicates a mildly negative stance on US equities (Table 1). However, most of the outstanding negatives are likely to be resolved soon (i.e., downward revisions of expectations). Table 1Equity Capitulation Scorecard Investment Implications Our equity capitulation indicator signals that cautious investors should continue to be underweight equities on the back of monetary tightening, slowing growth, and upcoming downward revision cycles. While Technicals and valuations make equities tempting, volatility in equities is likely to continue, and rallies will probably be short-lived. As always, long-term investors have more latitude in investment decision-making, and we believe that the long-term outlook for equities is positive. Bottom Line Our analysis concludes that US equities have not hit rock bottom yet, although many ingredients are already in place: Valuations are attractive, and equities are outright oversold. While buying equities at these levels is tempting, we recommend patience: Economic growth expectations are still elevated, and bottom-up earnings growth forecasts need to come down to reflect slowing growth and the direct and indirect effects of the war in Ukraine.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation