Geopolitics

Executive Summary   US Support For A Military Coup? A confluence of structural and cyclical factors makes the US highly prone to social and political instability, as in 2020. Today’s stagflationary economic environment further amplifies domestic political risk. The Biden administration’s decision to pursue a criminal investigation of former President Trump will drive political polarization higher, as will the overall 2022-24 political cycle. Investors should expect negative surprises from US politics, including social unrest, political violence, and domestic terrorism of whatever stripe. Such crisis events usually cause only a short-term spike in financial market volatility. A major crisis that affects election results could have a more lasting impact. The base case for US policy in 2023-24 is gridlock, which is marginally disinflationary. It would take an extraordinary surprise to change that.  On a relative basis, US assets benefit from domestic political risk because geopolitical risk rises even faster. Recommendation (Tactical) INITIATION DATE Return Long DXY (Dollar Index) Feb 23, 2022 10.8% Bottom Line: Investors should expect volatility and negative “October surprises” in the short term, at least through the midterm elections. US domestic political risk is high and will also amplify global geopolitical risk. Feature The US’s rolling political crisis is escalating again and political violence is likely to rise in the lead up to the midterm elections on November 8 and the presidential election in November 2024. The Department of Justice (DoJ) refused on August 15 to release the affidavit underpinning the Federal Bureau of Investigation’s (FBI) raid on former President Trump’s Mar-a-Lago residence in Florida. Never before has a US president suffered a raid on his home by the country’s federal law enforcement agencies – though presidents have been investigated before. It is not yet clear what charges will be brought against Trump but it is highly likely that he will be indicted for something. The Justice Department released a redacted version of the search warrant suggesting that Trump may be accused of having kept state secrets at his home in violation of the Presidential Records Act and possibly also the 1917 Espionage Act. Speculation says that some information he took back from the White House relates to nuclear weapons.1 The DoJ is pursuing a criminal investigation. The former president could very well end up on trial, or even in jail, but it is also possible that changes in political power will prevent him from going. What are the investment implications, if any? The US will see significant social and political upheaval but the main investment implication is that the US will continue to play an unpredictable and disruptive role abroad, perpetuating a flight to safety in financial markets, at least until the midterm elections are over.  Drivers Of US Political Instability The US political crisis should first be seen through the lens of geopolitics: The US is a continent-sized nation that is separated from the other world powers by large oceans. It is therefore highly defensible and economically insulated, with total exports accounting for only 10.2% of GDP.  However, this insularity and relative security create space for a fast growing and evolving society that is primarily focused on doing business rather than strengthening the state. The rapid creation of wealth is good but also produces large disparities in region, class, and race that periodically undermine stability. Maintaining domestic stability across the continent would be a constant challenge even if the government were not a federal republic with short political cycles driven by fickle popular opinion. Freedom is a source of political contention as well as wealth creation.   Over the past 70 years the society has become less religious and more secular, while the economy has become less manufacturing-oriented and more service-oriented. The shift to a high-tech and information-driven society has empowered the highly educated at the expense of the less educated. Capital owners have benefited from rising asset values, deregulation, and globalization, while labor has witnessed stagnant real wages. Agricultural and manufacturing regions have fallen behind.  Social stability is especially hard to maintain during cyclical periods of economic distress, highlighted today by the rising Misery Index (Chart 1). While inflation may subside in the short run, it will probably persist in the long run, and unemployment has nowhere to go but up. There is a demographic and generational factor that is also driving US instability today: The Baby Boom generation did not begin their adult lives with a robust policy consensus, like their parents’ generation, which shared sacrifices during the Great Depression and World War II. Instead the Boomers began with deep divisions due to the Vietnam War and social revolution of the 1960s. As they grew in wealth and power in the 1980s-90s, pro-growth tax policy, deregulation, and rapid socioeconomic changes aggravated these divisions. Inequality surged  (Chart 2). The Iraq War and 2008 financial crisis made matters worse. Chart 1US: High Misery Index Chart 2US: High Inequality Now the elites of this generation, who lead the two major parties, are trying to secure their economic and political interests before retirement and death. Bluntly, the pro-business faction is trying to prevent the pro-government faction from clawing back its wealth. Political polarization has reached the highest level since the early twentieth century (Chart 3). While polarization has subsided from the peaks of 2020, it could still exceed those peaks in the 2022-24 political cycle. The US will remain at or near “peak polarization” until generational change and geopolitical conflicts forge a new policy consensus. Bottom Line: The US is geopolitically secure but periodically struggles to maintain domestic stability. Today it is witnessing a confluence of structural and cyclical factors that generate social unrest and historic levels of political polarization. The 2022-24 election cycle will be tumultuous. Chart 3US: Peak Polarization Disaffection Can Lead To Violence Any kind of fanaticism can lead to violent extremism. Militants have emerged from secular movements on the right and left, from communism to fascism, as well as from religious movements.2 In recent years the US has seen a rise in violence, including crime and terrorism. Mass shootings have spiked since the 2008 financial crisis. Terrorism has revived to the highest levels since the 1980s, 96% of which is domestic terrorism (Chart 4). Recent improvements to the social safety net may or may not reduce violence. The stagflationary economic backdrop bodes ill. Opinion polls are of dubious accuracy when they ask people to admit to militant or criminal inclinations, but they still take the temperature of society. Several recent polls suggest that as many as 25% of Americans are willing to consider violence as a means of resolving political problems (Chart 5). Chart 4US: Domestic Terrorism, Political Violence Chart 5US Support For Political Violence? In addition, 55% of Republicans and 40% of independents claim that a military coup could be justified when there is “a lot of corruption,” a subjective standard to say the least (Chart 6). While this number has spiked over the 2020 election cycle, it also shows a substantial pre-existing willingness to entertain authoritarian solutions to political disputes. We do not take these polls at face value given the difficult subject matter. When a major violent event occurs and real people die, popular “support” for political violence will collapse across the United States. Nevertheless these data suggest a high level of disaffection and discontent, which is supported by the structural socioeconomic problems cited above.   Chart 6US Support For A Military Coup? The January 6, 2021 incident at the US Capitol was the crescendo of an explosion of social unrest that occurred across the country in 2020, triggered by the aforementioned structural factors, the Covid-19 pandemic, race riots, and political conflict over the 2020 election. The number of homicides rose to 7.4 per hundred thousand people, the highest annual number since the 1990s, higher than in 2001 when the 9/11 terrorist attacks occurred, and reminiscent of the turbulent late 1960s. This year’s midterm elections will be the first major electoral test since the chaotic events of 2020 and none of the underlying drivers of unrest have been resolved. On the contrary, recent signs are pointing to another escalation of social and political upheaval. The 2024 election will also spark unrest and violence. Bottom Line: The number of violent incidents is rising while a substantial minority of public opinion appears willing to entertain violent means of resolving political disputes. From Reality TV To Real Rebellion? The FBI’s raid on Trump’s Mar-a-Lago estate is naturally triggering a backlash from Trump supporters and Republicans. These groups were already distrustful of the federal government and particularly the FBI for spying on the Trump presidential campaign in the 2016 election.3 Republican support for the FBI and DoJ will fall sharply from its current level in opinion polling taken in 2019 (Chart 7, top panel). Trump opponents will argue that Trump is being investigated because of wrongdoing while Trump supporters will think that the Biden administration is trying to prevent him from running for re-election in 2024. Any lack of transparency by the Justice Department will heighten suspicion and acrimony. Chart 7US Views On 2021 Rebellion A fraction of radicalized Trump supporters could be motivated by this extraordinary event to conduct attacks. Already an armed suspect, allegedly linked to a right-wing extremist group and to the January 6 rebellion at the Capitol, attempted to storm an FBI field office in Cincinnati, Ohio. The Department of Homeland Security and FBI have warned about the risk of domestic terrorism for several years and have issued a new warning since the FBI raid on Mar-a-Lago.4 There is no easy way to resolve the dispute over the 2020 election or the January 6 rebellion because these events have taken on mythic status in the eyes of the different factions. For about half of Republicans, the January 6 incident was a patriotic defense of freedom – rather than an insurrection or attempt to prevent the peaceful and democratic transfer of power (Chart 7, bottom panel). Some small portion of those who view the election as stolen could become radicalized and act out violently. Trump received 46% of the popular vote in 2016 and 47% in 2020 (Chart 8). His favorability has suffered since the January 6 events but not as much as one might think. Among Republicans, Trump’s favorability remains largely unperturbed (Chart 9). While the vast majority of these voters are law-abiding, the decision to raid Trump’s home, and any future decision to press criminal charges, will drastically increase the risk of radicalization on the fringes. Chart 8Trump’s Share Of Popular Vote Chart 9Trump’s Popular Support Post-2020 It does not take a social scientist to recognize the potential for an increase in political violence if the federal government is perceived as using the arm of the law to prevent a popular candidate from contesting past or future elections. The risk of political violence cannot be dismissed because the US is a particularly well-armed country. There were 120 civilian-held firearms per 100 persons in the United States as of 2017. By contrast, the nearest country is France, with only 20 firearms per 100 persons (Chart 10). That does not mean that a major incident of violence will necessarily stem from the right wing. Only five years ago an extremist left-wing gunman tried to assassinate a whole group of Republican lawmakers while they were playing baseball. Earlier this year the Department Homeland Security warned about violent reactions to the Supreme Court’s overturning of the Roe v. Wade decision on abortion.5 If and when a major incident of political violence occurs, the public reaction will be a powerful rejection of violence across the political spectrum. For example, President Bill Clinton’s administration benefited from the Oklahoma City bombing in 1995 (Chart 11). Much will depend on the nature of the attack and which faction is most able to capitalize on its victimization. Chart 10Right To Bear Arms Shall Not Be Infringed Chart 11OKC Bombing Spurred Rally Round The Flag Ultimately instability will generate a popular consensus opposed to political violence and supportive of law and order, just as it did in previous periods of American upheaval. The future policy consensus will be “federalist” in orientation due to America’s geopolitics: there will be an increasing need to unify the states to achieve other strategic imperatives like prosperity and national security. We call this theme “Limited Big Government.” This re-centralization process will involve the federal government intervening to stabilize the society. It is not obvious which political party will first capture this consensus. It depends on the nature and timing of any crisis events and the cyclical rotation of parties. Bottom Line: The US is a heavily armed country that is currently prone to social and political instability. The risk of political violence and domestic terrorism of whatever stripe is already very high. In addition, a substantial portion of the country’s right-wing faction believes that the 2020 election was stolen, that the January 6 rebellion was justified, and that the federal government is now abusing its law enforcement powers to prevent a candidate from running in 2024. Domestic terrorism risk will increase.   Implications For The 2024 Election Federal agencies were well aware of the risk of a domestic backlash when they decided to raid Mar-a-Lago. Investigators may or may not produce ironclad evidence of wrongdoing by Trump, but polarization will continue to be the overriding dynamic in the short run. It is unlikely that any evidence will convince the different parties to change their opinions of Trump.    Assuming Republicans retake the House of Representatives this fall, they will likely impeach Biden, though they will lack the votes in the Senate to remove him from office. US domestic policy will be effectively paralyzed as the partisan conflict continues. The 2024 election will be required to settle the Trump saga and the future direction of US national policy. Trump’s legal troubles could be a blessing or a curse for the Republican Party in the 2024 cycle: If Trump is disqualified or put in jail, then he will become a political martyr for his populist base, motivating Republican voter turnout. At the same time, the Republican Party establishment will gain the advantage of nominating a more favorable candidate who will be eligible to hold the presidency for eight years. Republicans would benefit. If Trump is not disqualified, then he will be even more incentivized to run for the Republican nomination to avoid legal prosecution. In that case he will hinder Republican appeal among moderate and independent voters – leaving them vulnerable to a party split or third-party challenge. Even if he wins, he will only be eligible for the presidency for four years, limiting his party’s prospects. Republicans would suffer. The takeaway from the above is that Trump’s interests continue to be at odds with the interests of the Republican Party elite. If the Democrats aggressively prosecute Trump and try to put him behind bars, they will in fact help unify and motivate the Republican Party opposition. Two further conclusions can be drawn: First, because of the January 6 incident and the political fallout, any future attempt by protesters or rioters to storm a major federal power center will likely be met with overwhelming force rather than accommodation. If that occurs, and state violence is seen as partisan, then the party that uses force will suffer in public opinion. As with domestic terrorism, a major crisis is likely to occur. But it will ultimately be conducive to a new national policy consensus.  Second, US domestic instability will incentivize foreign powers to take advantage of US distraction to pursue their national interests aggressively in their own region. At the same time, the US government will also pursue a reactive foreign policy to attempt to divide the opposition and suppress domestic dissent. Therefore US domestic political instability increases global geopolitical instability.   Market Response Will Be Volatility What are the investment ramifications of the above? US corporate earnings are heavily insulated from political crises that do not affect either US policy or the structure of the government and economy. Volatility sometimes pops briefly during domestic terrorist events but not in a way that affects the investment outlook (Chart 12). Investors should bear this in mind since another crisis event is coming. True, if the Mar-a-Lago raid affects the midterm election – and hence the composition of the US government in 2023-24 – then financial markets will respond to some extent. However, investors can safely ignore this risk because the stagflationary economy will be the chief factor in the midterms and already favors the opposition party. For the same reason it remains highly likely that Republicans will retake the House of Representatives, producing legislative gridlock in 2023. The result is disinflationary in the short run, though inflation will be a persistent problem over the long run. If Democrats somehow retain control of both houses of Congress, i.e. the “Blue sweep risk,” then investors would see a substantial change in the policy outlook, as Democrats would have a second chance to raise taxes and social spending. But the odds of a blue sweep are low. Our House election model implies that Democrats will lose 22 seats when they only need to lose a net of five seats to lose control. Our Senate model gives 47.5% chance of Democrats retaining control, too close to call at this point (Appendix). The odds of another blue sweep are only 20% according to online betting market PredictIt. Chart 12Market Historically Ignores Domestic Terrorism US political instability has, if anything, supported the US dollar and US equity and bond outperformance for many years. The more unstable the US, the more unstable the world. Indeed, because of the US’s geopolitical position, the US often exports domestic instability to the rest of the world. That is the situation today as the Biden administration’s domestic-focused, reactive foreign policy exacerbates the conflicts with Russia and China. The Biden administration is willing to escalate strategic tensions with both China and Russia in the lead-up to the midterm elections – and this tendency will likely become the Biden Doctrine, lasting into 2024. Investors should remain defensively positioned, and overweight US assets, at least until the midterm election is over.     Matt Gertken Senior Vice President Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1     Read the warrant behind FBI search of Trump’s Mar-a-Lago,” PBS, August 12, 2022, pbs.org. 2     See Katarzyna Jasko et al, “A comparison of political violence by left-wing, right-wing, and Islamist extremists in the United States and the world,” PNAS [Proceedings of the National Academy of Sciences of the United States of America] 119:30 (2022), July 18, 2022, pnas.org. See also Herbert McClosky and Dennis Chong, “Similarities and Differences between Left-Wing and Right-Wing Radicals,” British Journal of Political Science 15:3 (1985), pp. 329-63, jstor.org.  3    See Jessica Lee, “Did Obama Get Caught ‘Spying’ on Trump’s 2016 Campaign?” Snopes, September 29, 2020, snopes.com. See also Wall Street Journal Editorial Board, “Trump Really Was Spied On,” February 14, 2022, wsj.com. 4    See Department of Homeland Security, “Strategic Intelligence Assessment and Data on Domestic Terrorism,” July 11, 2022, dhs.gov; Christopher Wray, “Worldwide Threats to the Homeland,” Federal Bureau of Investigation, September 17, 2020, fbi.gov. See also Ryan Lucas, “FBI, Homeland Security warn about threats to law enforcement after Trump search,” NPR, August 15, 2022, npr.org. 5    See Stef W. Kight, “DHS memo: Violent extremism ‘likely’ in wake of Roe v. Wade decision,” Axios, June 24, 2022, axios.com. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix  

Special Report

Listen to a short summary of this report.     Executive Summary Back From The Future: An Investor’s Almanac Stocks will rally over the next six months as recession risks abate but then begin to swoon as it becomes clear the Fed will not cut rates in 2023. A second wave of inflation will begin in mid-2023, forcing the Fed to raise rates to 5%. The 10-year US Treasury yield will rise above 4%. While financial conditions are currently not tight enough to induce a recession, they will be by the end of next year. In the past, the US unemployment rate has gone through a 20-to-22 month bottoming phase. This suggests that a recession will start in early 2024. The US dollar will soften over the next six months but then get a second wind as the Fed is forced to turn hawkish again. Over the long haul, the dollar will weaken, reflecting today’s extremely stretched valuations.   Bottom Line: Investors should remain tactically overweight global equities but look to turn defensive early next year. Somewhere in Hilbert Space I have long believed that anything that can possibly happen in financial markets (as well as in life) will happen. Sometimes, however, it is useful to focus on a “base case” or “modal” outcome of what the world will look like. In this week’s report, we do just that, describing the evolution of the global economy from the perspective of someone who has already seen the future unfold. September 2022 – Goldilocks! US headline inflation continues to decline thanks to lower food and gasoline prices (Chart 1). Supply-chain bottlenecks ease, as evidenced by falling transportation costs and faster delivery times (Chart 2). Most measures of economic activity bottom out and then begin to rebound. The surge in bond yields earlier in 2022 pushed down aggregate demand, but with yields having temporarily stabilized, demand growth returns to trend. The S&P 500 moves up to 4,400. Chart 1ALower Food And Gasoline Prices Will Drag Down Headline Inflation (I) Chart 1BLower Food And Gasoline Prices Will Drag Down Headline Inflation (II)   October 2022 – Europe’s Prospects of Avoiding a Deep Freeze Improve: Economic shocks are most damaging when they come out of the blue. With about half a year to prepare for a cut-off of Russian gas, the EU responds with uncharacteristic haste: Coal-fired electricity production ramps up; the planned closure of Germany’s nuclear power plants is postponed; the French government boosts nuclear capacity, which had been running at less than 50% earlier in 2022; and, for its part, the Dutch government agrees to raise output from the massive Groningen natural gas field after the EU commits to establishing a fund to compensate the surrounding community for any damage from increased seismic activity. EUR/USD rallies to 1.06.  November 2022 – Divided Congress and Trump 2.0: In line with pre-election polling, the Democrats retain the Senate but lose the House (Chart 3). Markets largely ignore the outcome. To no one’s surprise, Donald Trump announces his candidacy for the 2024 election. Over the following months, however, the former president has trouble rekindling the magic of his 2016 bid. His attacks on his main rival, Florida governor Ron DeSantis, fall flat. At one rally in early 2023, Trump’s claim that “Ron is no better than Jeb” is greeted with boos. Chart 2Supply-Chain Pressures Are Easing Chart 3Democrats Will Lose The House But Retain The Senate   December 2022 – China’s “At Least One Child Policy”: The 20th Party Congress takes place against the backdrop of strict Covid restrictions and a flailing housing market. In addition to reaffirming his Common Prosperity Initiative, President Xi stresses the need for actions that promote “family formation.” The number of births declined by nearly 30% between 2019 and 2021 and all indications suggest that the birth rate fell further in 2022 (Chart 4). Importantly for investors, Xi says that housing policy should focus not on boosting demand but increasing supply, even if this comes at the expense of lower property prices down the road. Base metal prices rally on the news. Chart 4China's Baby Bust January 2023 – Putin Declares Victory: Faced with continued resistance by Ukrainian forces – which now have wider access to advanced western military technology – Putin declares that Russia’s objectives in Ukraine have been met. Following the playbook in Crimea and the Donbass, he orders referenda to be held in Zaporizhia, Kherson, and parts of Kharkiv, asking the local populations if they wish to join Russia. The legitimacy of the referenda is immediately rejected by the Ukrainian government and the EU. Nevertheless, the Russian military advance halts. While the West pledges to maintain sanctions against Russia, the geopolitical risk premium in oil prices decreases. February 2023 – Credit Spreads Narrow Further: At the worst point for credit in early July 2022, US high-yield spreads were pricing in a default rate of 8.1% over the following 12 months (Chart 5). By late August, the expected default rate has fallen to 5.2%, and by January 2023, it has dropped to 4.5%. Perceived default risks decline even more in Europe, where the economy is on the cusp of a V-shaped recovery following the prior year’s energy crunch. Chart 5The Spread-Implied Default Rate Has Room To Fall If Recession Fears Abate March 2023 – Wages: The New Core CPI? US inflation continues to drop, but a heated debate erupts over whether this merely reflects the unwinding of various pandemic-related dislocations or whether it marks true progress in cooling down the economy. Those who argue that higher interest rates are cooling demand point to the decline in job openings. Skeptics retort that the drop in job openings has been matched by rising employment (Chart 6). To the extent that firms have been converting openings into new jobs, the skeptics conclude that labor demand has not declined. In a series of comments, Jay Powell stresses the need to focus on wage growth as a key barometer of underlying inflationary pressures. Given that wage growth remains elevated, market participants regard this as a hawkish signal (Chart 7). The 10-year Treasury yield rises to 3.2%. The DXY index, having swooned from over 108 in July 2022 to just under 100 in February 2023, moves back to 102. After hitting a 52-week high of 4,689 the prior month, the S&P 500 drops back below 4,500. Chart 6Drop In Job Openings Is Matched By Rise In Employment Chart 7Wage Growth Remains Strong   April 2023 – Covid Erupts Across China: After successfully holding back Covid for over three years, the dam breaks. When lockdowns fail to suppress the outbreak, the government shifts to a mitigation strategy, requiring all elderly and unvaccinated people to isolate at home. It helps that China’s new mRNA vaccines, launched in late 2022, prove to be successful. By early 2023, China also has sufficient supplies of Pfizer’s Paxlovid anti-viral drug. Nevertheless, the outbreak in China temporarily leads to renewed supply-chain bottlenecks. May 2023 – Biden Confirms He Will Stand for Re-Election: Saying he is “fit as a fiddle,” President Biden confirms that he will seek a second term in office. Little does he know that the US will be in a recession during most of his re-election campaign. Chart 8Consumer Confidence And Real Wages Tend To Move Together June 2023 – Inflation: The Second Wave Begins: The decline in inflation between mid-2022 and mid-2023 sows the seeds of its own demise. As prices at the pump and in the grocery store decline, real wage growth turns positive. Consumer confidence recovers (Chart 8). Household spending, which never weakened that much to begin with, surges. The economy starts to overheat again, leading to higher inflation. After having paused raising rates at 3.5% in early 2023, the Fed indicates that further hikes may be necessary. The DXY index strengthens to 104. The S&P 500 dips to 4,300. July 2023 – Tech Stock Malaise: Higher bond yields weigh on tech stocks. Making matters worse, investors start to worry that many of the most popular US tech names have gone “ex-growth.” The evolution of tech companies often follows three stages. In the first stage, when the founders are in charge, the company grows fast thanks to the introduction of new, highly innovative products or services. In the second stage, as the tech company matures, the founders often cede control to professional managers. Company profits continue to grow quickly, but less because of innovation and more because the professional managers are able to squeeze money from the firm’s customers. In the third stage, with all the low-lying fruits already picked, the company succumbs to bureaucratic inertia. As 2023 wears on, it becomes apparent that many US tech titans are entering this third stage. August 2023 – Long-term Inflation Expectations Move Up: Unlike in 2021-22, when long-term inflation expectations remained well anchored in the face of rising realized inflation, the second inflation wave in 2023 is accompanied by a clear rise in long-term inflation expectations. Consumer expectations of inflation 5-to-10 years out in the University of Michigan survey jump to 3.5%. Whereas back in August 2022, the OIS curve was discounting 100 basis points of Fed easing starting in early 2023, it now discounts rate hikes over the remainder of 2023 (Chart 9). The 10-year yield rises to 3.8%. The 10-year TIPS yield spikes to 1.2%, as investors price in a higher real terminal rate. The S&P 500 drops to 4,200. The financial press is awash with comparisons to the early 1980s (Chart 10). Chart 9The Markets Expect The Fed To Cut Rates By Over 100 Basis Points Starting In 2023 Chart 10The Early-1980s Playbook October 2023 – Hawks in Charge: After a second round of tightening, featuring three successive 50 basis-point hikes, the Fed funds rate reaches a cycle peak of 5%. The 10-year Treasury yield gets up to as high as 4.28%. The 10-year TIPS yield hits 1.62%. The DXY index rises to 106. The S&P 500 falls to 4,050. November 2023 – Housing Stumbles: With mortgage yields back above 6%, the US housing market weakens anew. The fallout from rising global bond yields is far worse in some smaller developed economies such as Canada, Australia, and New Zealand, where home price valuations are more stretched (Chart 11). Chart 11Rising Rates Will Weigh On Developed Economies With Pricey Housing Markets January 2024 – Unemployment Starts to Rise: After moving sideways since March 2022, the US unemployment rate suddenly jumps 0.2 percentage points to 3.6%, with payrolls contracting for the first time since the start of the pandemic. The 22-month stretch of a flat unemployment rate is broadly in line with the historic average (Table 1). Table 1In Past Cycles, The Unemployment Rate Has Moved Sideways For Nearly Two Years Before A Recession Began February 2024 – The US Recession Begins: Although there was considerable debate about whether the US was entering a recession at the time, in early 2025, the NBER would end up declaring that February 2024 marked the start of the recession. The 10-year yield falls back below 4% while the S&P 500 drops to 3,700. Lower bond yields are no longer protecting stocks.  March 2024 – The Fed Remains in Neutral: Jay Powell says further rate hikes are unwarranted in light of the weakening economy, but with core inflation still running at 3.5%, the Fed is in no position to ease. April 2024 – The Global Recession Intensifies: The US unemployment rate rises to 4.7%. The economic downdraft is especially sharp in America’s neighbor to the north, where the Canadian housing market is in shambles. Back in June 2022, the Canadian 10-year yield was 21 basis points above the US yield. By April 2024, it is 45 basis points below. Europe and Japan also fall into recession. Commodity prices continue to drop, with Brent oil hitting $60/bbl. May 2024 – The Fed Cuts Rates: Reversing its position from just two months earlier, the Federal Reserve cuts rates for the first time since March 2020, lowering the Fed funds rate from 5% to 4.5%. The Fed funds rate will ultimately bottom at 2.5%, below the range of 3.5%-to-4% that most economists will eventually recognize as neutral. August 2024 – Republican National Convention: Unwilling to spend much of his own money on the campaign, and with most donations flowing to DeSantis, Trump’s bid to reclaim the White House fizzles. While the former president never formally bows out of the race, the last few months of his primary campaign end up being a nostalgia tour of his past accomplishments, interspersed with complaints about all the ways that he has been wronged. In the end, though, Trump makes a lasting imprint on the Republican party. During his acceptance speech, in typical Trumpian style, Ron DeSantis attacks Joe Biden for “eating ice cream while the economy burns” and declares, to thunderous applause, that “Americans are sick and tired of having woke nonsense hurled in their faces and then being dared to deny it at the risk of losing their jobs.” Chart 12The Dollar Is Very Overvalued October 2024 – The Stock Market Hits Bottom: While the unemployment rate continues to rise for another 12 months, ultimately reaching 6.4%, the S&P troughs at 3,200. The 10-year Treasury yield settles at 3.1% before starting to drift higher. The US dollar, which began to weaken anew after the Fed starts cutting rates, enters a prolonged bear market. As in past cycles, the dollar is unable to defy the gravitational force from extremely stretched valuations (Chart 12). November 2024 – President DeSantis: Against the backdrop of rising unemployment, uncomfortably high inflation, and a sinking stock market, Ron DeSantis cruises to victory in the 2024 presidential election. Unlike Trump, DeSantis deemphasizes corporate tax cuts and deregulation during his presidency, focusing instead on cultural issues. With the Democrats still committed to progressive causes, big US corporations discover that for the first time in modern history, neither of the two major political parties are willing to champion their interests. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn & Twitter Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores      

Executive Summary   US Support For A Military Coup? A confluence of structural and cyclical factors makes the US highly prone to social and political instability, as in 2020. Today’s stagflationary economic environment further amplifies domestic political risk. The Biden administration’s decision to pursue a criminal investigation of former President Trump will drive political polarization higher, as will the overall 2022-24 political cycle. Investors should expect negative surprises from US politics, including social unrest, political violence, and domestic terrorism of whatever stripe. Such crisis events usually cause only a short-term spike in financial market volatility. A major crisis that affects election results could have a more lasting impact. The base case for US policy in 2023-24 is gridlock, which is marginally disinflationary. It would take an extraordinary surprise to change that.  On a relative basis, US assets benefit from domestic political risk because geopolitical risk rises even faster. Recommendation (Tactical) INITIATION DATE Return Long DXY (Dollar Index) Feb 23, 2022 10.8% Bottom Line: Investors should expect volatility and negative “October surprises” in the short term, at least through the midterm elections. US domestic political risk is high and will also amplify global geopolitical risk. Feature The US’s rolling political crisis is escalating again and political violence is likely to rise in the lead up to the midterm elections on November 8 and the presidential election in November 2024. The Department of Justice (DoJ) refused on August 15 to release the affidavit underpinning the Federal Bureau of Investigation’s (FBI) raid on former President Trump’s Mar-a-Lago residence in Florida. Never before has a US president suffered a raid on his home by the country’s federal law enforcement agencies – though presidents have been investigated before. It is not yet clear what charges will be brought against Trump but it is highly likely that he will be indicted for something. The Justice Department released a redacted version of the search warrant suggesting that Trump may be accused of having kept state secrets at his home in violation of the Presidential Records Act and possibly also the 1917 Espionage Act. Speculation says that some information he took back from the White House relates to nuclear weapons.1 The DoJ is pursuing a criminal investigation. The former president could very well end up on trial, or even in jail, but it is also possible that changes in political power will prevent him from going. What are the investment implications, if any? The US will see significant social and political upheaval but the main investment implication is that the US will continue to play an unpredictable and disruptive role abroad, perpetuating a flight to safety in financial markets, at least until the midterm elections are over.  Drivers Of US Political Instability The US political crisis should first be seen through the lens of geopolitics: The US is a continent-sized nation that is separated from the other world powers by large oceans. It is therefore highly defensible and economically insulated, with total exports accounting for only 10.2% of GDP.  However, this insularity and relative security create space for a fast growing and evolving society that is primarily focused on doing business rather than strengthening the state. The rapid creation of wealth is good but also produces large disparities in region, class, and race that periodically undermine stability. Maintaining domestic stability across the continent would be a constant challenge even if the government were not a federal republic with short political cycles driven by fickle popular opinion. Freedom is a source of political contention as well as wealth creation.   Over the past 70 years the society has become less religious and more secular, while the economy has become less manufacturing-oriented and more service-oriented. The shift to a high-tech and information-driven society has empowered the highly educated at the expense of the less educated. Capital owners have benefited from rising asset values, deregulation, and globalization, while labor has witnessed stagnant real wages. Agricultural and manufacturing regions have fallen behind.  Social stability is especially hard to maintain during cyclical periods of economic distress, highlighted today by the rising Misery Index (Chart 1). While inflation may subside in the short run, it will probably persist in the long run, and unemployment has nowhere to go but up. There is a demographic and generational factor that is also driving US instability today: The Baby Boom generation did not begin their adult lives with a robust policy consensus, like their parents’ generation, which shared sacrifices during the Great Depression and World War II. Instead the Boomers began with deep divisions due to the Vietnam War and social revolution of the 1960s. As they grew in wealth and power in the 1980s-90s, pro-growth tax policy, deregulation, and rapid socioeconomic changes aggravated these divisions. Inequality surged  (Chart 2). The Iraq War and 2008 financial crisis made matters worse. Chart 1US: High Misery Index Chart 2US: High Inequality Now the elites of this generation, who lead the two major parties, are trying to secure their economic and political interests before retirement and death. Bluntly, the pro-business faction is trying to prevent the pro-government faction from clawing back its wealth. Political polarization has reached the highest level since the early twentieth century (Chart 3). While polarization has subsided from the peaks of 2020, it could still exceed those peaks in the 2022-24 political cycle. The US will remain at or near “peak polarization” until generational change and geopolitical conflicts forge a new policy consensus. Bottom Line: The US is geopolitically secure but periodically struggles to maintain domestic stability. Today it is witnessing a confluence of structural and cyclical factors that generate social unrest and historic levels of political polarization. The 2022-24 election cycle will be tumultuous. Chart 3US: Peak Polarization Disaffection Can Lead To Violence Any kind of fanaticism can lead to violent extremism. Militants have emerged from secular movements on the right and left, from communism to fascism, as well as from religious movements.2 In recent years the US has seen a rise in violence, including crime and terrorism. Mass shootings have spiked since the 2008 financial crisis. Terrorism has revived to the highest levels since the 1980s, 96% of which is domestic terrorism (Chart 4). Recent improvements to the social safety net may or may not reduce violence. The stagflationary economic backdrop bodes ill. Opinion polls are of dubious accuracy when they ask people to admit to militant or criminal inclinations, but they still take the temperature of society. Several recent polls suggest that as many as 25% of Americans are willing to consider violence as a means of resolving political problems (Chart 5). Chart 4US: Domestic Terrorism, Political Violence Chart 5US Support For Political Violence? In addition, 55% of Republicans and 40% of independents claim that a military coup could be justified when there is “a lot of corruption,” a subjective standard to say the least (Chart 6). While this number has spiked over the 2020 election cycle, it also shows a substantial pre-existing willingness to entertain authoritarian solutions to political disputes. We do not take these polls at face value given the difficult subject matter. When a major violent event occurs and real people die, popular “support” for political violence will collapse across the United States. Nevertheless these data suggest a high level of disaffection and discontent, which is supported by the structural socioeconomic problems cited above.   Chart 6US Support For A Military Coup? The January 6, 2021 incident at the US Capitol was the crescendo of an explosion of social unrest that occurred across the country in 2020, triggered by the aforementioned structural factors, the Covid-19 pandemic, race riots, and political conflict over the 2020 election. The number of homicides rose to 7.4 per hundred thousand people, the highest annual number since the 1990s, higher than in 2001 when the 9/11 terrorist attacks occurred, and reminiscent of the turbulent late 1960s. This year’s midterm elections will be the first major electoral test since the chaotic events of 2020 and none of the underlying drivers of unrest have been resolved. On the contrary, recent signs are pointing to another escalation of social and political upheaval. The 2024 election will also spark unrest and violence. Bottom Line: The number of violent incidents is rising while a substantial minority of public opinion appears willing to entertain violent means of resolving political disputes. From Reality TV To Real Rebellion? The FBI’s raid on Trump’s Mar-a-Lago estate is naturally triggering a backlash from Trump supporters and Republicans. These groups were already distrustful of the federal government and particularly the FBI for spying on the Trump presidential campaign in the 2016 election.3 Republican support for the FBI and DoJ will fall sharply from its current level in opinion polling taken in 2019 (Chart 7, top panel). Trump opponents will argue that Trump is being investigated because of wrongdoing while Trump supporters will think that the Biden administration is trying to prevent him from running for re-election in 2024. Any lack of transparency by the Justice Department will heighten suspicion and acrimony. Chart 7US Views On 2021 Rebellion A fraction of radicalized Trump supporters could be motivated by this extraordinary event to conduct attacks. Already an armed suspect, allegedly linked to a right-wing extremist group and to the January 6 rebellion at the Capitol, attempted to storm an FBI field office in Cincinnati, Ohio. The Department of Homeland Security and FBI have warned about the risk of domestic terrorism for several years and have issued a new warning since the FBI raid on Mar-a-Lago.4 There is no easy way to resolve the dispute over the 2020 election or the January 6 rebellion because these events have taken on mythic status in the eyes of the different factions. For about half of Republicans, the January 6 incident was a patriotic defense of freedom – rather than an insurrection or attempt to prevent the peaceful and democratic transfer of power (Chart 7, bottom panel). Some small portion of those who view the election as stolen could become radicalized and act out violently. Trump received 46% of the popular vote in 2016 and 47% in 2020 (Chart 8). His favorability has suffered since the January 6 events but not as much as one might think. Among Republicans, Trump’s favorability remains largely unperturbed (Chart 9). While the vast majority of these voters are law-abiding, the decision to raid Trump’s home, and any future decision to press criminal charges, will drastically increase the risk of radicalization on the fringes. Chart 8Trump’s Share Of Popular Vote Chart 9Trump’s Popular Support Post-2020 It does not take a social scientist to recognize the potential for an increase in political violence if the federal government is perceived as using the arm of the law to prevent a popular candidate from contesting past or future elections. The risk of political violence cannot be dismissed because the US is a particularly well-armed country. There were 120 civilian-held firearms per 100 persons in the United States as of 2017. By contrast, the nearest country is France, with only 20 firearms per 100 persons (Chart 10). That does not mean that a major incident of violence will necessarily stem from the right wing. Only five years ago an extremist left-wing gunman tried to assassinate a whole group of Republican lawmakers while they were playing baseball. Earlier this year the Department Homeland Security warned about violent reactions to the Supreme Court’s overturning of the Roe v. Wade decision on abortion.5 If and when a major incident of political violence occurs, the public reaction will be a powerful rejection of violence across the political spectrum. For example, President Bill Clinton’s administration benefited from the Oklahoma City bombing in 1995 (Chart 11). Much will depend on the nature of the attack and which faction is most able to capitalize on its victimization. Chart 10Right To Bear Arms Shall Not Be Infringed Chart 11OKC Bombing Spurred Rally Round The Flag Ultimately instability will generate a popular consensus opposed to political violence and supportive of law and order, just as it did in previous periods of American upheaval. The future policy consensus will be “federalist” in orientation due to America’s geopolitics: there will be an increasing need to unify the states to achieve other strategic imperatives like prosperity and national security. We call this theme “Limited Big Government.” This re-centralization process will involve the federal government intervening to stabilize the society. It is not obvious which political party will first capture this consensus. It depends on the nature and timing of any crisis events and the cyclical rotation of parties. Bottom Line: The US is a heavily armed country that is currently prone to social and political instability. The risk of political violence and domestic terrorism of whatever stripe is already very high. In addition, a substantial portion of the country’s right-wing faction believes that the 2020 election was stolen, that the January 6 rebellion was justified, and that the federal government is now abusing its law enforcement powers to prevent a candidate from running in 2024. Domestic terrorism risk will increase.   Implications For The 2024 Election Federal agencies were well aware of the risk of a domestic backlash when they decided to raid Mar-a-Lago. Investigators may or may not produce ironclad evidence of wrongdoing by Trump, but polarization will continue to be the overriding dynamic in the short run. It is unlikely that any evidence will convince the different parties to change their opinions of Trump.    Assuming Republicans retake the House of Representatives this fall, they will likely impeach Biden, though they will lack the votes in the Senate to remove him from office. US domestic policy will be effectively paralyzed as the partisan conflict continues. The 2024 election will be required to settle the Trump saga and the future direction of US national policy. Trump’s legal troubles could be a blessing or a curse for the Republican Party in the 2024 cycle: If Trump is disqualified or put in jail, then he will become a political martyr for his populist base, motivating Republican voter turnout. At the same time, the Republican Party establishment will gain the advantage of nominating a more favorable candidate who will be eligible to hold the presidency for eight years. Republicans would benefit. If Trump is not disqualified, then he will be even more incentivized to run for the Republican nomination to avoid legal prosecution. In that case he will hinder Republican appeal among moderate and independent voters – leaving them vulnerable to a party split or third-party challenge. Even if he wins, he will only be eligible for the presidency for four years, limiting his party’s prospects. Republicans would suffer. The takeaway from the above is that Trump’s interests continue to be at odds with the interests of the Republican Party elite. If the Democrats aggressively prosecute Trump and try to put him behind bars, they will in fact help unify and motivate the Republican Party opposition. Two further conclusions can be drawn: First, because of the January 6 incident and the political fallout, any future attempt by protesters or rioters to storm a major federal power center will likely be met with overwhelming force rather than accommodation. If that occurs, and state violence is seen as partisan, then the party that uses force will suffer in public opinion. As with domestic terrorism, a major crisis is likely to occur. But it will ultimately be conducive to a new national policy consensus.  Second, US domestic instability will incentivize foreign powers to take advantage of US distraction to pursue their national interests aggressively in their own region. At the same time, the US government will also pursue a reactive foreign policy to attempt to divide the opposition and suppress domestic dissent. Therefore US domestic political instability increases global geopolitical instability.   Market Response Will Be Volatility What are the investment ramifications of the above? US corporate earnings are heavily insulated from political crises that do not affect either US policy or the structure of the government and economy. Volatility sometimes pops briefly during domestic terrorist events but not in a way that affects the investment outlook (Chart 12). Investors should bear this in mind since another crisis event is coming. True, if the Mar-a-Lago raid affects the midterm election – and hence the composition of the US government in 2023-24 – then financial markets will respond to some extent. However, investors can safely ignore this risk because the stagflationary economy will be the chief factor in the midterms and already favors the opposition party. For the same reason it remains highly likely that Republicans will retake the House of Representatives, producing legislative gridlock in 2023. The result is disinflationary in the short run, though inflation will be a persistent problem over the long run. If Democrats somehow retain control of both houses of Congress, i.e. the “Blue sweep risk,” then investors would see a substantial change in the policy outlook, as Democrats would have a second chance to raise taxes and social spending. But the odds of a blue sweep are low. Our House election model implies that Democrats will lose 22 seats when they only need to lose a net of five seats to lose control. Our Senate model gives 47.5% chance of Democrats retaining control, too close to call at this point (Appendix). The odds of another blue sweep are only 20% according to online betting market PredictIt. Chart 12Market Historically Ignores Domestic Terrorism US political instability has, if anything, supported the US dollar and US equity and bond outperformance for many years. The more unstable the US, the more unstable the world. Indeed, because of the US’s geopolitical position, the US often exports domestic instability to the rest of the world. That is the situation today as the Biden administration’s domestic-focused, reactive foreign policy exacerbates the conflicts with Russia and China. The Biden administration is willing to escalate strategic tensions with both China and Russia in the lead-up to the midterm elections – and this tendency will likely become the Biden Doctrine, lasting into 2024. Investors should remain defensively positioned, and overweight US assets, at least until the midterm election is over.     Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com     Footnotes 1     Read the warrant behind FBI search of Trump’s Mar-a-Lago,” PBS, August 12, 2022, pbs.org. 2     See Katarzyna Jasko et al, “A comparison of political violence by left-wing, right-wing, and Islamist extremists in the United States and the world,” PNAS [Proceedings of the National Academy of Sciences of the United States of America] 119:30 (2022), July 18, 2022, pnas.org. See also Herbert McClosky and Dennis Chong, “Similarities and Differences between Left-Wing and Right-Wing Radicals,” British Journal of Political Science 15:3 (1985), pp. 329-63, jstor.org.  3    See Jessica Lee, “Did Obama Get Caught ‘Spying’ on Trump’s 2016 Campaign?” Snopes, September 29, 2020, snopes.com. See also Wall Street Journal Editorial Board, “Trump Really Was Spied On,” February 14, 2022, wsj.com. 4    See Department of Homeland Security, “Strategic Intelligence Assessment and Data on Domestic Terrorism,” July 11, 2022, dhs.gov; Christopher Wray, “Worldwide Threats to the Homeland,” Federal Bureau of Investigation, September 17, 2020, fbi.gov. See also Ryan Lucas, “FBI, Homeland Security warn about threats to law enforcement after Trump search,” NPR, August 15, 2022, npr.org. 5    See Stef W. Kight, “DHS memo: Violent extremism ‘likely’ in wake of Roe v. Wade decision,” Axios, June 24, 2022, axios.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 A4House Election Model Table A5APolitical Capital: White House And Congress Table A5BPolitical Capital: Household And Business Sentiment Table A5CPolitical Capital: The Economy And Markets

Executive Summary Russia’s Crude Oil Output Will Fall Russia will have to lower oil production to ensure output it hasn’t placed with non-EU buyers does not tax its limited storage facilities, ahead of the bloc’s December 5 embargo. The EU’s insurance/reinsurance ban on ships carrying Russian material also commences in December. It will profoundly affect Russian output, if fully implemented. Russian and Chinese firms will expand ship-to-ship transfers on the high seas, along with external processing and storage services to mask crude and product exports. The EU embargos will force Russia to shut in ~ 1.6mm b/d of output by year-end, rising to 2mm b/d in 2023, by our reckoning. Gas-to-oil switching in Europe will boost distillate and residual fuel demand by ~ 800K b/d this winter. Chinese policymakers will be compelled to deploy greater fiscal and credit support to reverse weakening GDP. Tighter monetary policy in DM economies will dampen aggregate demand. Bottom Line: EU embargoes on Russian oil imports will significantly tighten markets, and lift Brent to $119/bbl by year-end. This has a 60% chance of being offset by ~ 1mm b/d of Iranian oil exports in 2023, in our estimation. We are maintaining our Brent forecast at $110/bbl on average for this year, and $117/bbl next year. WTI will trade $3-$5/bbl lower. At tonight’s close we are re-establishing our long COMT ETF position. Risks remain to the upside. Feature Chart 1Russia’s Crude Oil Output Will Fall Following an unexpected increase in production during June and July, Russia will have to begin reducing its oil output ahead of the implementation of the EU’s embargo on its seaborne crude oil imports, which kicks on December 5. EU, UK and US shipping insurance and reinsurance sanctions also are scheduled to be implemented in December. If fully implemented, ~ 2.3mm b/d of seaborne imports of Russian crude oil will be excluded from EU markets by year-end. Come February, another 800k b/d of refined products will be embargoed. On the back of these lost sales, and production that cannot be loaded on ships due to insurance/reinsurance bans, we expect Russian production to fall ~ 2mm b/d by the end of next year (Chart 1).1 As noted in previous research, a goodly chunk of Russian crude continues to go to China and India. Together, these two states accounted for just over 40% of Russia’s crude sales last month – ~ 1.9mm b/d of a total of ~ 4.5mm b/d. This is down from just under 45.5% in May, according to Reuters. Both China and India have benefited from discounted prices of ~ 30% vs. Brent, which is a powerful inducement to buy. Asia accounts for more than half of Russia’s seaborne crude oil sales, according to Bloomberg data. Related Report  Commodity & Energy StrategyTighter Oil Markets On The Way Whether China and India can maintain these purchases depends on whether ships taking oil to them can get their cargoes insured. Both states have domestic insurance providers, and, in the case of the latter, long-standing trade relationships going back decades. Other Asian economies do not have such financial infrastructure. Still, this is a high concentration of sales to two buyers. In addition, press reports indicate China spent $347mm to secure tankers to conduct high-risk ship-to-ship (STS) transfers of Russian crude in the Atlantic Ocean.2 Similar STS transfers have been used to move ~ 1.2mm b/d of Iranian and Venezuelan crude oil, most of which ends up in China, according to Lloyds. Base Case Sees Markets Balance In our base case analysis, markets remain relatively balanced going into winter. On the supply side, we expect core OPEC 2.0 – the Kingdom of Saudi Arabia (KSA) and the United Arab Emirates (UAE) – to continue to provide crude to the markets subject to their spare-capacity constraints (Chart 2, top panel). KSA likely will be producing close to 11mm b/d by year-end – vs its current output of 10.6mm b/d output presently – and the UAE will be close to 3.5mm b/d, vs 3.1mm b/d at present. KSA’s max capacity is 12mm b/d, while the UAE’s is 4mm b/d; both will want to maintain spare capacity to offset unexpected exogenous supply shocks next year. These two states account for most of the spare capacity in the world (Chart 3). The rest of OPEC 2.0 will continue to struggle to maintain its production, which makes the core producers’ spare capacity critically important (Chart 2, bottom panel). Chart 2Core OPEC 2.0 Will Increase Supply Chart 3Spare Capacity Concentrated In Core OPEC 2.0 Outside of OPEC 2.0, we are expecting the largest contribution to global supply will continue to come from US shale production (Chart 4). Shale-oil output in the top 5 US basins is expected to increase ~540K b/d this year, and next. This will take shale output to slighly above 7.5mm b/d and account for 76% of Lower 48 production in the States this year. Next year, we are expecting US Lower 48 production to rise 700K b/d, and for total US crude output to go to 12.8mm b/d, a new record. Chart 4US Remains Top Non-OPEC 2.0 Supplier This winter we are expecting an uptick in oil demand – particularly for distillates like gasoil and diesel in Europe, as EU firms switch from natural gas to oil on the margin. We expect this will add 800K b/d of demand over the winter months (November through March), which will lift our overall demand estimate 150k b/d this year, and 20K b/d next year – +2.19mm b/d vs +2.04mm b/d, and 1.82mm b/d vs. 1.80mm b/d next year. Chinese year-on-year oil demand growth remains negative. January-July 2022 demand was 15.24mm b/d vs 15.34mm b/d in 2021, continuing a string of y/y contractions. The two other major economic pillars of global oil demand – the US and Europe – show positive y/y growth of 800K b/d each over the same period. Global demand in 1H22 recovered to 98% of its pre-COVID-19 level – even with China’s negative y/y growth – while supply recovered to 96% of its pre-pandemic level, according to the International Energy Forum (IEF). Over most of the forecast period, we estimate global balances will continue to show the level of supply below that of demand, which will lead to continued physical deficits (Chart 5). Refined-product inventories increased by 34mm barrels in 1H22, while crude-oil stocks fell 23mm barrels. Global crude and product inventories are ~ 460mm barrels below their five-year average, which includes pandemic demand destruction, the IEF reported. We continue to expect inventories to remain below their 2010-14 average, which we prefer to track – it excludes the market-share wars of 2015-17 and that of 2020, and the pandemic’s effects on inventories (Chart 6). This will revive the backwardation in Brent and WTI prices, particularly if the loss of Russian barrels is larger than we expect this year and next. This could be dampened if the US resumes its SPR releases after they’ve run their course in October. Chart 5Global Market Balanced, But Slight Deficits Will Persist Chart 6OECD Inventories Below 5Y Average Investment Implications Our analysis indicates markets are mostly balanced going into winter (Table 1). That said, the balance of risks remains to the upside ahead of the EU’s embargoes on Russian crude and product imports, and the EU/UK/US insurance/reinsurance bans on providing cover for vessels carrying Russian material. This all is highly contingent on the extent to which the EU and its allies follow through on these punitive actions imposed on Russia in retaliation for its invasion of Ukraine. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 The removal from the market of some 2mm b/d of Russian oil production due to the various EU embargoes – even if it is offset by the return of 1mm b/d of Iranian exports on the back of a deal with the US – will push crude oil prices higher and inventories lower (Chart 7).3  Chart 7Brent Price Expectation Unchanged, But Demand Shifts To Winter Given these views, we remain long the oil and gas producer XOP ETF, which is up 19.5% since we re-established it on July 5, and, at tonight’s close, will be re-establishing our COMT ETF, to take advantage of higher energy and commodity prices and increasing backwardation in oil markets as inventories draw.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Commodities Round-Up Energy: Bullish US distillate inventories – diesel and heating oil mostly – were up less than 1% for the week ended 12 August 2022, according to the US EIA. US distillate inventories stood at 112mm barrels. This did nothing to reverse the deep drawdown in distillate inventories of 18.5% y/y, which, along with European stocks, refiners are attempting to rebuild going into the 2022-23 winter. We expect natgas-to-oil switching this winter to add 800k b/d of demand to the market over the Nov-Mar winter season. Most of this demand will be for distillates, in our view, given its dual use as a fuel for industrial applications and household space-heating. Distillate demand could be higher this winter, if a La Niña produces colder-than-normal temperatures. The US Climate Prediction Center gives the odds of such an outcome 60% going into the 2022-23 winter. This would lift ultra-low-sulfur diesel futures in the US and gasoil futures in Europe higher as inventories draw (Chart 8). Base Metals: Bullish Copper prices dropped on weaker-than-expected Chinese macroeconomic data for July, although the fall was bounded by the People’s Bank of China’s decision to cut interest rates. According to US CFTC data, copper trading volumes are lower than pre-pandemic levels, as hedge funds' net speculative positions turned negative beginning in May and have mostly remained in the red since then. Low trading volumes will result in copper prices being highly susceptible to macroeconomic events, especially those occurring in China. Precious Metals: Neutral Gold prices are facing difficulty overcoming market expectations of high interest rates for the rest of this year (Chart 9). The bearish influence of tightening monetary policy and a strong USD has the upper hand on the supportive effect of recession risks, inflation, and geopolitical uncertainty for gold prices. Recent strength in US stock markets - which historically is inversely correlated with gold prices - following better-than-expected earnings, also contributed to recent gold price weakness. Chart 8 Chart 9     Footnotes 1 Please see Oil: It Ain't Over Till It's Over, which we published 11 August 2022, for additional discussion. NB: We discuss the differences between our view and that of our Geopolitical Strategy service regarding a deal between the US and Iran, which returns 1mm b/d of crude oil exports to the market. We give 60% odds to such a deal, while our colleagues at the GPS service assign a 40% probability to it. In our base case modeling presented herein, we expect these barrels to return to the market by 2Q23, perhaps sooner. 2 Please see Anonymous Chinese shipowner spends $376m on tankers for Russian STS hub published by Lloyd’s List 9 August 2022. The report notes, “All the ships are aged 15 years or older, precluding them from chartering by most oil majors, as well being unable to secure conventional financing, suggesting the beneficial owner is cash rich. The high seas logistics network offers scant regulatory and technical oversight as crude cargoes loaded on aframax tankers from Baltic Russian ports are transferred to VLCCs mid-Atlantic for onward shipment to China. One cargo has been tracked to India.“ 3 Please see Oil: It Ain't Over Till It's Over, which we published 11 August 2022, for additional discussion. NB: We discuss the differences between our view and that of our Geopolitical Strategy service regarding a deal between the US and Iran, which returns 1mm b/d of crude oil exports to the market. We give 60% odds to such a deal, while our colleagues at the GPS service assign a 40% probability to it. In our base case modeling presented herein, we expect these barrels to return to the market by 2Q23, perhaps sooner.   Investment Views and Themes Strategic Recommendations Trades Closed in 2022

Special Report

Executive Summary US Deficits Will Rise Before They Fall The Inflation Reduction Act combined with the Chips and Science Act will add $88 billion to the budget deficit through FY2027. The two bills would only reduce the deficit by $11.1 billion by 2031. The deficit that year will be $2 trillion.    Hence Congress’s latest actions add to the deficit in the short run and are effectively deficit-neutral over the long run. That is not disinflationary.  Gridlock is still the likeliest outcome of the midterm elections. That is disinflationary for 2023-24 because fiscal policy freezes. Whether gridlock will persist after 2024 is unknown. Federal investments in US computer chips and renewable energy could enhance productivity over the long run. That could well be disinflationary … but the magnitude and timing are unknown. Overall, US social spending, industrial spending, defense spending, and government intervention are rising as the nation-state responds to social unrest and geopolitical conflict. Inflation will depend on many things, but this policy trend is not disinflationary. Close Recommendation (Tactical) Closing Level CLOSING DATE Return Long US Treasuries Vs. TIPS 1.3768 AUG 12, 2022 1.53%   Bottom Line: Close long US Treasuries relative to TIPS. But stay long the US dollar. Biden’s legislative victories underscore our strategic themes of Limited Big Government and Peak Polarization – and are not disinflationary.  Feature President Biden’s approval rating ticked up to 40% after a series of policy wins, including the passage of the Inflation Reduction Act and the Chips and Science Act. These bills reinforce our strategic theme of Limited Big Government, i.e. a rising role for the state within the US’s free market context. When Biden unveiled his anti-inflation agenda back in June we argued that his only real options to reduce inflation before the midterm elections hinged on other people: namely the Federal Reserve, the Saudis, the Iranians, and also Capitol Hill. With regard to Congress, we expected Democrats to pass a budget reconciliation bill. We saw that they were repackaging this bill as an “inflation reduction” measure to improve their election prospects. But we argued that it would not fight inflation in any substantive way.1 Now that the bill is on the way to Biden’s desk, it is only fair to ask: What will be the impact? Will it reduce inflation or not? The short version is no. The bill does not stand alone but is part of the Biden administration’s “last-ditch effort” to pass two major bills before the midterms. These two laws are deficit-neutral at best but slightly stimulative in the short run – and hence marginally inflationary. These laws could prove disinflationary over the long run, as investments in semiconductors and renewable energy should drive innovation. But that is hard to predict. We are optimistic on that front but for the foreseeable future the effects are neutral or inflationary. To understand this view, we need to review BCA’s stance on inflation overall and then discuss the legislation. The BCA View On Inflation BCA sees this year’s inflationary bout as both a cyclical and a structural phenomenon. The cyclical rise in inflation stemmed from the pandemic and the ensuing economic stimulus. This cycle is peaking now. Commodity prices are moderating and goods spending has fallen two-thirds of the way back to where it stood prior to the pandemic, suggesting that inflation will take a step back. At very least inflation has stopped skyrocketing (Chart 1). Yet the structural drivers of inflation will persist. Chart 1Inflation Rolls Over ... For Now The long-term inflation thesis hinges first and foremost on global population trends. Fewer prime-age workers as a share of the population means that the price of a prime-age worker goes up. It also hinges on the decline in the global glut of savings, the rise of mercantilism and trade protectionism (i.e. hypo-globalization), and the conclusion of household deleveraging in the wake of the 2008 crisis. Structurally looser fiscal policy – soft budgets – also plays a role. The decay of the liberal world order since 2008 financial crisis entails that western governments face the combined threats of social unrest at home and great power competition abroad. These governments’ answer is to take a more active role in the economy to appease popular wrath, improve energy security, and bulk up national defense. The result will be larger deficits. Larger budget deficits reduce the savings available to the private sector and constrain future supply, feeding into inflation. The result is that, in the United States, the neutral rate of interest will likely prove to be higher than expected, monetary conditions will be looser than expected in real terms, and hence the economy will overheat. At least until central banks and fiscal authorities impose austerity.  Bottom Line: Inflation is a cyclical and structural phenomenon in the United States. Cyclically inflation is starting to moderate as various factors from the pandemic and fiscal stimulus wear off. But structurally inflation will be a persistent problem due to population aging, the end of the savings glut, hypo-globalization, geopolitical conflict, and a rising government role in the economy. New Laws Do Not Cut The Deficit Until 2027 At Best Now we can put the Biden administration’s policy into context. The stagflationary cyclical backdrop poses a severe challenge for the ruling Democratic Party. Midterm elections are only three months away and yet headline inflation is still running at 8.5% and core inflation is rising unabated at 5.9% year-on-year. The median voter suffers from high inflation in the form of falling real income and wages. Yet the Democratic legislative agenda has focused on increasing spending, which adds to inflation.  If US gasoline prices continue to moderate, the median household’s inflation expectations will come down – and that is a positive short-term development for Democrats (Chart 2). That is why President Biden went to Saudi Arabia with his tail between his legs to beg for more crude oil production. That is why he is trying to do a deal with Iran too (though there our view is pessimistic). That is why he has urged Europe to wait until after the midterm to implement full oil sanctions on Russia. Hence also the Senate repackaged the -$4 trillion “Build Back Better” spending splurge as a +$300 billion “Inflation Reduction” fiscal reform. But will the Inflation Reduction Act truly reduce inflation? Will it affect the cyclical or structural drivers mentioned above?  Chart 2Inflation Expectations Moderating The title of the bill alone should prompt investors to be skeptical. The bill does not meaningfully reduce budget deficits. According to the Democratic Party it will generate $300 billion in savings over 10 years, mostly as a result of capping drug costs that Medicare pays to hospitals on behalf of about 64 million Americans. However, the Committee for a Responsible Federal Budget provides a more realistic scenario in which the savings amount to $160 billion, or about half as much as advertised (Table 1).2 The CBO estimates the bill will reduce the budget deficit by $100 billion over 10 years, one third of the official selling point. Table 1What Is Inside The Inflation Reduction Act Of 2022? Table 2 shows the CBO’s baseline estimates of the US budget deficit outlook as of July 2021, May 2022, and August 2022 (i.e. the latter with the new legislation). The trend line with the reconciliation bill is virtually indistinguishable from the May estimate (Chart 3). Table 2US Budget Balance Projections Before/After The Inflation Reduction Act Chart 3What Deficit Reduction? Table 3 shows the specific change in the budget deficit for each year, illustrated in Chart 4. The bill modestly reduces the deficit in 2023 but increases the deficit in subsequent years until 2028. When the bill’s savings peak at $41 billion in 2031, they will shave off 2% of the $2 trillion deficit. Table 3Change In US Deficit Due To Inflation Reduction Act And Chips And Science Act In other words, the deficit reduction will not occur until after the 2028 election – by which time it will be swamped by other political and economic factors. In addition, the bipartisan Chips and Science Act will add $47.5 billion to the budget deficit through FY2026 and $79.3 billion through FY2031. Combining them shows that Congress is still adding to spending despite today’s 5.9% core inflation reading – while delaying the miniscule deficit reduction until the latter part of the decade. Credit should be given to the Democrats for offsetting their new spending with revenue increases. But in realistic terms Congress’s latest actions are deficit-neutral at best. The question was how to pay for the desired spending rather than how to impose budget consolidation. Austerity is politically impractical in the context of left-wing and right-wing populism. Chart 4US Deficits Will Rise Before They Fall The new fiscal spending makes sense given the strategic predicament that the US faces. But it should flag to investors that the only real fiscal discipline on the horizon will come after the midterm election, when Congress is gridlocked and fiscal policy is basically frozen. Bottom Line: The Inflation Reduction Act combined with the Chips and Science Act will add about $88 billion to the budget deficit through FY2027. The two bills only reduce the growth of the budget deficit by $11.1 billion by 2031. They will not reduce investors’ inflation expectations over the next five years. Cyclical inflation expectations will fall for other reasons – such as Fed rate hikes, the slowdown in global growth, and looming gridlock. Reducing Drug Prices And EV Prices Is Not Generally Disinflationary What about the sector effects of the Inflation Reduction Act? Could they be disinflationary? The bill raises a minimum corporate tax rate of 15% to pay for renewable energy subsidies, it bulks up the Internal Revenue Service’s tax collecting capabilities to pay for an expansion of Obamacare subsidies, and it empowers Medicare to negotiate pharmaceutical prices, creating revenue savings for the federal government.   Theoretically caps on drug prices will push prices down, while subsidies to buy electric vehicles (EV) will incentivize Americans to buy those cars and expand the domestic EV supply chain. Hence Democrats can at least claim to be reducing drug price inflation and arguably EV price inflation. Drug price caps are popular and could increase social stability. Electric car subsidies are less popular but tap into demands for domestic manufacturing and action on climate change. Neither will generate substantial opposition in the voting booth. However, the general level of prices will not fall as a result of these sector-specific interventions. Spending on motor vehicles is around 4.2% of total personal consumption expenditure (Chart 5, first panel). Spending on prescription drugs is around 3.2% of total personal consumption expenditure (Chart 5, second panel). Hence the bill could at maximum affect 7.4% of total consumer spending. But only certain drugs will face price caps and only EVs will be subsidized, so the effect is even narrower than that. Spending on cars grew by 1.7% between 2003-20, in line with economic growth. Drug spending grew faster, in line with an aging society, at 2.9% over the same period (Chart 6). Normally the contribution to inflation is negligible for cars but higher-than-average for drugs. True, after Covid-19 car prices surged while drug prices fell below average, but that process should normalize (Chart 7).  Chart 5The Role Of Cars And Drugs In Inflation Chart 6Growth Of Car And Drug Spending Chart 7Change In Car And Drug Prices Only 20 drugs will be eligible for Medicare negotiation per year. The top 20 drugs amount to around 18% of the pharmaceutical market. The new government-negotiated prices will begin to take effect in 2027. The effect will be to dampen domestic manufacturers’ incentive to produce generics, leading to supply constraints or substitution effects (e.g. imports). Hence overall drug prices will not fall as much as expected. The US lacks universal healthcare coverage, so price controls represent an economic transfer between corporations or between corporations and government – not between corporations and consumers. Capping drug prices will benefit insurers directly and consumers only indirectly. The profit will change from the hands of Big Pharma to Big Insurance (managed healthcare providers) (Chart 8). Incidentally big insurers will also benefit from the bill’s expansion of the Obamacare subsidies. Of course, Obamacare enrollees will see a marginal increase in disposable income – especially lower-income individuals, who have a higher propensity to consume. This is positive from the perspective of social stability but likely to be inflationary, not disinflationary. Lower insurance premiums mean more spending cash. Chart 8Big Insurance Versus Big Pharma As for the bill’s green subsidies, EVs account for about 5.6% of cars sold. Subsidies will encourage the production of EVs and accelerate the growth of EV market share. The point is to make EV prices competitive with other cars since EVs are more costly to make, especially if they are to be made domestically. Non-EVs may have to lower their prices but, as we have seen, car inflation is not a major contributor to general inflation, at least not in normal times. Of course, no electric vehicles will qualify for the new rebate immediately. The law requires a large share of qualifying electric cars to be manufactured in North America, or at least not to be produced in “countries of concern” such as China. China is still the leader in making critical components of EVs, especially batteries. Such policies are not conducive to the most efficient manufacturing methods and lowest consumer prices. Rather they seek to shift supply chains to allied countries or to “onshore” them within the United States for strategic reasons, even at a higher cost to consumers. As such the new law reflects the US’s newfound populism, economic nationalism, industrial policy, and trade protectionism. It epitomizes the connection between great power competition and hypo-globalization, prioritizing supply chain resilience at the expense of economic efficiency. That makes sense from a national security point of view but is not likely to be disinflationary – quite the opposite. The bipartisan Chips and Science Act will dovetail with these measures to revive US industrial policy, steer capital into priority projects, and encourage domestic investment. This law and the climate change subsidies are federal investments that should boost productivity and enhance the supply side of the economy. We are optimistic over the long run regarding the productivity enhancements that could accrue from the government’s historic shift to re-initiate these kinds of investments. The space program in the 1960s may be too optimistic but it is still analogous. The US is already in the midst of Cold War II.  If a major breakthrough in renewable energy eventually occurs that is tied to investments from the Inflation Reduction Act, then it will justify the bill’s anti-inflation moniker. But that remains to be seen. In the meantime, these investments will quicken US economic activity when the economy is already at full employment and inflation is running hot. Bottom Line: Cars do not contribute much to inflation in normal times and this bill gives subsidies to make electric cars in the US, which is not optimal for costs. Drugs contribute positively to inflation but Medicare caps will not lower drug prices until 2027 and general price effects are debatable. Overall, social unrest and great power competition are leading to greater government involvement in the economy, which is marginally inflationary. Economic Slowdown Is Disinflationary What will be the effect of this legislation on the midterm election campaign? Economic sentiment improved over the past month, even among Republicans. That led to a drop in polarization for the right reasons, i.e. a resilient economy, rather than the wrong reasons, i.e. the universal loathing of inflation (Chart 9). Polarization will stay near peak levels during the 2022-24 election campaign but the bipartisan Chips Act, the Biden administration’s adoption of hawkish foreign policy on trade and China, and the administration’s attempt to pursue at least a deficit-neutral approach to the budget reinforce our “Peak Polarization” theme. Long-term US policy consensus is developing beneath the still extreme polarization in the short term. Business activity is improving, which has contributed to the equity rally on the basis that the Fed is achieving a “soft landing” (Chart 10). We expect a hard landing due to the combination of negative macro and geopolitical factors but the latest data brings a positive surprise. Chart 9Economic Sentiment Ticks Up ... Even Among Republicans Chart 10Business Activity Improves In the short term, Biden and the Democrats will benefit from passing legislation (“getting things done”) and piggybacking on the fact that inflation is rolling over and the economy is showing some positive surprises. Biden’s approval rating is showing signs of stabilizing, albeit at a low level (Chart 11). The two parties are neck and neck in congressional ballot, with Democrats taking back the lead again from Republicans (Chart 12). If this trend continues it will mitigate the Democrats’ losses in the midterms. The Senate is competitive. Chart 11Biden’s Approval Will Perk Up At Least Somewhat Chart 12US Parties Neck And Neck In Generic Congressional Ballot If inflation rolls over, real wages will improve, which will boost consumer confidence and, if it comes by October, could  help the Democrats further (Chart 13). Chart 13Uptick In Real Wage Would Boost Consumer Confidence Still, Democrats are likely to lose the House of Representatives in the midterms, as the ruling party usually loses seats and Democrats only have a five-seat margin. In other words, we would fade the emerging “Blue Sweep” risk (i.e. risk that Democrats keep control of both houses of Congress). A sweep is possible but unlikely, especially because many of Biden’s foreign policy problems can still come back to haunt him before the midterm. Two consecutive quarters of negative GDP growth usually results in an official recession. The jury is still out. Bankruptcies are ticking up and unemployment has nowhere to go but up (Chart 14). The stagflationary environment will probably persist through the midterm. Biden will face a rocky road to re-election. Chart 14Yet Unemployment And Bankruptcy Will Rise Investment Takeaways Inflation expectations began to roll over due to the global slowdown, the drop in commodity prices, and the Fed’s rate hikes, but structural factors suggest inflation will remain a problem over the long run. The Inflation Reduction Act will not be implemented in time to have any effect on prices in 2022. It will slightly reduce the budget deficit next year but expand the deficit from FY2024-27. Combined with the Chips and Science Act the effect is slightly stimulative or inflationary until FY2028 at earliest.   The bill increases policy uncertainty ahead of the midterms. Democrats will be able to take credit for any moderation of inflation through October and hence the election will become more competitive. But the election outcome is still highly likely to be congressional gridlock. Gridlock is disinflationary in 2023-24 because it implies that fiscal policy will shift to neutral – or even that real deficit reduction will occur if Biden compromises with a partially or wholly Republican congress. Structurally the US suffers from an imbalance of savings and investment. The global savings glut more than filled the gap and prevented inflation for several decades. Now the society is aging, the savings glut is depleting, globalization is retreating, and governments need to maintain spending to address high domestic and foreign challenges. US policy is forming a new consensus (“Peak Polarization”) that includes a larger role for government within the US context (“Limited Big Government”) in order to fight against social instability and geopolitical threats. The result is inflationary or at least not disinflationary. A high-tech and/or green energy productivity boom is possible and would combat the structural drivers of inflation. We are optimistic but the disinflationary impact is not forthcoming immediately and much remains to be seen.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com   Footnotes 1     Specifically we argued that the bill would be “mildly stimulating for the economy (i.e. inflationary) and none of the supply-side improvements would reduce inflation in time for the midterms.” We also implied that the act would probably not correct the US’s long-term rise in budget deficits as a share of GDP. 2     The difference has to do with the Affordable Care Act (Obamacare). Obamacare subsidies were expanded during the pandemic. The reconciliation bill will spend about $100 billion on extending the subsidies by three years. But it will be politically difficult for future congresses to revoke these subsidies. Hence the CBO assumes they will become permanent.   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 A4House Election Model Table A5APolitical Capital: White House And Congress Table A5BPolitical Capital: Household And Business Sentiment Table A5CPolitical Capital: The Economy And Markets  

Special Report

Executive Summary With the fourth Taiwan Strait crisis materializing, the odds of a major war between the world’s great powers have gone up. Our decision trees suggest the odds are around 20%, or double where they stood from the Russian war in Ukraine alone. The world is playing “Russian roulette” … with a five-round revolver. Going forward, our base case is for Taiwan tensions to flatten out (but not fall) after the US and Chinese domestic political events conclude this autumn. However, if China escalates tensions after the twentieth national party congress, then the odds of an invasion will rise significantly. If conflict erupts in Taiwan, then the odds of Russia turning even more aggressive in Europe will rise. Iran is highly likely to pursue nuclear weapons. Not A Lot Of Positive Catalysts In H2 2022 Tactical Recommendation Inception Date Return LONG US 10-YEAR TREASURY 2022-04-14 1.3% LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 13.8% Bottom Line: Investors should remain defensively positioned at least until the Chinese party congress and the US midterm election conclude this fall. Geopolitical risk next year will depend on China’s actions in the Taiwan Strait. Feature Chart 1Speculation Rising About WWIII Pessimists who pay attention to world events have grown concerned in recent years about the risk that the third world war might break out. The term has picked up in online searches since 2019, though it is the underlying trend of global multipolarity, rather than the specific crisis events, that justifies the worry (Chart 1).1 What are the odds of a major war between the US and China, or the US and Russia? How might that be calculated? In this report we present a series of “decision trees” to formalize the different scenarios and probabilities. If we define WWIII as a war in which the United States engages in direct warfare with either Russia or China, or both, then we arrive at a 20% chance that WWIII will break out in the next couple of years! Those are frighteningly high odds – but history teaches that these odds are not unrealistic and that investors should not be complacent. Political scientist Graham Allison has shown that the odds of a US-China war over the long term are about 75% based on historical analogies. The takeaway is that nations will have to confront this WWIII risk and reject it for the global political environment to improve. Most likely they will do so as WWIII, and the risk of nuclear warfare that it would bring, constitutes the ultimate constraint. But the current behavior of the great powers suggests that they have not recognized their constraints yet and are willing to continue with brinksmanship in the short term. The Odds Of A Chinese Invasion Of Taiwan The first question is whether China will invade Taiwan. In April 2021 we predicted that the fourth Taiwan Strait crisis would occur within 12-24 months but that it would not devolve into full-scale war. This view is now being tested. In Diagram 1 we provide a decision tree to map out China’s policy options toward Taiwan and assign probabilities to each option. Diagram 1Decision Tree For Fourth Taiwan Strait Crisis (Next 24 Months) While China has achieved the capability to invade Taiwan, the odds of failure remain too high, especially without more progress on its nuclear triad. Hence we give only a 20% chance that China will mobilize for invasion immediately. Needless to say any concrete signs that China is planning an invasion should be taken seriously. Investors and the media dismissed Russia’s military buildup around Ukraine in 2021 to their detriment. At the same time, there is a good chance that the US and China are merely testing the status quo in the Taiwan Strait, which will be reinforced after the current episode. After all, this crisis was the fourth Taiwan Strait crisis – none of the previous crises led to war. If Presidents Biden and Xi Jinping are merely flexing their muscles ahead of important domestic political events this fall, then they have already achieved their objective. No further shows of force are necessary on either side, at least for the next few years. We give 40% odds to this scenario, in which the past week’s tensions will linger but the status quo is reinforced. In that case, the structural problem of the Taiwan Strait would flare up again sometime after the US and Taiwanese presidential elections in 2024, i.e. outside the time frame of the diagram. Unfortunately we are pessimistic over the long run and would give high probability to war in Taiwan. For that reason, we give equal odds (40%) to a deteriorating situation within the coming two years. If China expands drills and sanctions after the party congress, after Xi has consolidated power, then it will be clear that Xi is not merely performing for his domestic audience. Similarly if the Biden administration continues pushing for tighter high-tech export controls against China after the midterm election, and insists that US allies and partners do the same, then the US implicitly believes that China is preparing some kind of offensive operation. The danger of invasion would rise from 20% to 40%. Even in that case, one should still believe that crisis diplomacy between the US and China will prevent full-scale war in 2023-24. But the risk of miscalculation would be very high. The last element of this decision tree holds that China will prefer “gray zone tactics” or hybrid warfare rather than conventional amphibious invasion of the kind witnessed in WWII. The reasons are several. First, amphibious invasions are the most difficult military operations. Second, Chinese forces are inexperienced while the US and its allies are entrenched. Third, hybrid warfare will sow division among the US allies about how best to respond. Fourth, Russia has demonstrated several times over the past 14 years that hybrid warfare works. It is a way of maximizing strategic benefits and minimizing costs. The world knows how the West reacts to small invasions: it uses economic sanctions. It does not yet know how the West reacts to big invasions. So China will be incentivized to take small bites. And yet in Taiwan’s case those tactics may not be sustainable. Our Taiwan decision tree does not account for the likelihood that a hybrid war or “proxy war” will evolve into a major war. But that likelihood is in fact high. So we are hardly overrating the risk of a major US-China war. Bottom Line: Over the next two years, the subjective odds of a US-China proxy war over Taiwan are about 32% while the odds of a direct US-China war are about 4%. The true test comes after Xi Jinping consolidates power at this fall’s party congress. We expect Xi to focus on rebooting the economy so we continue to favor emerging Asian markets excluding China and Taiwan. The Odds Of Russian War With NATO The second question is whether Russia’s war in Ukraine will morph into a broader war with the West. The odds of a major Russia-West war are greater in this case than in China’s, as a war is already raging, whereas tensions in the Taiwan Strait are merely shadow boxing so far. An investor’s base case should hold that the Ukraine war will remain contained in Ukraine, as Europeans do not want to fight a devastating war with Russia merely because of the Donbas. But things often go wrong in times of war. The critical question is whether Russia will attack any NATO members. That would trigger Article Five of the alliance’s treaty, which holds that “an armed attack against one or more [alliance members] in Europe or North America shall be considered an attack against them all,” justifying the use of armed force if necessary to restore security. Since Russia’s invasion of Ukraine this year, President Biden has repeatedly stated that the US will “defend every inch of NATO territory,” including the Baltic states of Latvia, Lithuania, and Estonia, which joined NATO in 2004. This is not a change of policy but it is the US’s red line and highly likely to be defended. Hence it is a major constraint on Russia. In Diagram 2 we map out Russia’s different options and assign probabilities. Diagram 2Decision Tree For Russia-Ukraine War (Next 24 Months) We give 55% odds that Russia will declare victory after completing the conquest of Ukraine’s Donbas region and the land bridge to Crimea. It will start looking to legitimize its conquests by means of some diplomatic agreement, i.e. a ceasefire. This is our base case for 2023. There is evidence that Russia is already starting to move toward diplomacy.2 The reason is that Russia’s economy is suffering, global commodity prices are falling, Russian blood and treasure are being spent. President Putin will have largely achieved his goal of hobbling Ukraine as long as he controls the mouth of the Dnieper river and the rest of the territory he has invaded. Putin needs to seal his conquests and try to salvage the economy and society. The sooner the better for Russia, so that Europe can be prevented from forming a consensus and implementing a full natural gas embargo in the coming years. However, there is a risk that Putin’s ambition gets the better of him. So we give 35% odds that the invasion expands to southwestern Ukraine, including the strategic port city of Odessa, and to eastern Moldova, where Russian troops are stationed in the breakaway region of Transdniestria. This new campaign would render Ukraine fully landlocked, neutralize Moldova, and give Russia greater maritime access. But it would unify the EU, precipitate a natural gas embargo, and weaken Russia to a point where it could become desperate. It could retaliate and that retaliation could conceivably lead to a broader war. We allot only a 7% chance that Putin attacks Finland or Sweden for attempting to join NATO. Stalin failed in Finland and Putin’s army could not even conquer Kiev. The UK has pledged to support these states, so an attack on them will most likely trigger a war with NATO. A decision to attack Finland would only occur if Russia believed that NATO planned to station military bases there – i.e. Russia’s declared red line. Any Russian attack on the Baltic states is less likely because they are already in NATO. But there is some risk it could happen if Putin grows desperate. We put the risk of a Baltic invasion at 3%. In short, if Russia uses its energy stranglehold on Europe not to negotiate a favorable ceasefire but rather to expand its invasions, then the odds of a broader war will rise. Bottom Line: The result is a 55% chance of de-escalation over the next 24 months, a 35% chance of a small escalation (e.g. Odessa, Moldova), and a 10% chance of major escalation that involves NATO members and likely leads to a NATO-Russia war. Tactically, investors should buy developed-market European currency and assets if the global economy rebounds and Russia makes a clear pivot to halting its military campaign and pursuing ceasefire talks. Cyclically, there needs to be a deeper US-Russia understanding for a durable bull market in European assets. The Odds Of US-Israeli Strikes On Iran The third geopolitical crisis taking place this year could be postponed as we go to press – if President Biden and Ayatollah Ali Khamenei agree to rejoin the 2015 US-Iran nuclear deal. But we remain skeptical. The Biden administration wants to rejoin the 2015 nuclear deal and free up about one million barrels per day of Iranian crude oil to reduce prices at the pump before the midterm election. US grand strategy also wants to engage with Iran and stabilize the Middle East so that the US can pivot to Asia. The EU is proposing the deal since it has even greater need for Iranian resources and wants to prevent Iran from getting nuclear weapons. Russia and China are also supportive as they want to remove US sanctions for trading with Iran and do not necessarily want Iran to get nukes. There is only one problem: Iran needs nuclear weapons to ensure its regime’s survival over the long run. The question is whether Khamenei is willing to authorize a deal with the Americans a second time. The first deal was betrayed at great cost to his regime. President Ebrahim Raisi, who hopes to replace the 83-year-old Khamenei before long, is surely staunchly opposed to wagering his career and personal security on whether Republicans win the 2024 election. Iran has already achieved nuclear breakout capacity – it has enough 60%-enriched uranium to construct nuclear devices – and it is unclear why it would achieve this capacity if it did not ultimately seek to obtain a nuclear deterrent. Especially given that it may someday need to protect its regime from military attacks by the US and its allies. However, our conviction level is medium because President Biden wants to lift sanctions and can do so unilaterally. The Biden administration has not taken any of the preliminary actions to make a deal come together but that could change.3 There is a good cyclical case to be made for short-term, stop-gap deal. According to BCA’s Commodity & Energy Strategist Bob Ryan, Saudi Arabia and the UAE only have about 1.5 million barrels of spare oil production capacity between them. The EU oil embargo and western sanctions on Russia will force about two million barrels per day to be stopped, soaking up most of OPEC’s capacity. Hence the Biden administration needs the one million barrels that Iran can bring. We cannot deny that the Iranians may sign a deal to allow Biden to lift sanctions. That would benefit their economy. They could allow nuclear inspectors while secretly shifting their focus to warhead and ballistic missile development. While Iran will not give up the long pursuit of a nuclear deterrent, it is adept at playing for time. Still, Iran’s domestic politics do not support a deal – and its grand strategy only supports a deal if the US can provide credible security guarantees, which the US cannot do because its foreign policy is inconsistent. US grand strategy supports a deal but only if it is verifiable, i.e. not if Iran uses it as cover to pursue a bomb anyway. Iran has not capitulated after three years of maximum US sanctions, a pandemic, and global turmoil. And Iran sees a much greater prospect of extracting strategic benefits from Russia and China now that they have turned aggressive against the West. Moscow and Beijing can be strategic partners due to their shared acrimony toward Washington. Whereas the US can betray the Raisi administration just as easily as it betrayed the Rouhani administration, with the result that the economy would be whipsawed again and the Supreme Leader and the political establishment would be twice the fools in the eyes of the public. Diagram 3 spells out Iran’s choices. Diagram 3Decision Tree For Iran Nuclear Crisis (Next 24 Months) If negotiations collapse (50% odds), then Iran will make a mad dash for a nuclear weapon before the US and Israel attack. If the US and Iran agree to a deal (40%), then Iran might comply with the deal’s terms through the 2024 US election, removing the issue from investor concerns for now. But their long-term interest in obtaining a nuclear deterrent will not change and the conflict will revive after 2024. If talks continue without resolution (10%), Iran will make gradual progress on its nuclear program without the restraints of the deal (though it may not need to make a mad dash). In short, Russia and China need Iran regardless of whether it freezes its nuclear program, whereas the US and Israel will form a balance-of-power Abraham Alliance to contain Iran even if it does freeze its nuclear program. Bottom Line: Investors should allot 40% odds to a short-term, stop-gap US-Iran nuclear deal. The oil price drop would be fleeting. Long-term supply will not be expanded because the US cannot provide Iran with the security guarantees that it needs to halt its nuclear program irreversibly. The Odds Of World War III Now comes the impossible part, where we try to put these three geopolitical crises together. In what follows we are oversimplifying. But the purpose is to formalize our thinking about the different players and their options. Diagram 4 begins with our conclusions regarding the China/Taiwan conflict, adjusts the odds of a broader Russian war as a result, and adds our view that Iran is highly likely to pursue nuclear weapons. Again the time frame is two years. Diagram 4Decision Tree For World War III (Next 24 Months) The alternate conflict scenario to WWIII consists of “limited wars” – a dangerous concept that refers to hybrid and proxy wars in which the US is not involved, or only involved indirectly. Or it could be a conflict with Iran that does not involve Russia and China. We begin with China because China is the most capable and most ambitious global power today. China’s strategic rise is upsetting the global order and challenging the United States. We also start with China because we have some evidence this year that Russia does not intend to expand the war beyond Ukraine. Either China takes further aggressive action in Taiwan – creating a unique opportunity for Russia to take greater risks – or not. If not, then the odds of WWIII fall precipitously over the two-year period. This scenario is our base case. But if China attacks Taiwan and the US defends Taiwan, we give a high probability to Russia invading the Baltics. If China stages hybrid attacks and the US only supports Taiwan indirectly, then we increase the odds of Russian aggression only marginally. The result is 20% odds of WWIII, i.e. a direct war between the US and Russia, or China, or both. Whether this war could remain limited is debatable. War gaming since 1945 shows that any war between major nuclear powers will more likely escalate than not. But nuclear weapons bring mutually assured destruction, the ultimate constraint. The nuclear escalation risk is why we round down the probability of WWIII in our decision trees. The more likely 59% risk scenario of “limited wars” may seem like a positive outcome but it includes major increases in geopolitical tensions from today’s level, such as a Chinese hybrid war against Taiwan. Bottom Line: According to this exercise the odds of WWIII could be as high as 20%. This is twice the level in our Russia decision tree, which is appropriate given that our Taiwan crisis forecast has materialized. The critical factor is whether Beijing continues escalating the pressure on Taiwan after the party congress this fall. That could unleash a dangerous chain reaction. The global economy and financial markets still face downside risk from geopolitics but 2023 could see improvements if Russia moves toward a ceasefire and China delays action against Taiwan to reboot its economy. Investment Takeaways When Russia invaded Ukraine earlier this year, our colleague Peter Berezin, Chief Global Strategist, argued that the odds of nuclear Armageddon were 10%. At very least this is a reasonable probability for the odds that Russia and NATO come to blows. Now the expected Taiwan crisis has materialized. We guess that the odds of a major war have doubled to 20%. The corollary is an 80% chance of a better outcome. Analytically, we still see Russia as pursuing a limited objective – neutralizing Ukraine so that it cannot be prosperous and militarily powerful – while China also pursues a limited objective – intimidating Taiwan so that it pursues subordination rather than nationhood. Unless these objectives change, we are still far from World War III. The world can live with a hobbled Ukraine and a subordinated Taiwan. However, there can be no denying that the trajectory of global affairs since the 2008 global financial crisis has followed a pathway uncomfortably similar to the lead up to World War II: financial crisis, economic recession, deflation, domestic unrest, currency depreciation, trade protectionism, debt monetization, military buildup, inflation, and wars of aggression. If roulette is the game, then the odds of a global war are one-sixth or 17%, not far from the 20% outcome of our decision trees. Even assuming that we are alarmist, the fact that we can make a cogent, formal argument that the odds of WWIII are as high as 20% suggests that investors should wait for the current tensions over Ukraine and Taiwan to decrease before making large new risky bets. A simple checklist shows that the global macro and geopolitical context is gloomy (Table 1). We need improvement on the checklist before becoming more optimistic. Table 1Not A Lot Of Positive Catalysts In H2 2022 Chart 2Stay Defensively Positioned In H2 2022 Specifically what investors need is to be reasonably reassured that Russia will not expand the war to NATO and that China will not invade Taiwan anytime soon. This requires a new diplomatic understanding between the Washington and Moscow and Washington and Beijing that forestalls conflict. That kind of understanding can only be forged in crisis. The relevant crises are under way but not yet complete. There is likely more downside for global equity investors before war risks are dispelled through the usual solution: diplomacy. Wait for concrete and credible improvements to the global system before taking a generally overweight stance toward risky assets. Favor government bonds over stocks, US stocks over global stocks, defensive sectors over cyclicals, and disfavor Chinese and Taiwanese currency and assets (Chart 2).     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1      See Graham Allison, Destined For War: Can America and China Escape Thucydides’s Trap? (New York: Houghton Miffin Harcourt, 2017). 2     For example, the Turkish brokered deal to ship grain out of Odessa, diplomatic support for rejoining the 2015 Iran nuclear deal, referendums in conquered territories like Kherson, and attempts to build up leverage in arms reduction talks. Cutting off Europe’s energy is ultimately a plan to coerce Europe into settling a ceasefire favorable for Russia. 3     Iran is still making extraneous demands – most recently that the IAEA drop a probe into how certain manmade uranium particles appeared in undisclosed nuclear sites in Iran. The IAEA has not dropped this probe and its credibility will suffer if it does. Meanwhile Biden is raising not lowering sanctions on Iran, even though sanction relief is a core Iranian demand. Biden has not removed the Iranian Revolutionary Guards or the Qods Force from the terrorism list. None of these hurdles are prohibitive but we would at least expect to see some movement before changing our view that a deal is more likely to fail than succeed. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades ()

Executive Summary Oil Markets Remain Tight US and Iranian negotiators received an EU proposal for reviving the Iran nuclear deal on Monday, which could return ~ 1mm b/d of oil to markets.  The EU’s embargo of Russian seaborne crude imports, which commences December 5, will remove 90% of seaborne imports of Russian crude (~ 2.3mm b/d) by year-end.  In February 2023, another 800k b/d of refined products will be embargoed.  December also will usher in insurance and reinsurance sanctions on shipping Russian oil – arguably the strongest sanctions the EU, UK and US can impose. Without those Iranian barrels, the determination of the EU, UK and US to enforce a Russian oil embargo will be suspect. We give odds of 60% to a US-Iran deal getting done in the near term.  Our Geopolitical Strategy maintains the likelihood of a deal is 40% at best. Bottom Line: Oil markets are pricing in the likelihood of large energy supply dislocations over the next couple of months.  The evolution of prices hinges upon the degree to which the EU’s embargo on Russian oil imports is implemented.  A revived Iran nuclear deal with the West would offset some of the embargoed Russian oil.  Even so, oil balances still will remain tilted to deficit conditions in 2023.  We continue to expect Brent will move above our 2022 $110/bbl expectation by 4Q22, and average $117/bbl next year. Feature US and Iranian negotiators received a proposal from EU negotiators for reviving the Iran nuclear deal on Monday.1 If the US and Iran can agree, the door opens for 1mm b/d of Iranian oil to return to markets. These barrels are becoming increasingly important to the EU, especially following the suspension of southerly flows of oil on Russia’s Druzhba pipeline due to a payment dispute.2 Brent popped ~ $1.50/bbl Tuesday morning as the Druzhba news broke, and the backwardation in the forward market increased (Chart 1). Brent gave back these early gains by the end of trading, following news a Hungarian refiner transferred the fee required to use the Ukrainian section of the pipeline.3 Chart 1Oil Markets Remain Tight Complicated Motives On All Sides The EU obviously has an interest in freezing Iran’s nuclear program and accessing more Iranian fossil fuels while it is locked in an energy struggle with Russia – hence the its proposal to revive the Iran nuclear deal. However, the US and Iranian positions are more complicated. Iranian’s Supreme Leader Ali Khamenei has an interest in removing the US’s economic sanctions – and in obtaining deliverable nuclear weapons, notes Matt Gertken, BCA Research’s chief geopolitical strategist. Khamenei’s plan is to develop a nuclear weapon so that Iran can deter any aggression from a future US administration or the Abraham alliance. This is the path to regime survival, power succession, and national security. Hence Iran will not freeze its nuclear program over the long run. But Khamenei may wish to buy time while the Democrats still run the White House. Chart 2KSA, UAE Preserving Spare Capacity We’ve noted repeatedly the Biden administration has been pressing the Kingdom of Saudi Arabia (KSA) and the United Arab Emirates (UAE) – the only states in OPEC 2.0 able to raise output and maintain production at higher levels – to increase output for the better part of this year. These efforts yielded only a 100k b/d production increase earlier this month. KSA and the UAE insist they are close to the maximum levels of oil they can supply to the market, given their current production and the need to maintain minimal spare capacity (Chart 2).4 KSA’s max capacity is 12mm b/d. The Kingdom will be producing at or slightly above 11mm b/d later this year to offset declines in non-core OPEC 2.0 production. KSA’s trying to get its max capacity to 13mm b/d, but that will take until 2027, according to the state oil company ARAMCO. UAE’s max capacity is 4mm b/d. It will be producing at or close to 3.5mm b/d this year, and after that they’ll want to hang on to that last bit as spare capacity. UAE’s trying to get its spare capacity to 5mm b/d, but that’s going to take until 2030, according to its state oil company ADNOC. There’s an increasing risk to the Russian output arising from the EU embargo scheduled to take effect December 5, and sanctions on providing insurance and reinsurance to ships carrying Russian material. If the EU/UK/US embargo is successful and results in Russia being forced to shut in 2mm b/d by the end of next year, per our expectation, KSA and UAE spare capacity will not cover the loss of production, and falling output within OPEC 2.0. Given these dynamics – and the expectation at least some of the sanctions will stick after Dec. 5 – KSA and UAE have to hang on to those last barrels to be able to meet the increasingly likely loss of Russian shut-in production. Additional spare capacity is not available in the US shales, or in any of the other producing provinces outside OPEC 2.0 sufficient to cover the loss of Russian barrels. Indeed, output from OPEC 2.0 outside the core producers has been trending lower for years (Chart 3).5 Complicating a deal with Iran is the possibility it could re-open the breach between the US and KSA. If KSA wanted to express its displeasure with a US-Iran deal it wouldn’t need to do much to re-balance the market: If the Kingdom does not offset production losses by the rest of OPEC 2.0, or step up to cover, e.g., Libyan production – now back on the market with just under 500k b/d – global supply falls and prices rise, all else equal.6 Chart 3KSA, UAE Are Core OPEC 2.0 Our Geopolitical Strategy gives 40% odds of an Iran deal and 60% odds that negotiations fall apart (or drag on without resolution). We make the odds higher – 60% chance of success – given the compelling interest of the Biden administration to get more oil into the market going into midterms in November, and a general interest in the West to offset potential losses of Russian volumes to sanctions that kick in in December. The difference in these views hinges on what Iran will do, as the Biden administration is seeking a deal. Sanctions Kicking In In December The EU is set to roll into its embargo of Russian oil imports on December 5. If fully implemented, ~ 2.3mm b/d of seaborne imports of Russian crude oil will be excluded from EU markets by year-end. Beginning in February, another 800k b/d of refined products will be embargoed. EU, UK and US shipping insurance and reinsurance sanctions also are set to kick in in December. These arguably are the strongest sanctions available to the West in its effort to take Russian oil and refined products off the market (no insurance means no shipping). The EU recently relaxed sanctions on buying and transporting Russian crude oil, which will allow additional volumes of oil to be purchased and transported to end-use markets.7 While this will let a little more Russian oil into the market in the near term, we believe it opens the possibility of additional exceptions being made by the EU to make more oil available, if prices move sharply higher on the back of increasing supply scarcity. The EU and US are looking a bit wobbly on the insurance and reinsurance bans due to kick in in December.8 If they relax or forego these sanctions in some fashion, more Russian crude and products will flow to market in 4Q22 than currently is anticipated. This would undermine US efforts to secure a price cap on Russian oil sales. Slower sanction enforcement is a path available to Biden that does not involve bowing to Iran’s various demands. Some, but not all, of the Russian volumes lost to EU exports will continue to be scooped up by China and India, which have become the largest buyers of Russian oil following the sanctions imposed by the West after the invasion of Ukraine.9 India loaded 29.5mm barrels of Russian crude in July – a record – while China loaded 18.1mm barrels. These levels likely will fall, but these two states will remain big buyers of Russian crude and products going forward. Household Budgets Will Remain Strained High energy prices – particularly for gasoline and diesel fuel – and falling real incomes have eaten into US household budgets, and are a key factor for Biden’s low approval ratings (Chart 4). July US CPI was unchanged from June and was 8.5% higher y-o-y. While the gasoline price index dropped from June, it remained one of the main contributors to the high energy index. (Chart 5).10 Based on the sharp increase in gasoline prices over the first six months of this year, we estimate the cost of running a car is 50% higher in 1H22 vs. 1H21 in the US. Chart 4Wealth Destruction Key To Low Biden Approval Chart 5Energy Driving High US Prices US gasoline and distillate prices have rolled over since mid-June, driven by high refined-product prices, which weakened demand, and fear of global recession as central banks tighten monetary policy. Higher Russian crude output in 1H22 – up 3.6% to ~ 10.1mm b/d – partly contributed to weaker product prices. However, this trend likely will reverse: Russian crude output in 2Q22 was down 1.1% y/y to 9.7mm b/d, based on our estimates. We expect prices of gasoline and diesel fuel to remain at elevated levels, given low inventories (Chart 6), and a second consecutive year of lower US refining capacity (Chart 7). Higher crude oil prices brought about by Russian oil and product embargoes will feed into these refined product prices, pushing them higher. Chart 6Low Product Stocks… Chart 7…And Refining Capacity Are Bullish For Petrol Products There is scope for an increase in gasoline demand over the rest of the driving season, while elevated US and overseas distillate demand will support diesel and heating oil prices. The eurozone’s record high inflation in July was driven by energy prices (Chart 8), indicating high energy prices are a problem for households worldwide. According to the Household Electricity Price Index, residential electricity prices in EU capitals were more than 70% higher in 1H22 y/y. The IMF expects high fuel prices will increase EU households’ share of energy expenditure by 7% in 2022.11 In response to high energy prices, governments are enacting policies such as price caps and direct transfers to lower the damage to household wealth.12 An unintended consequence of this will be high prices for longer, as consumers will not register the signal the market is sending via higher prices to encourage lower demand. This will result in continued draws on inventories. Chart 8High Energy Prices Responsible For Eurozone Inflation Investment Implications With EU sanctions scheduled to become effective December 5, oil markets are focused on supply measures that could sharply reduce Russian oil exports. This makes the US-Iran negotiations to revive the Iran nuclear deal critically important. Agreement to restore the deal could return 1mm b/d of oil to markets at a time when supplies are at risk of contracting sharply going into 2023. Failure to restore these volumes will tighten supply significantly if the EU’s embargo of Russian oil imports is successful. We give the restoration of the Iran nuclear deal a 60% chance of success. In and of itself, the return of Iranian oil exports will not offset all of the potential loss of Russian crude oil exports to the EU. That said, the evolution of crude oil prices hinges upon the degree to which the EU’s embargo on Russian oil imports is implemented. There's a subtle point to be aware of in the evolution of US-Iran negotiations: The Biden administration could just turn a blind eye to Iranian crude sales, without agreeing to revive the nuclear deal being negotiated. Signing a deal, on the other hand, would be more positive for supply than merely not contesting Iranian's renewed exports of 1mm b/d of crude. It is worthwhile bearing in mind that the point of the deal is that Iran pauses its nuclear program, which reduces war risk in the medium term, or as long as deal is in force. Reducing the level of agita in the region, at least for a couple of years, is a net benefit. Our geopolitical strategist Matt Gertken notes, "If Iranians sign a deal, then they are endorsing Biden and the Democratic Party for 2024, meaning they want a Democratic White House in the US through 2028. There would be no reason to sign it unless you plan to implement at least through 2024." We remain bullish oil, and continue to expect Brent to trade above $110/bbl on average this year, and $117/bbl next year. We remain long the XOP ETF to retain our exposure to oil and gas E+Ps.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com     Commodities Round-Up Energy: Bullish The EIA expects US natural gas inventories to finish the injection season at ~ 3.5 Tcf – 6% below the five-year average – at the end of October (Chart 9). LNG exports are expected to average 11.2 Bcf/d, which, if realized, will be 14% over 2021 levels. The EIA increased its estimate of LNG exports on the back of an earlier-than-expected return of Freeport LNG exports. For 2023, the EIA expects US LNG exports will average 12.7 Bcf/d. Close to 70% of the 57 bcm of US LNG exports are being shipped to Europe, where it is helping offset the cutoff of Russian gas supplies following the war in Ukraine. In 1H22, the US became the world’s largest exporter of LNG. Dry gas production in the US is expected to average just under 97 Bcf/d in 2022, a 3% increase over 2021 levels. Base Metals: Bullish Total Chinese copper imports for July were up 9.3% at ~464kt for July, despite economic weakness and a property market slowed by companies' payment defaults and lower consumer confidence in real estate groups. Copper in SHFE warehouses were at 35kt which is 65% lower y/y as of the week ending August 5th, while stocks in China’s copper bonded inventories were 40% lower y/y at 262kt for the month of June. Low copper prices and Chinese stocks, and high imports indicate that the world’s largest copper consumer is capitalizing on weak prices to restock low inventories. Precious Metals: Bullish The World Gold Council reported gold ETF outflows for the third consecutive month in July at 80.1 tons (Chart 10) due to low gold prices, a strong USD and a hawkish Fed. The latest July US CPI data was unchanged from June, as high prices due to pandemic induced supply chain bottlenecks eased. Inflation remains well above target. Despite the mildly positive inflation data, we expect the Fed to hike interest rates again in September. The magnitude of this hike will depend on the August US CPI and employment prints, given the Fed’s data dependency. By year-end, if the Russian oil embargo and insurance bans on shipping vessels are implemented in their current form, high crude oil prices will feed into inflation, and the Fed will be forced to remain aggressive. Chart 9 Chart 10     Footnotes 1     Please see Agreement on nuclear deal within reach but obstacles remain published by politico.com on August 8, 2022. 2     Please see Russia suspends oil exports via southern leg of Druzhba pipeline due to transit payment issues published by reuters.com on August 9, 2022. 3    Please see Oil drops on Druzhba pipeline news and U.S. inflation expectations published by reuters.com on August 10, 2022.  According to the International Association of Oil Transporters, the Druzhba pipeline capacity is ~ 1.3mm b/d.  In July, its southern leg supplying Hungary, the Czech Republic and was carrying ~ 230k b/d, according to OilX, a satellite service monitoring oil and shipping movements globally. 4    Please see Tighter Oil Markets On The Way, which we published on July 21, 2022, for additional detail. 5    Please see footnote #4. 6    The background factor in this situation is Russia’s involvement in Libya’s civil disorder.  We noted in our July 14, 2022 report Russia Pulls Oil, Gas Supply Strings: “Sporadic force majeure declarations and output losses in Libya, where Russian mercenaries actively support Khalifa Haftar’s Libyan National Army (LNA), continue to make supply assessments difficult.” 7     Please see How the EU Will Allow a Slight Increase in Russian Oil Exports published by Bloomberg.com on August 1, 2022. 8    Please see US warns of surge in fuel costs as it renews push for Russian oil price cap published by ft.com on July 26, 2022. 9    Please see Russian crude prices recover on strong India, China demand, and Column-Russian crude is more reliant on India and China, but signs of a peak: Russell | Reuters, published by reuters.com on August 7 and August 9, 2022. 10   After fuel oils, the 44% y-o-y increase in the gasoline price index was the largest contributor to the increase in the energy index. 11    Please see Surging Energy Prices in Europe in the Aftermath of the War: How to Support the Vulnerable and Speed up the Transition Away from Fossil Fuels, published by the IMF on July 29, 2022. 12    For an example of such policy, please see State aid: Commission approves Spanish and Portuguese measure to lower electricity prices amid energy crisis     Investment Views and Themes Strategic Recommendations Trades Closed in 2022

Executive Summary Biden Taps China-Bashing Consensus House Speaker Nancy Pelosi’s visit to Taiwan reflects one of our emerging views in 2022: the Biden administration’s willingness to take foreign policy risks ahead of the midterm elections. Biden’s foreign policy will continue to be reactive and focused on domestic politics through the midterms. Hence global policy uncertainty and geopolitical risk will remain elevated at least until November 8.  Biden is seeing progress on his legislative agenda. Congress is passing a bill to compete with China while the Democrats are increasingly likely to pass a second reconciliation bill, both as predicted. These developments support our view that President Biden’s approval rating will stabilize and election races will tighten, keeping domestic US policy uncertainty elevated through November. These trends pose a risk to our view that Republicans will take the Senate, but the prevailing macroeconomic and geopolitical environment is still negative for the ruling Democratic Party. We expect legislative gridlock and frozen US fiscal policy in 2023-24. Close Recommendation (Tactical) Initiation Date  Return Long Refinitiv Renewables Vs. S&P 500 Mar 30, 2022 25.4% Long Biotech Vs. Pharmaceuticals Jul 8,  2022 -3.3% Bottom Line: While US and global uncertainty remain high, we will stay long US dollar, long large caps over small caps, and long US Treasuries versus TIPS. But these are tactical trades and are watching closely to see if macroeconomic and geopolitical factors improve later this year. Feature President Biden’s average monthly job approval rating hit its lowest point, 38.5%, in July 2022. However, Biden’s anti-inflation campaign and midterm election tactics are starting to bear fruit: gasoline prices have fallen from a peak of $5 per gallon to $4.2 today, the Democratic Congress is securing some last-minute legislative wins, and women voters are mobilizing to preserve abortion access.  These developments mean that the Democratic Party’s electoral prospects will improve marginally between now and the midterm election, causing Senate and congressional races to tighten – as we have expected. US policy uncertainty will increase. Investors will see a rising risk that Democrats will keep control of the Senate – and conceivably even the House – and hence retain unified control of the executive and legislative branches. This “Blue Sweep” risk will challenge the market consensus, which overwhelmingly (and still correctly) expects congressional gridlock in 2023-24. A continued blue sweep would mean larger tax hikes and social spending, while gridlock would neutralize fiscal policy for the next two years. Investors should fade this inflationary blue sweep risk and continue to plan for disinflationary gridlock. First, our quantitative election models still predict that Democrats will lose control of both House and Senate (Appendix). Second, Biden’s midterm tactics face very significant limitations, particularly emanating from geopolitics – the snake in this report’s title. Pelosi’s Trip To Taiwan Raises Near-Term Market Risks One of Biden’s election tactics is our third key view for 2022: reactive foreign policy. Initially we viewed this reactiveness as “risk-averse” but in May we began to argue that Biden could take risky bets given his collapsing approval ratings. Either way, Biden is using foreign policy as a means of improving his party’s domestic political fortunes. In particular, he is willing to take big risks with China, Russia, Iran, and terrorist groups like Al Qaeda. The template is the 1962 congressional election, when President John F. Kennedy largely defied the midterm election curse by taking a tough stance against Russia in the Cuban Missile Crisis (Chart 1). If Biden achieves a foreign policy victory, then Democrats will benefit. If he instigates a crisis, voters will rally around his administration out of patriotism. Nancy Pelosi’s visit to Taipei is the prominent example of this key view. The trip required full support from the US executive branch and military and was not only the swan song of a single politician. It was one element of the Biden administration’s decision to maintain the Trump administration’s hawkish China policy. Thus while Congress passes the $52 billion Chips and Science Act to enhance US competitiveness in technology and semiconductor manufacturing, Biden is also contemplating tightening export controls on computer chip equipment that China needs to upgrade its industry.1 Biden is reacting to a bipartisan and popular consensus holding that the US needs to take concrete measures to challenge China and protect American industry (Chart 2). This is different from the old norm of rhetorical China-bashing during midterms. Chart 1Biden Provokes Foreign Rivals Chart 2Biden Taps China-Bashing Consensus Reactive US foreign policy will continue through November and possibly beyond – including but not limited to China. The US chose to sell long-range weapons to Ukraine and provide intelligence targeting Russian forces, prompting Russia to declare that the US is now “directly” involved in the Ukraine conflict. The US decision to eradicate Al Qaeda leader Ayman Al-Zawahiri also reflects this foreign policy trend. Reactive foreign policy will increase the near-term risk of new negative geopolitical surprises for markets. Note that the 1962 Cuban Missile Crisis analogy is inverted when it comes to the Taiwan Strait. China is willing to take much greater risks than the US in its sphere of influence. The same goes for Russia in Ukraine. If US policy backfires then it may assist the Democrats in the election – but not if Biden suffers a humiliation or if the US economy suffers as a result. Chart 3US Import Prices Will Stay High From Greater China US import prices will continue to rise from Greater China (Chart 3), undermining Biden’s anti-inflation agenda. Supply kinks in the semiconductor industry will become relevant again whenever demand rebounds  (Chart 4). Global energy prices will also remain high as a result of the EU’s oil embargo and Russia’s continued tightening of European natural gas supplies. Chart 4New Semiconductor Kinks Will Appear When Demand Recovers OPEC has decided only to increase oil production by 100,000 barrels per day, despite Biden’s visit to Saudi Arabia cap in hand. We argued that the Saudis would give a token but would largely focus on weakening global demand rather than pumping substantially more oil to help Biden and the Democrats in the election. The Saudis know that Biden is still attempting to negotiate a nuclear deal with Iran that would free up Iranian exports. So the Saudis are not giving much relief, and if Biden fails on Iran, oil supply disruptions will increase. Bottom Line: Price pressures will intensify as a result of the US-China and US-Russia standoffs – and probably also the US-Iran standoff. Hawkish foreign policy is not conducive to reducing inflationary ills. Global policy uncertainty and geopolitical risk will remain high throughout the midterm election season, causing continued volatility for US equities. Abortion Boosts Democratic Election Odds Earlier this year we highlighted that the Supreme Court’s overturning of the 1972 Roe v. Wade decision would lead to a significant mobilization of women voters in favor of the Democratic Party ahead of the midterm election. The first major electoral test since the court’s ruling, a popular referendum in the state of Kansas, produced a surprising result on August 2 that confirms and strengthens this thesis. Kansas is a deeply religious and conservative state where President Trump defeated President Biden by a 15% margin in 2020. The referendum was held during the primary election season, when electoral turnout skews heavily toward conservatives and the elderly. Yet Kansans voted by an 18% margin (59% versus 41%) not to amend the constitution, i.e. not to empower the legislature to tighten regulations on abortion. Voter turnout is not yet reported but likely far higher than in recent non-presidential primary elections. Kansans voted in the direction of  nationwide opinion polling on whether abortion should be accessible in cases where the mother’s health is endangered. They did not vote in accordance with more expansive defenses of abortion, which are less popular (Chart 5). If the red state of Kansas votes this way then other states will see an even more substantial effect, at least when abortion is on the ballot. Chart 5Abortion Will Mitigate Democrats’ Losses The question is how much of this Roe v. Wade effect will carry over to the general congressional elections. The referendum focused exclusively on abortion. Voters did not vote on party lines. Voters never like it when governments try to take away rights or privileges that have previously been granted. But in November the election will center on other topics, including inflation and the economy. And midterm elections almost always penalize the incumbent party. Our quantitative election models imply that Democrats will lose 22 seats in the House and two seats in the Senate, yielding Congress to the Republicans next year (Appendix). Still, women’s turnout presents a risk to our models. Women’s support for the Democratic Party has not improved markedly since the Supreme Court ruling, as we have shown in recent reports (Chart 6). But the polling could pick up again. Women’s turnout could be a significant tailwind in a year of headwinds for the Democrats. Bottom Line: Democrats’ electoral prospects have improved, as we anticipated earlier this year (Chart 7). This trend will continue as a result of the mobilization of women. Republicans are still highly likely to take Congress but our conviction on the Senate is much lower than it is on the House. Chart 6Biden’s And Democrats’ Approval Among Women Chart 7Democrats’ Odds Will Improve On Margin Reconciliation Bill: Still 65% Chance Of Passing Ultimately Democrats’ electoral performance will depend on inflation, the economy, and cyclical dynamics. If inflation falls over the course of the next three months, then Democrats will have a much better chance of stemming midterm losses. That is why President Biden rebranded his slimmed down “Build Back Better” reconciliation bill as the “Inflation Reduction Act.” We maintain our 65% odds that the bill will pass, as we have done all year. There is still at least a 35% chance that Senator Kyrsten Sinema of Arizona could defect from the Democrats, given that she opposed any new tax hikes and the reconciliation bill will impose a 15% minimum tax on corporations. A single absence or defection would topple the budget reconciliation process, which enables Democrats to pass the bill on a simple majority vote. We have always argued that Sinema would ultimately fall in line rather than betraying her party at the last minute before the election. This is even more likely given that moderate-in-chief, Senator Joe Manchin of West Virginia, negotiated and now champions the bill. But some other surprise could still erase the Democrats’ single-seat majority, so we stick with 65% odds. Most notably the bill will succeed because it actually reduces the budget deficit – by an estimated $300 billion over a decade (Table 1). Deficit reduction was the original purpose of lowering the number of votes required to pass a bill under the budget reconciliation process. Now Democrats are using savings generated from new government caps on pharmaceuticals (a popular measure) to fund health and climate subsidies. Given deficit reduction, it is conceivable that a moderate Republican could even vote for the bill. Table 1Democrats’ Inflation Reduction Act (Budget Reconciliation) Bottom Line: Democrats are more likely than ever to pass their fiscal 2022 reconciliation bill by the September 30 deadline. The bill will cap some drug prices and reduce the deficit marginally, so it can be packaged as an anti-inflation bill, giving Democrats a legislative win ahead of the midterm. However, its anti-inflationary impact will ultimately be negligible as $300 billion in savings hardly effects the long-term rising trajectory of US budget deficits relative to output. The bill will add to voters’ discretionary income and spur the renewable energy industry. And if it helps the Democrats retain power, then it enables further spending and tax hikes down the road, which would prove inflationary. The reconciliation bill, annual appropriations, and the China competition bill were the remaining bills that we argued would narrowly pass before the US Congress became gridlocked again. So far this view is on track.   Investment Takeaways Companies that paid a high effective corporate tax rate before President Trump’s tax cuts have benefited relative to those that paid a low effective rate. They stood to suffer most if Trump’s tax cuts were repealed. But Democrats were forced to discard their attempt to raise the overall corporate tax rate last year. Instead the minimum corporate rate will rise to 15%, hitting those that paid the lowest effective rate, such as Big Tech companies, relative to high-tax rate sectors such as energy (Chart 8, top panel). Tactically energy may still underperform tech but cyclically energy could outperform and the reconciliation bill would feed into that trend. Similarly, companies that faced high foreign tax risk, because they made good income abroad but paid low foreign tax rates, stand to suffer most from the imposition of a minimum corporate tax rate (Chart 8, bottom panel). Again, Big Tech stands to suffer, although it has already priced a lot of bad news and may not perform poorly in the near term. Chart 8Market Responds To Minimum Corporate Tax Chart 9Market Responds To New Climate Subsidies Renewable energy stocks have rallied sharply on the news of the Democrats’ reconciliation bill getting back on track (Chart 9). We are booking a 25.4% gain on this tactical trade and will move to the sidelines for now, although renewable energy remains a secular investment theme. Health stocks, particularly pharmaceuticals, have taken a hit from the new legislation as we expected. However, biotech has not outperformed pharmaceuticals as we expected, so we will close this tactical trade for a loss of 3.3%. The reconciliation bill will cap drug prices for only the most popular generic drugs and does not pose as much of a threat to biotech companies (Chart 10). Biotech should perform well tactically as long bond yields decline – they are also historically undervalued, as noted by Dhaval Joshi of our Counterpoint strategy service. So we will stick to long Biotech versus the broad market. US semiconductors remain in a long bull market and will be in heavy demand once global and US economic activity stabilize. They are also likely to outperform competitors in Greater China that face a high and persistent geopolitical risk premium (Chart 11).  Chart 10Market Responds To Drug Price Caps Chart 11Market Responds To China Competition Bill Tactically we prefer bonds to stocks, US equities to global equities, defensive sectors to cyclicals, large caps to small caps, and growth stocks to value stocks (Chart 12). The US is entering a technical recession, Europe is entering recession, China’s economy is weak, and geopolitical tensions are at extreme highs over Ukraine, Taiwan, and Iran. The US is facing an increasingly uncertain midterm election. These trends prevent us from adding risk in our portfolio in the short term. However, much bad news is priced and we are on the lookout for positive economic surprises and successful diplomatic initiatives to change the investment outlook for 2023. If the US and China recommit to the status quo in the Taiwan Strait, if Russia moves toward ceasefire talks in Ukraine, if the US and Iran rejoin the 2015 nuclear deal, then we will take a much more optimistic attitude. Some political and geopolitical risks could begin to recede in the fourth quarter – although that remains to be seen. And even then, geopolitical risk is rising on a secular basis. Chart 12Tactically Recession And Geopolitics Will Weigh On Risk Assets Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com       Footnotes 1     Alexandra Alper and Karen Freifeld, “U.S. considers crackdown on memory chip makers in China,” Reuters, August 1, 2022, reuters.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 A4House Election Model Table A5APolitical Capital: White House And Congress Table A5BPolitical Capital: Household And Business Sentiment Table A5CPolitical Capital: The Economy And Markets