India

Executive Summary Long-Term Contracts Needed To Increase LNG Supply The EU will have to reverse course and execute long-term contracts with natural gas producers, LNG shippers and pipeline operators to incentivize production of supplies needed to contain energy prices. Long-term contracting will offer the EU an opportunity to address political and economic fragmentation risks via joint taxation policies.  This would transform state-level risks via-a-vis energy and military security into joint-and-several obligations. The G7’s plan to cap Russian oil prices will be DOA.  The most oil import-dependent EM economies – China and India – will find deeply discounted crude irresistible. Hydrocarbon producers and refiners will increase investments in carbon-capture and storage technology, to maintain their new-found advantage as secure energy sources.  Additional subsidies and funding for this technology will be forthcoming. Bottom Line: The hard realities of military conflict and a lack of investment in production and refining will force governments to incentivize substantial investments in hydrocarbons – particularly natural gas and LNG infrastructure – to address global energy scarcity during a time of war.  We remain long oil and gas exposures via the COMT ETF, and long equity refining and services exposures via the CRAK and IEZ ETFs.  We will re-establish our producer-oriented XOP ETF position if prompt Brent futures trade down to $105/bbl in the front month.  We also remain tactically long Brent and eurozone natgas futures and options. Feature The G7 last opined on liquified natural gas (LNG) supply in May, and as was the case this week, it left even casual observers uncertain as to what it is seeking to achieve: It advocated for a halt to further investments in fossil-fuel projects and, at the same time, called for higher LNG supplies to be provided for the EU states.1  The EU faces daunting energy security and supply constraints.2 A deepening energy scarcity will, we expect, push the EU into recession later this year, as natural-gas rationing is invoked to ensure there are sufficient supplies to meet human needs this winter.  Natgas scarcity will force the EU to reverse course on its renewable-energy transition in the medium term and prioritize fossil-fuel investments, in our view.  Long-term contracting with LNG suppliers will be required to incentivize needed investment in production and transportation to replace Russian gas imports.  Such contracting is a necessity for hydrocarbon producers, given governments’ continued calls for no additional fossil-fuel investment.  Quicksilver shifts in policy are a continuing source of uncertainty for investors and energy-supply firms. Over time, the EU will have to replace close to 7 Tcf/yr of Russian gas imports (Chart 1, middle panel).  This will propel the EU into the ranks of the world’s largest LNG importers (Chart 2).  Chart 1EU Needs To Replace ~ 7 Tcf/yr Of LNG Chart 2EU Will Become A World-Class LNG Importer Chart 3Long-Term Contracts Needed To Increase LNG Supply Given the length of contracts typically executed with LNG exporters – in excess of 20-plus years – EU governments will be compelled to allow firms and member states to sign long-term contracts for these supplies.  EU governments also will be required to begin planning for and developing LNG importing infrastructure, as these supplies become available over the next 3-5 years. In the meantime, LNG prices will remain under pressure as competition heats up globally ahead of the coming winter (Chart 3). G7 Price-Cap Scheme Will Be DOA The G7’s scheme to impose a price cap on Russian oil exports will be DOA as soon as details are presented.  This is because the world’s largest oil import-dependent economies – China and India – not only have long trading histories with Russia, but they also operate their own oil-transport fleets that can circumvent insurance-related obstacles imposed by the US and the UK.  China and India already find discounted Russian oil irresistible, and are unlikely to acquiesce to US demands for a price cap.  China imports 75% of its 15.5mm b/d of oil consumption, while India imports ~ 85% of the 5mm b/d of oil it consumes.  Even if oil importers taking Russia's exports going to the EU were to sign on to a price-cap scheme, Russia could always unilaterally cut its oil and condensate production by 20-30% and force Brent prices sharply higher for remaining contract holders. This would almost surely lead to higher prices – above $140/bbl, based on our earlier estimates – and raise Russia’s net export proceeds in the process, since the G7 does not want all of Russia's oil taken off the market.3 Government Interventions Exacerbate Scarcity Governments of states with contestable elections increasingly are intervening – or attempting to do so – in global energy markets and imposing often-contradictory policies that nominally favor consumers at the expense of energy producers.  This almost always is counter-productive: Price caps intended to soften the blow of higher-cost electricity and hydrocarbons discourages the necessary conservation of scarce resources.  So-called windfall profits taxes discourage the investment required to address supply scarcity.  Higher demand and lower supply does not lead to lower prices.  Even grander schemes – e.g., the monopsony cartels floated by G7 member states like the US and EU, along with China – almost surely would reduce the profitability of developing and marketing new energy supplies, which also would exacerbate scarcity of supply by discouraging investment. These quick ad hoc fixes work at cross purposes in solving the problem of global energy scarcity.  While they are in keeping with a penchant of governments to demonstrate they are addressing voters’ concerns, such policies mistake a quick response for long-term solutions. Investment Implications The EU will, in our opinion, be forced to reverse course and sign long-term LNG supply contracts to replace Russian natural gas imports.  This will not derail its renewable-energy transition strategy, but it will significantly delay it.  We remain long oil and gas exposures via the S&P GSCI and COMT ETF, and long equity refining and services exposures via the CRAK and IEZ ETFs.  We will re-establish our producer-focused XOP ETF position if Brent trades down to $105/bbl in the front month.  We also remain tactically long Brent and eurozone natgas futures and options (see p. 7 below). Housekeeping Notes We were stopped out of our long S&P GSCI position with a gain of 64%.  We are getting long again at the close. We also were stopped out of our long 4Q22 $120/bbl Brent calls with a 16% return. Separately, there will be no Commodity Round-Up in this week’s publication.  We are broadcasting our Commodity Round-Up today at 9 a.m. EDT.    Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1     Please see The G7 wants to dump natural gas … but not yet published by politico.com 27 May 2022.  The report notes, “The G7 called for an end to international investments in fossil fuels by the end of this year and slammed private finance for continuing to back dirty energy — but left a big out for EU countries desperate to replace Russian gas.  ‘We acknowledge that investment in [the liquefied natural gas] sector is necessary in response to the current crisis, in a manner consistent with our climate objectives and without creating lock-in effects,’ the ministers said.” 2     Please see One Hot Mess: EU Energy Policy, published 26 May 2022.  This report delves into the EU’s post-Cold War foreign policy.  For three decades, EU foreign policy largely was set by Germany, the organization's most powerful economy.  Successive generations of German politicians championed the idea that the West could bring the former Soviet Union – and later Russia – into the modern world of global trade through Ostpolitik, which had, at its core, a belief in the power of trade to effect political and economic change.  This policy is kaput. 3    Please see Higher Gasoline, Diesel Prices Ahead, which we published 2 June 2022.  It is available at ces.bcaresearch.com. Investment Views and Themes Strategic Recommendations Tactical Trades Trades Closed in 2022

Executive Summary EU Embargoes Russian Oil The EU imposed an embargo on 90% of Russian oil imports, which will provoke retaliation. Russia will squeeze Europe’s economy ahead of critical negotiations over the coming 6-12 months. Russian gains on the battlefield in Ukraine point to a ceasefire later, but not yet – and Russia will need to retaliate against NATO enlargement. The Middle East and North Africa face instability and oil disruptions due to US-Iran tensions and Russian interference. China’s autocratic shift is occurring amid an economic slowdown and pandemic. Social unrest and internal tensions will flare. China will export uncertainty and stagflation.  Inflation is causing disparate effects in South Asia – instability in Pakistan and Sri Lanka, and fiscal populism in India.   Asset Initiation Date Return Long Brazilian Financials / Indian Equities (Closed) Feb 10/22 22.5%  Bottom Line: Markets still face three geopolitical hurdles: Russian retaliation; Middle Eastern instability; Chinese uncertainty. Feature Global equities bounced back 6.1% from their trough on May 12 as investors cheered hints of weakening inflation and questioned the bearish consensus. BCA’s Global Investment Strategy correctly called the equity bounce. However, as BCA’s Geopolitical Strategy service, we see several sources of additional bad news. Throughout the Ukraine conflict we have highlighted two fundamental factors to ascertain regarding the ongoing macroeconomic impact: Will the war cut off the Russia-EU energy trade? Will the war broaden beyond Ukraine? Chart 1Russian-Exposed Assets Will Suffer More In this report we update our views on these two critical questions. The takeaway is that the geopolitical outlook is still flashing red. The US dollar will remain strong and currencies exposed to Russia and geopolitical risk will remain weak (Chart 1). In addition, China’s politics will continue to produce uncertainty and negative surprises this year. Taken together, investors should remain defensive for now but be ready to turn positive when the market clears the hurdles we identify. The fate of the business cycle hangs in the balance.  Energy Ties Eroding … Russia Will Retaliate Over Oil Embargo Chart 2AEU Embargoes Russian Oil Europe is diversifying from Russian oil and natural gas. The European Union adopted a partial oil embargo on Russia that will cut oil imports by 90% by the end of 2022. It also removed Sberbank from the SWIFT banking communications network and slapped sanctions on companies that insure shipments of Russian crude. The sanctions will cut off all of Europe’s seaborne oil imports from Russia as well as major pipeline imports, except the Southern Druzhba pipeline. The EU made an exception for landlocked eastern European countries heavily dependent on Russian pipeline imports – namely Hungary, Slovakia, the Czech Republic, and Bulgaria (Chart 2A).  Focus on the big picture. Germany changed its national policy to reduce Russian energy dependency for the sake of national security. From Chancellors Willy Brandt to Angela Merkel, Germany pursued energy cooperation and economic engagement as a means of lowering the risk of war with Russia. Ostpolitik worked in the Cold War, so when Russia seized Crimea in 2014, Merkel built the Nord Stream 2 pipeline. But Merkel’s policy failed to persuade Russia that economic cooperation is better than military confrontation – rather it emboldened President Putin, who viewed Europe as divided and corruptible. Chart 2BRussia Squeezes EU’s Natural Gas Russia’s regime is insecure and feels threatened by the US and NATO. Russia believed that if it invaded Ukraine, the Europeans would maintain energy relations for the sake of preserving overall strategic stability. Instead Germany and other European states began to view Russia as irrational and aggressive and hence a threat to their long-term security. They imposed a coal ban, now an oil ban the end of this year, and a natural gas ban by the end of 2027, all formalized under the recently announced RePowerEU program. Russia retaliated by declaring it would reduce natural gas exports to the Netherlands and probably Denmark, after having already cut off Finland, Poland, and Bulgaria (Chart 2B). As a pretext Russia points to its arbitrary March demand that states pay for gas in rubles rather than in currencies written in contracts. This ruble payment scheme is being enforced on a country-by-country basis against those Russia deems “unfriendly,” i.e. those that join NATO, adopt new sanctions, provide massive assistance to Ukraine, or are otherwise adverse. Chart 3Russia Actively Cutting Gas Flows Russia and Ukraine are already reducing natural gas exports through the Ukraine and Turkstream pipelines while the Yamal pipeline has been empty since May – and it is only a matter of time before flows begin to fall in the Nord Stream 1 pipeline to Germany (Chart 3). German government and industry are preparing to ration natural gas (to prioritize household needs) and revive 15 coal plants if necessary. Europe is attempting to rebuild stockpiles for the coming winter, when Russian willingness and capability to squeeze natural gas flows will reach a peak. The big picture is demonstrated by game theory in Diagram 1. The optimal situation for both Russia and the EU is to maintain energy exports for as long as possible, so that Russia has revenues to wage its war and Europe avoids a recession while transitioning away from Russian supplies (bottom right quadrant, each side receives four points). The problem is that this solution is not an equilibrium because either side can suffer a sudden shock if the other side betrays the tacit agreement and stops buying or selling (bottom left and top right quadrants). Diagram 1EU-Russia Standoff: What Does Game Theory Say? The equilibrium – the decision sets in which both Russia and the EU are guaranteed to lose the least – is a situation in which both states reduce energy trade immediately. Europe needs to cut off the revenues that fuel the Russian war machine while Russia needs to punish and deter Europe now while it still has massive energy leverage (top left quadrant, circled). Once Europe diversifies away, Russia loses its leverage. If Europe does not diversify immediately, Russia can punish it severely by cutting off energy before it is prepared.   Russian energy weaponization is especially useful ahead of any ceasefire talks in Ukraine. Russia aims for Ukrainian military neutrality and a permanently weakened Ukrainian state. To that end it is seizing territory for the Luhansk and Donetsk People’s Republics, seizing the southern coastline and strategic buffer around Crimea, and controlling the mouth of the Dnieper river so that Ukraine is forever hobbled (Map 1). Once it achieves these aims it will want to settle a ceasefire that legitimizes its conquests. But Ukraine will wish to continue the fight. Map 1Russian Invasion Of Ukraine, 2022 Russia will need leverage over Europe to convince the EU to lean on Ukraine to agree to a ceasefire. Something similar occurred in 2014-15 when Russia collaborated with Germany and France to foist the Minsk Protocols onto Ukraine. If Russia keeps energy flowing to EU, the EU not only gets a smooth energy transition away from Russia but also gets to keep assisting Ukraine’s military effort. Whereas if Russia imposes pain on the EU ahead of ceasefire talks, the EU has greater interest in settling a ceasefire. Finally, given Russia’s difficulties on the battlefield, its loss of European patronage, and potential NATO enlargement on its borders, Moscow is highly likely to open a “new front” in its conflict with the West. Josef Stalin, for example, encouraged Kim Il Sung to invade South Korea in 1950. Today Russia’s options lie in the Middle East and North Africa – the regions where Europe turns for energy alternatives. Not only Libya and Algeria – which are both inherently fertile ground for Russia to sow instability –  but also Iran and the broader Middle East, where a tenuous geopolitical balance is already eroding due to a lack of strategic understanding between the US and Iran. Russia’s capabilities are limited but it likely retains enough influence to ignite existing powder kegs in these areas.   Bottom Line: Investors still face a few hurdles from the Ukraine war. First, the EU’s expanding energy embargo and Russian retaliation. Second, instability in the Middle East and North Africa. Hence energy price pressures will remain elevated in the short term and kill more demand, thus pushing the EU and the rest of the world toward stagflation or even recession. War Contained To Ukraine So Far … But Russia To Retaliate Over NATO Enlargement At present Russia is waging a full-scale assault on eastern and southern Ukraine, where about half of Donetsk awaits a decision (Map 2). If Russia emerges victorious over Donetsk in the summer or fall then it can declare victory and start negotiating a ceasefire. This timeline assumes that its economic circumstances are sufficiently straitened to prevent a campaign to the Moldovan border.1   Map 2Russia May Declare Victory If It Conquers The Rest Of Donetsk There are still ways for the Ukraine war to spill over into neighboring areas. For example, the Black Sea is effectively a Russian lake at the moment, which prevents Ukrainian grain from reaching global markets where food prices are soaring. Eventually the western maritime powers will need to attempt to restore freedom of navigation. However, Russia is imposing a blockade on Ukraine, has more at stake there than other powers, and can take greater risks. The US and its allies will continue to provide Ukraine with targeting information against Russian ships but this assistance could eventually provoke a larger naval conflict. Separately, the US has agreed to provide Ukraine with the M142 High Mobility Artillery Rocket System (HIMARS), which could lead to attacks on Russian territory that would prompt a ferocious Russian reaction. Even assuming that the Ukraine war remains contained, Russia’s strategic conflict with the US and the West will remain unresolved and Moscow will be eager to save face. Russian retaliation will occur not only on account of European energy diversification but also on account of NATO enlargement. Finland and Sweden are attempting to join NATO and as such the West is directly repudiating the Putin regime’s chief strategic demand for 22 years. Finland shares an 830 mile border with Russia, adding insult to injury. The result will be another round of larger military tensions that go beyond Ukraine and prolong this year’s geopolitical risk and uncertainty. Russia’s initial response to Finland’s and Sweden’s joint application to NATO was to dismiss the threat they pose while drawing a new red line. Rather than forbidding NATO enlargement, Russia now demands that no NATO forces be deployed to these two states. This demand, which Putin and other officials expressed, may or may not amount to a genuine Russian policy change. Russia’s initial responses should be taken with a grain of salt because Turkey is temporarily blocking Finland’s and Sweden’s applications, so Russia has no need to respond to NATO enlargement yet. But the true test will come when and if the West satisfies Turkey’s grievances and Turkey moves to admit the new members. If enlargement becomes inevitable, Russia will respond. Russia will feel that its national security is fundamentally jeopardized by Sweden overturning two centuries of neutrality and Finland reversing the policy of “Finlandization” that went so far in preventing conflict during the Cold War. Chart 4Military Balances Stacking Up Against Russia Russia’s military options are limited. Russia has little ability to expand the war and fight on multiple fronts judging by the army’s recent performance in Ukraine and the Red Army’s performance in the Winter War of 1939. This point can be illustrated by taking the military balance of Russia and its most immediate adversaries, which add up to about half of Russian military strength even apart from NATO (Chart 4). Russian armed forces already demonstrated some pragmatism in April by withdrawing from Kyiv and focusing on more achievable war aims. Unless President Putin turns utterly reckless and the Russian state fails to restrain him, Russia will opt for defensive measures and strategic deterrence rather than a military offensive in the Baltics. Hence Russia’s military response will come in the form of threats rather than outright belligerence. However, these threats will probably include military and nuclear actions that will raise alarm bells across Europe and the United States. President Dmitri Medvedev has already warned of the permanent deployment of nuclear missiles in the Kaliningrad exclave.2 This statement points to only the most symbolic option of a range of options that will increase deterrence and elevate the fear of war. Otherwise Russia’s retaliation will consist of squeezing global energy supply, as discussed above, including by opening a new front in the Middle East and North Africa. Instability should be expected as a way of constraining Europe and distracting America. Higher energy prices may or may not convince the EU to negotiate better terms with Russia but they will sow divisions within and among the allies. Ultimately Russia is highly unlikely to sacrifice its credibility by failing to retaliate for the combination of energy embargo and NATO enlargement on its borders. Since its military options are becoming constrained (at least its rational ones), its economic and asymmetrical options will grow in importance. The result will be additional energy supply constraints. Bottom Line: Even assuming that the war does not spread beyond Ukraine – likely but not certain – global financial markets face at least one more period of military escalation with Russia. This will likely include significant energy cutoffs and saber-rattling – even nuclear threats – over NATO enlargement.   China’s Political Situation Has Not Normalized China continues to suffer from a historic confluence of internal and external political risk that will cause negative surprises for investors. Temporary improvements in government policy or investor sentiment – centered on a relaxation of “Zero Covid” lockdowns in major cities and a more dovish regulatory tone against the tech giants – will likely be frustrated, at least until after a more dovish government stance can be confirmed in the wake of the twentieth national party congress in October or November this year. At that event, Chinese President Xi Jinping is likely to clinch another ten years in power and complete the transformation of China’s governance from single-party rule to single-person rule. This reversion to autocracy will generate additional market-negative developments this year. It has already embedded a permanently higher risk premium in Chinese financial assets because it increases the odds of policy mistakes, international aggression, and ultimately succession crisis. The most successful Asian states chose to democratize and expand free markets and capitalism when they reached a similar point of economic development and faced the associated sociopolitical challenges. But China is choosing the opposite path for the sake of national security. Investors have seen the decay of Russia’s economy under Putin’s autocracy and would be remiss not to upgrade the odds of similarly negative outcomes in China over the long run as a result of Xi’s autocracy, despite the many differences between the two countries. China’s situation is more difficult than that of the democratic Asian states because of its reviving strategic rivalry with the United States. US Secretary of State Antony Blinken recently unveiled President Biden’s comprehensive China policy. He affirmed that the administration views China as the US’s top strategic competitor over the long run, despite the heightened confrontation with Russia.3 The Biden administration has not eased the Trump administration’s tariffs or punitive measures on China. It is unlikely to do so during a midterm election year when protectionist dynamics prevail – especially given that the Xi administration will be in the process of reestablishing autocracy, and possibly repressing social unrest, at the very moment Americans go to the polls. Re-engagement with China is also prohibited because China is strengthening its strategic bonds with Russia. President Biden has repeatedly implied that the US would defend Taiwan in any conflict with China. These statements are presented as gaffes or mistakes but they are in fact in keeping with historical US military actions threatening counter-attack during the three historic Taiwan Strait crises. The White House quickly walks back these comments to reassure China that the US does not support Taiwanese independence or intend to trigger a war with China. The result is that the US is using Biden’s gaffe-prone personality to reemphasize the hard edge (rather than the soft edge) of the US’s policy of “strategic ambiguity” on Taiwan. US policy is still ambiguous but ambiguity includes the possibility that a president might order military action to defend Taiwan. US attempts to increase deterrence and avoid a Ukraine scenario are threatening for China, which will view the US as altering the status quo and penalizing China for Russia’s actions. Beijing resumed overflights of Taiwan’s air defense identification zone in the wake of Biden’s remarks as well as the decision of the US to send Senator Tammy Duckworth to Taiwan to discuss deeper economic and defense ties. Consider the positioning of US aircraft carrier strike groups as an indicator of the high level of strategic tensions. On January 18, 2022, as Russia amassed military forces on the Ukrainian border – and the US and NATO rejected its strategic demands – the US had only one publicly acknowledged  aircraft carrier in the Mediterranean (the USS Harry Truman) whereas it had at least five US carriers in East Asia. On February 24, the day of Russia’s invasion of Ukraine, the US had at least four of these carriers in Asia. Even today the US has at least four carriers in the Pacific compared to at least two in Europe – one of which, notably, is in the Baltics to deter Russia from attacking Finland and Sweden (Map 3). The US is warning China not to take advantage of the Ukraine war by staging a surprise attack on Taiwan. Map 3Amid Ukraine War, US Deters China From Attacking Taiwan Of course, strategic tensions are perennial, whereas what investors are most concerned about is whether China can secure its economic recovery. The latest data are still disappointing. Credit growth continues to falter as the private sector struggles with a deteriorating demographic and macroeconomic outlook (Chart 5). The credit impulse has entered positive territory, when local government bonds are included, reflecting government stimulus efforts. But it is still negative when excluding local governments. And even the positive measure is unimpressive, having ticked back down in April (Chart 6). Chart 5Credit Growth Falters Amid Economic Transition Chart 6Silver Lining: Credit Impulse Less Negative Bottom Line: Further monetary and fiscal easing will come in China, a source of good news for global investors next year if coupled with a broader policy shift in favor of business, but the effects will be mixed this year due to Covid policy and domestic politics. Taken together with a European energy crunch and Middle Eastern oil supply disruptions, China’s stimulus is not a catalyst for a sustainable global equity market rally this year. South Asia: Inflation Hammers Sri Lanka And Pakistan Since 2020 we have argued that the global pandemic would result in a new wave of supply pressures and global social unrest. High inflation is blazing a trail of destruction in emerging markets, notably in South Asia, where per capita incomes are low and political institutions often fragile. Chart 7South Asia: Surging Inflation Sri Lanka has been worst affected (Chart 7). Inflation surged to an eye-watering 34% in April  and is expected to rise further. Surging inflation has affected Sri Lanka disproportionately because its macroeconomic and political fundamentals were weak to begin with. The tourism-dependent Sri Lankan economy suffered a body blow from terrorist attacks in 2019 and the pandemic in 2020-21. Then 2022 saw a power struggle between Sri Lanka’s President Gotabaya Rajapaksa and members of the national assembly including Prime Minister (PM) Mahinda Rajapaksa. The crisis hit a crescendo when the country defaulted on external debt obligations last month. These events weigh on Sri Lanka’s ability to transition from a long civil war (1983-2009) to a path of sustained economic development. While the political crisis has seemingly stabilized following the appointment of new Prime Minister Ranil Wickremesinghe, we remain bearish on a strategic time horizon. This is mainly because the new PM is unlikely to bring about structural solutions for Sri Lanka’s broken economy. Moreover, Sri Lanka holds more than $50 billion of foreign debt, or 62% of GDP. Another country that has been dealing with political instability alongside high inflation in South Asia is Pakistan, where inflation hit a three-year high in April (see Chart 7 above). The latest twist in Pakistan’s never-ending cycle of political uncertainty comes from the ousted Prime Minister Imran Khan. The former PM, who commands an unusual popular support group due to his fame as a cricketer prior to entering politics, is demanding fresh elections and otherwise threatening to hold mass protests. Pakistan’s new coalition government and Prime Minister Shehbaz Sharif, who came to power amid parliamentary intrigues, are refusing elections and ultimatums. From a structural perspective Pakistan is characterized by a weak economy and an unusually influential military. Now it faces high inflation and rising food prices – indeed it is one of the countries that is most dangerously exposed to the Russia-Ukraine war as it depends on these two for over 70% of its grain imports. Bottom Line: MSCI Sri Lanka has underperformed the MSCI EM index by 58.3% this year to date. Pakistan has underperformed the same index by 41.6% over the same period. Against this backdrop, we remain strategic sellers of both bourses. Instability in these countries is also one  of the factors behind our strategic assessment of India as a country with a growing domestic policy consensus. South Asia: India’s Fiscal Populism And Geopolitics Inflation is less rampant in India, although still troublesome. Consumer prices nearly jumped to an 8-year high in April (see Chart 7). With a loaded state election calendar due over the next 12-18 months, the jump in inflation naturally triggered a series of mitigating policy responses. Ban On Wheat Exports: India produces 14% of the world’s wheat and 11% of grains, and exports 5% and 7%, respectively. India’s exports could make a large profit in the context of global shortages. But Prime Minister Narendra Modi is entering into the political end of the business cycle, with key state elections due that will have an impact on the ruling party’s political standing two years before the next federal election. He fears political vulnerability if exports continue amid price pressures at home. The emphasis on food security is typical but also bespeaks a lack of commitment to economic reform. Chart 8India's Real Interest Rates Fall Surprise Rate Hikes: The Reserve Bank of India (RBI) increased the policy repo rate by 40 basis points at an unscheduled meeting on May 4, thereby implementing its first rate hike since August 2018. With real rates in India lower than those in China or Brazil (Chart 8), the RBI will be forced to expedite its planned rate hikes through 2022. Tax Cuts On Fuel: India’s central government also announced steep cuts in excise duty on fuel. This is another populist measure that reduces political pressures but fails to encourage the private sector to adjust.  These measures will help rein in inflation but the rate hikes will weigh on economic growth while the tax cuts will add to India’s fiscal deficit. Indeed, India is resorting to fiscal populism with key state elections looming. Geopolitical risk is less of a concern for India – indeed the Ukraine war has strengthened its bargaining position. In the short run, India benefits from the ability to buy arms and especially cheap oil from Russia while the EU imposes an embargo. But over the long run its economy and security can be strengthened by greater interest from the US and its allies, recently highlighted by the fourth meeting of the Quadrilateral Security Dialogue (Quad) and the launch of the US’s Indo-Pacific Economic Framework (IPEF). These initiatives are modest but they highlight the US’s need to replace China with India and ASEAN over time, a trend that no US administration can reverse now because of the emerging Russo-Chinese strategic alliance. At the same time, the Quad underscores India’s maritime interests and hence the security benefits India can gain from aligning its economy and navy with the other democracies. Bottom Line: Fiscal populism in the context of high commodity prices is negative for Indian equities. However, our views on Russia, the Middle East, and China all point to a sharper short-term spike in commodity prices that ultimately drives the world economy deeper into stagflation or recession. Therefore we are booking a 22.5% profit on our tactical decision to go long Brazilian financials relative to Indian equities.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Chart 9Russia: GeoRisk Indicator Chart 10Other Measures Of Russian Geopolitical Risk Chart 11China: GeoRisk Indicator Chart 12United Kingdom: GeoRisk Indicator Chart 13Germany: GeoRisk Indicator Chart 14France: GeoRisk Indicator Chart 15Italy: GeoRisk Indicator Chart 16Canada: GeoRisk Indicator Chart 17Spain: GeoRisk Indicator Chart 18Australia: GeoRisk Indicator Chart 19Taiwan: GeoRisk Indicator Chart 20Korea: GeoRisk Indicator Chart 21Turkey: GeoRisk Indicator Chart 22South Africa: GeoRisk Indicator Chart 23Brazil: GeoRisk Indicator   Footnotes 1     Recent diplomatic flaps between core European leaders and Ukrainian President Volodymyr Zelensky reflect Ukraine’s fear that Europe will negotiate a “separate peace” with Russia, i.e. accept Russian territorial conquests in exchange for economic relief. 2     Dmitri Medvedev explicitly states ‘there can be no more talk of any nuclear-free status for the Baltic - the balance must be restored’ in warning Finland and Sweden joining NATO. Medvedev is suggesting that nuclear weapons will be placed in this area where Russia has its Kaliningrad exclave sandwiched between Poland and Lithuania. Guy Faulconbridge, ‘Russia warns of nuclear, hypersonic deployment if Sweden and Finland join NATO’, April 14, 2022, Reuters. 3    See Antony J Blinken, Secretary of State, ‘The Administration’s Approach to the People’s Republic of China’, The George Washington University, Washington D.C., May 26, 2022, state.gov. Additionally, see President Joe Biden’s remarks on China and getting involved military to defend Taiwan in a joint press conference with Japan’s Prime Minister Kishida Fumio. ‘Remarks by President Biden and Prime Minister Kishida Fumio of Japan in Joint Press Conference’, Akasaka Palace, Tokyo, Japan, May 23, 2022, whitehouse.gov.   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Section III: Geopolitical Calendar

Executive Summary Indian Voter’s Economic Miseries Are Ascendant India has a strong strategic geopolitical position but is likely to face turbulence in the short term. This is because India remains expensive, and investors worry if the record political stability shown by India since 2014 can last. We highlight that the ruling Bhartiya Janata Party (BJP) may lose some seats in the near term. India’s most populous states could witness a few cases of social conflict as economic miseries grow. India may also temporarily resort to a degree of fiscal populism. But the BJP will be able to hold power for a third consecutive term in 2024, that too with a simple majority. The burst of fiscal populism will be temporary. Moreover, the next tier of India’s most populous states are well-positioned to drive India’s growth story in the long run. We urge investors to tactically short India / long Brazil financials given that India may see some turbulence in the short run. Strategic investors should consider long India tech / short China tech. Trade Recommendation Inception Date Return SHORT INDIA / LONG BRAZIL FINANCIALS 2022-02-10 12.5% Bottom Line: The ruling political party in India may face some political setbacks in the short term. It could even resort to fiscal populism. But the ruling party in a base case, should be able to retain power for a third term in 2024. On a tactical timeframe we advise caution on India but remain constructive on a strategic horizon. Feature The woods are lovely, dark and deep, But I have promises to keep, And miles to go before I sleep, And miles to go before I sleep. – Robert Frost, Stopping By Woods On A Snowy Evening (New Hampshire, 1923)   The protagonist in this famous poem is overwhelmed by the beauty of the wintry woods, but then must stay vigilant about the here and now. The situation that confronts an investor into India today, is surprisingly similar. India has a strong strategic geopolitical position, a position that has strengthened following the Ukraine war. However, Indian markets might face turbulence in the short term. This is because India remains expensive and its ability to keep promises (about high degrees of political stability or about its fiscal discipline) could be tested on a tactical time horizon. In specific, investors with exposure to India worry about three politico-economic challenges: The Anti-Incumbency Challenge Related Report  Geopolitical StrategyIndia's Politics: Know When To Hold 'Em, Know When To Fold 'Em 13 September 2013 is a key date in India’s modern history. On this day the Bhartiya Janata Party (BJP) announced Narendra Modi as BJP’s prime ministerial (PM) candidate just a few months ahead of the 2014 general elections. From 13 September 2013 till date, MSCI India has incidentally outperformed MSCI EM by a resounding 94.8%. In 2013, markets celebrated the rise of the Modi-led BJP government since such a dispensation was new, and it promised to deliver structural reform. But now when general elections will be held in 2024, the BJP must deal with a middling report card on reforms and a two-term anti-incumbency to boot. Given this clients worry if 2024 could see India go back to an era of coalition governments? The Fiscal Challenge India under BJP has displayed impressive degrees of fiscal discipline. With rising inflation now adding to Indian voters’ miseries and with a loaded state election calendar due in 2023, investors ask if India’s notable streak of fiscal fortitude can last? The Demographics Challenge As China’s weak demographic future becomes clearer, India’s youthful demographics keep attracting paeans. This is partially responsible for the fact that India has traded at a five-year average premium of 54.5% to China on forward price to earnings. With increasing reports of communal violence and inflation-related protests breaking out in India, investors also worry about India’s so-called demographic dividend and how best to play the game? In a foundational GPS Special Report published in 2018 we had made the point that, “Predicting political outcomes is difficult, but to generate geopolitical alpha investors should focus on ‘beating the spread’ not predicting the match winner”. At a time when there is much uncertainty about India’s immediate future, we highlight three key base case predictions with respect to India. By highlighting these key predictions, we hope investors can position themselves for generating geopolitical alpha. We conclude the report with actionable investment recommendations. India’s High Political Stability, Likely To Stay In 2024 Chart 1Bhartiya Janata Party’s (BJP) Win In India In 2014 Was Historic The Bhartiya Janata Party (BJP) stormed into power in 2014. Its assumption of power under PM Modi’s leadership was historic. This is because this was the first time since 1984 that a single political party had managed to secure a simple majority on its own steam (Chart 1). The rise of BJP in this resurrected avatar marked a structural break from the past, in three distinct ways: End To Instability Of Nineties: The rise of BJP 2.0 in 2014 marked an end to the political instability seen in the nineties when governments struggled to complete their full five-year terms. This is a problem that India’s South Asian neighbors like Sri Lanka and Pakistan are yet to overcome. End Of Coalition Politics Of Early 2000s: BJP’s rise in 2014 also marked an end to the coalition politics of the early 2000s. While three coalition governments in India managed to complete their five-year terms from 1999-2014, the reform agenda over this period was often held at ransom by smaller coalition partners. India’s ability to break away from coalition governments back in 2014 was commendable given that several developing countries as well as developed countries still have coalition governments at the helm. Regime Continuity: The BJP’s rise in 2014 and their re-election in 2019 meant that the same political party was able to hold power in India (that too with a simple majority) for a decade. Other EMs have not seen this quality of continuity over the last few years.  Owing to this streak of unprecedented political stability that India has been able to offer since 2014, India has attracted a high premium relative to democratic EM peers (Chart 2). But with India’s general elections due in 2024, investors into India are keen to know if India will continue to attract this high political stability premium. This worry is justified for two sets of reasons: (1)    The last time any government in India was able to pull off three consecutive full five-year terms, was way back in the sixties. There is no recent precedent to BJP’s pursuit for a third consecutive term in India. (2)   The most recent election held in India’s largest state i.e., Uttar Pradesh saw the BJP retain power but saw its seat count fall by 18%. This, investors worry could be an indicator of BJP losing traction in the politically critical region of northern India. Reading the tea leaves left behind after all recent elections suggests that India is most likely to see a single political party maintain a simple majority for a third consecutive term in 2024. BJP’s footprint northern in India will be dented owing to anti-incumbency. But despite this, the BJP should be able to maintain a simple majority at the national level in 2024. This is because the BJP appears to be working on deploying a crucial strategy i.e., to offset declines in north India with gains elsewhere. India’s northern states account for 45% of India’s population. Whilst the BJP’s rise in 2014 was pivoted on this geography, its ability to retain power beyond a decade will be dependent on its ability to offset losses in India’s sprawling north with gains in other large states. Interestingly, the BJP’s predecessor i.e., the Congress party had to deal with the reciprocal of this problem. The Congress party stayed in power for a decade (from 2004-14) owing to support from southern and western Indian states. But then the Congress party’s reign could not last beyond a decade because it failed to break into northern India (Chart 3); at a time when it was losing popularity in India’s west and south. Chart 2India Has Been Trading At A Premium To EM Democracies​​​​​​ Chart 3Congress Party-Led UPA Alliance Could Not Break Into North India​​​​​​ The fact that the BJP is now working to straddle both i.e. (1) its traditional base in the north and west as well as (2) new geographies in the east and south is evident from the recent election results: 2019 General Elections: Even as BJP’s seat count in the north Indian states of Uttar Pradesh and Bihar fell in 2019 (Chart 3) it managed to offset this decline by increasing presence in India’s east (in states like West Bengal and Orissa) and in India’s south (in states like Karnataka and Telangana). Consequently, the share of BJP’s seats accounted for by major states outside north India notably increased in 2019 from 2014 (Chart 4). Recent State Elections: The BJP has evidently been able to offset losses in its core northern base (in states like Uttar Pradesh), by increasing its presence in India’s east (in states like West Bengal and Bihar) (Chart 5). Chart 4BJP Is Growing Its Influence Outside North India​​​​​​ Chart 5BJP Is Offsetting Losses In North With Gains In East​​​​​​ Chart 6In a Base Case, BJP Should Cross The Halfway Mark At 2024 General Elections In fact, it is critical to note that state elections are due in Gujarat in December 2022, where the BJP is highly likely to lose seat share as it faces a five-term anti-incumbency. Given that Gujarat as a region too is part of BJP’s core voter base, BJP’s seat losses in Gujarat could trigger a wave of selling on India’s bourses. If this leads India’s expensive valuations to be driven down, then this could present a buying opportunity because as long as the BJP keeps compensating for losses in traditional constituencies with inroads into newer realms (like say Karnataka where state elections are due in May 2023 or in Rajasthan and Madhya Pradesh where elections are due in end-2023); BJP’s standalone seat count in 2024 is highly likely to cross the half-way mark (Chart 6). To conclude, we re-iterate our constructive outlook on India on a strategic horizon, in view of the high probability of regime continuity lasting in this EM beyond a decade. In a worst-case scenario, we expect a BJP-led coalition to assume power in India in 2024 but this coalition too will be stable and should need the support of a maximum of two regional parties. Bottom Line: The BJP will lose seat share in parts of north and west India but should be able to retain power in 2024 by offsetting these losses with gains in India’s east and south. Most recent election results confirm that the BJP is working meticulously to make this formula work. If BJP’s political losses in its traditional constituencies triggers a market correction, then this should be used as a buying opportunity by strategic investors. Fiscal Risks In India Are Not Dead; They Will Surface, Before Receding Again In 1952 when India’s first national assembly was formed, left-leaning parties were the mainstay of India’s national politics. Back then a left-of-center party i.e., the Congress Party was in power with +70% seats in the national assembly. Then, the leftist Communist Party of India (CPI) was the second largest political party. As the decades went by left-leaning policies kept losing importance in India but the left-of-center national parties influenced Indian politics in a big way right up until 2014. Cut to 2014, the rise of the Bhartiya Janata Party (BJP) meant that the mainstay of Indian politics now became right-of-center politics. Left-leaning parties became too insignificant to matter at the national level with the Congress Party and the Communist Party of India (M) now cumulatively accounting for only about 11% seats in the national assembly. India’s political pendulum swinging to the right was accompanied by another key development i.e., India’s fiscal management became more prudent (Chart 7). Doles and transfer payments were restrained, and efforts were also made to shore-up tax revenues. But does the BJP-led transition to right-of-center politics mean that left-of-center politics in India are dead, as are the associated risks of fiscal populism? The Indian bond market seems to think so. India’s 10-year bond yield is up only 85 bps since 1 Jan 2020 to date, which is lower than a 106 bps increase seen in the US or 573 bps increase seen in a large emerging market like Brazil. Notwithstanding the superior fiscal discipline maintained by BJP-led governments so far, it is worth asking if this streak of fiscal resilience can last over the next two years? We highlight that even as the right-of-center BJP will remain a force to reckon with, we expect the BJP’s fiscal policy to temporarily swerve to the left owing to three sets of reasons: Miseries Breed Populism: It is true that recent BJP-led governments have maintained superior fiscal discipline (Chart 7). However high levels of inflation are known to feed populist tendencies of governments globally. India will be no exception to this trend because economic miseries of India’s median voter have worsened over the last six months (Chart 8). Chart 7BJP Led Governments Have Maintained Tighter Fiscal Deficits In India​​​​​​ Chart 8Economic Miseries Of India's Median Voter Have Been Worsening​​​​​​ Chart 9Government Spends Tend To Pick Up In The Run-Up To General Elections Political Cycle: History also suggests that there is a cyclical element to fiscal laxity in India. Populism as a theme tends to become more defined in the two years leading to a general election (Chart 9). This cyclicality in fiscal expansion could also be driven by the fact that India tends to have a loaded state election calendar in the year just before a general election. Competition: As the BJP’s reign matures, it will increasingly face competition from regional parties (Chart 10). Given that most major regional political parties in India operate on the segment between the center and the left of political spectrum (Chart 10), BJP may see sense in metamorphosizing its fiscal policy into one which is closer to the left, albeit temporarily. Chart 10Regional Parties Like SP And AAP Could Grow Their National Footprint Chart 11India’s Debt Levels Are High And Rising It is worth noting that as compared to major EMs, India’s debt levels are high today (Chart 11). Against this backdrop an expansion of India’s fiscal deficit could result in turbulence in Indian markets. Bottom Line: The BJP is highly likely to temporarily switch to an expansive fiscal policy stance in the run up to the 2024 general elections. This shift will be driven by the need to retain power in the face of rising miseries of its median voter and to overcome competition from influential regional players. Most Populous Regions, May Not Necessarily Be Drivers Of India’s Growth The ‘demographic dividend’ narrative is often used to justify a bullish stance on India. But such a narrative oversimplifies India’s investment case and may even yield poor investment outcomes. India’s demographics power its consumption engine, but the same demographics can also be a liability sometimes. This is because while India is young, its populace is also poor and large. The combination of a massive population (that creates pressure on limited resources) and nascent institutions (that are yet to ensure a fair use of resources) is at the heart of corruption in India. For instance, the coming to light of the 2G-spectrum scam a decade ago on 16 November 2010 saw Indian markets correct by 6% over the next ten days. Hence ‘corruption’ is one of the ways in which India’s demographics can end-up being a drag on India’s investment returns. Chart 12Six Indian States Account For India’s Political Nucleus With China’s population likely to have peaked last year, India’s population which is likely to peak in the 2040s - keeps attracting investor interest. In this report we peel the onion around India’s demographics in a way that allows investors to make the most of its demographics, whilst avoiding pitfalls associated with the same. We highlight that paradoxically; India’s most populous states may not be the main drivers of India’s growth over the next decade. On the other hand, investing in the ‘next eight’ most populous states, could present a superior opportunity to profit from India’s demographics. Six Indian states account for more than half of India’s population (Chart 12) and each of these states are larger than Germany or Turkey in terms of population (Map 1). Despite being populous, these states could emerge as flashpoints of social conflict over the next decade. This is because it is possible that these states’ economic growth fails to be brisk enough to meet aspirations of its vast populace. Early signs of this phenomenon are evident from the fact that these states’ share in India’s population has been rising, but their share in national income has fallen (Chart 13). Today these six states account for more than half of India’s population but generate less than half of its national GDP (Chart 14). Map 1India’s Most Populous States, May Not Necessarily Lead On Growth Chart 13Most Populous States Of India, Are Not Necessarily Leading On Growth​​​​​​ Chart 14Next Eight Largest States Of India Are Economically Dynamic​​​​​​ Despite accounting for the lion’s share of India’s population, these six states’ growth potential could be compromised by: Economic Weakness: Primary sectors account for an unusually large share of the local economies of the most populous states today (Chart 15). Social Complexity: Most of the populous states are also characterized by greater social complexity as compared to other Indian states (Chart 16). In other words, their populations are young but are also poor and more heterogenous, which in turn exposes these states to a higher risk of social conflict. Chart 15Primary Activities Account For A Large Chunk Of Populous States’ GDP​​​​​​ Chart 16The Risk Of Social Conflict Is Higher, In The More Populous States ​​​​​​ ​​​Leverage: The debt to GDP ratio of the more populous states often tends to be higher too (Chart 17).​​​​​​​ Now contrary to the situation in India’s most populous states, India’s ‘next eight’ largest states (by population) could emerge as hubs of economic dynamism (Map 1). This is because: Faster Growth: These states' share in national GDP is growing faster than the pace at which their share in India’s population is growing (Chart 13). As of today, the next eight states account for less than a third of India’s population but more than a third of India’s national income (Chart 14). Fewer Constraints: The next eight most populous states have more modern economic structures (Chart 15), lower risk of social conflict (Chart 16) and mildly superior public finances (Chart 17). Last but not the least, the ‘next eight’ states are poised favorably from a political perspective as well. This is because the Bhartiya Janta Party (i.e., BJP) has a weak footprint in these states (Chart 18) and will be keen to offer supportive economic policies to win over their median voter. Chart 17More Populous States, Also Can Be More Leveraged​​​​​​ Chart 18Next Eight Most Populous States Likely To Attract More Political Attention Going Forward​​​​​​ Bottom Line: While the demographic dividend that India enjoys is real, its benefits will not be spread uniformly across India’s geographies. For instance, some of the most populous states of India could lag on the growth front. To profit from India’s demographics and yet mitigate risks associated with the same, we urge investors to build portfolios that maximize exposure to the second tier of populous states in India. Investment Conclusion The Bhartiya Janta Party (BJP) in India appears set to emerge as the first party in India’s modern history to retain power beyond a decade with a simple majority. But to pull off this rare feat, it will have to metamorphosize and may exhibit some changes such as: Develop a focus on regions that are outside its core constituency, in a bid to offset anti-incumbency in its core constituencies. Sharpen its policy focus on the next tier of populous states, given that some of these states have greater growth potential and given that the BJP’s footprint in the second tier of populous states has room to grow. Adopt an expansive fiscal policy in the run up to the 2024 elections, to combat the rising economic miseries of India’s median voter. To play these dynamics, we urge clients to consider the following trades: Strategic Trades For clients with a holding period mandate of more than 12 months, we urge such investors to go strategically long Indian tech / short Chinese tech (Chart 19). The trade allows investors to play the unique and high degrees of political stability that India will offer on a strategic horizon. Chart 19Strategic Trade: Long Indian Tech / Short Chinese Tech​​​​​​ Chart 20Tactical Trade: Short India / Long Brazilian Financials​​​​​​ Moreover, it is notable the Indian tech industry’s key bases are concentrated in Karnataka, Andhra Pradesh and Telangana. All three states fall within the next tier of populous states of India. Thus, this trade allows investors to maximize exposure to both an economically vibrant region and sector of India. Tactical Trades For investors with a holding period mandate of less than 12 months, a trade that can be activated to profit from India’s short-term geopolitical risks is to short India / long Brazilian Financials (Chart 20). This allows investors to profit from the cyclical risks that will affect India (1) as commodity prices stay high and (2) as rising economic miseries fan fiscal risks.​​​​​​​   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary India’s annual consumer price inflation will rise a notch from current levels but is unlikely to surpass 8% in a sustained manner. Demand-driven price pressures are absent in the Indian economy. So are wage pressures. That leaves commodity prices as the sole source of inflation. Global industrial commodity prices dictate India’s producer price inflation, but not consumer price inflation. The latter is determined by domestic factors. Higher import costs on fertilizer and edible oils will push up India’s food inflation a bit, but food inflation is mainly affected by the ‘Minimum Support Price’ that the government pays to farmers for food procurement. The central bank is making a policy mistake by raising interest rates to suppress commodity price-driven inflation when domestic demand is quite weak. The Indian profit outlook has deteriorated meaningfully due to falling margins. Higher interest rates will add to the headwinds. This bourse is also very expensive relative to its EM peers. India: Consumer Price Inflation Is A Function Of Broad Money Supply Bottom Line: Absolute return investors should avoid this bourse. Asset allocators should stay underweight India in EM and Emerging Asian equity portfolios. Bond investors should stay neutral India in EM and Emerging Asian domestic bond portfolios. Feature In much of the developed world, inflation has risen to 40-year highs. Inflation has surged in many developing countries as well. India has been one major exception in the latter group − where both headline and core consumer inflation have remained rangebound so far (Chart 1). The question is, if and for how long will India be able to buck the tide of higher global inflation? On a related note, what would be the likely effects of higher inflation on Indian markets? We believe headline and core CPI in India will rise from the current levels of around 6.5%; but will not go past 8% on a sustainable basis. This is much below the double digit levels the country often witnessed in the 1990s and 2000s. The main reason behind our optimism is that demand-driven price pressures are absent in the current cycle. The sole source of inflation is higher global commodity prices, which could be peaking on a rate of change basis. The commodity-led nature of inflation in India also makes monetary policy a less effective tool to control it in this cycle. In fact, considerable monetary tightening will be a policy error as it could nip the already weak domestic demand in the bud. We turned bearish on Indian stocks in March this year, and believe they have more downside in absolute terms. Their recent relative outperformance will also fizzle out sooner rather than later, as this was partially due to investors forsaking the Chinese market. This caused a sharp fall in the latter boosting other bourses’ relative performances (Chart 2). Chart 1India Has So far Been An Exception To The Global Trend Of Surging Inflation Chart 2Indian Stocks Will Weaken More And Underperform EM   Investors would therefore do well to stay underweight Indian stocks in EM and Emerging Asian equity portfolios for now. Local currency bond investors should stay neutral India in the respective EM and Emerging Asian bond portfolios. Why Has Inflation Stayed Downbeat? Just like in other economies, labor productivity trends set the tone of India’s structural inflation backdrop. Up until the early 2000s, India’s average productivity gains used to be rather low: of the order of 3% annually. Thereafter, a surge in capital spending on infrastructure and other productive capacity propelled India’s average annual productivity growth rate to twice as high. This has helped improve India’s structural inflation backdrop considerably. That said, over a cyclical horizon, it is the ebbs and flows of broad money supply (M3) that determines India’s consumer inflation trajectory (Chart 3). Chart 3India: Consumer Price Inflation Is A Function Of Broad Money Supply Chart 4Money Supply Will Stay Tame As Its Sources Are Rather Muted Broad money supply in India has decelerated over the past year and a half. This is in sharp contrast to most developed economies and many emerging economies in Latin America and EMEA; and it is the main reason why inflation prints have diverged between those countries and India. In the foreseeable future, there is little indication that India’s broad money supply will accelerate by any meaningful measure. This is because the major sources of money creation – bank credit origination and the central bank and commercial banks’ purchases of non-bank securities − have all remained rather muted in the recent past. Bank credit has grown only at a 7% nominal annualized rate over the past three years. In real terms (deflated by headline CPI), they have barely risen. Commercial banks’ purchases of government bonds are growing at only 5%. The central bank’s monetization of government debt, the other source of money creation, has also decelerated since early 2020 (Chart 4). The decelerating broad money supply means the odds of a demand-driven surge in consumer price inflation is also quite low. What About Commodity-Led Inflation? Elevated commodity prices have pushed up India’s consumer price inflation by a notch. Yet, given that much of the rally in global industrial commodities is probably already behind us, it’s effect on future inflation in India will likely be limited: Global industrial commodity prices drive India’s producer price inflation1 (PPI). But the correlation with India’s consumer price inflation is only tenuous (Chart 5). Moreover, given that India’s PPI tracks global commodity prices with a few months lag, this is also set to decelerate in the coming months.  Consistently, the pass-through effect from high global crude prices to local gasoline and diesel prices in India has also rolled over on a rate of change basis (Chart 6, top panel). Chart 5Global Commodity Prices Dictate India's Producer Prices, But Not Consumer Prices Chart 6Domestic Fuel Price Inflation Is Much Lower Than Crude Price Would Suggest   Notably, Indian authorities did not reduce local gasoline and diesel prices back in 2020-21 when global crude prices had slumped. Hence, the incremental rise in local fuel prices in the past several months has not been as steep as they might have been (Chart 6, bottom panel). As a result, energy-related inflation prints in India are not as high as crude oil prices would suggest. In fact, CPI for Fuel & Light and Transport & Communication2 have both decelerated from 12%+ YoY rate to 8% and are slowing further. That means the pass-through from higher fuel prices to the rest of the economy going forward will also be receding. Fertilizer (mostly potash) and edible oil3 are the two other major commodities that India imports. The import bill of these two items has almost doubled in dollar as well as in rupee terms in the past year due to surging prices globally. Together, they now account for 5% of India’s total imports. Higher import costs of these items will lead to slightly higher food prices in future. That said, India’s food inflation moves more with the “Minimum Support Price” (MSP). This is the price that the government pays to farmers for procuring various food grains every year (Chart 7, top panel). Since the government is by far the single largest purchaser, the price it pays sets the floor in the market. In recent years, authorities did not hike procurement prices by much. Unless authorities announce a much higher MSP for the current year, both food and headline CPI will likely stay under control. Finally, India is largely self-reliant when it comes to food. The buffer stock of the country’s food grains, currently at 74 million tons, far exceeds the estimated requirements (Chart 8). Short of any logistics debacle therefore, it’s hard to imagine that food prices could soar sustainably. Chart 7The Government's Support Prices Have A strong Bearing On Food Inflation And Rural Wages Chart 8India's Buffer Stock Of Food Grains Is Quite Robust   All that said, food inflation is the main risk on India’s inflation horizon. The reason for that is rising food prices often unmoor household inflation expectations, and eventually lead to higher realized inflation. Chart 9 shows that higher food prices in India do leak into non-food prices, albeit to a limited extent. As such, marginally higher food prices owing to higher import costs of fertilizer and edible oils will see India’s core inflation also rise a bit.   Chart 9Higher Food Inflation Leaks Into Core Inflation, But Only So Much How High Can Core CPI Rise? As discussed, India’s core inflation will likely remain mostly under control. A crucial reason for that is wage pressures are absent in India. This is in stark contrast to the US, where high wage pressures are threatening to morph into a wage-inflation spiral. In rural India, both farm and non-farm nominal wages have been growing at an average sub-5% rate since 2016, which is below CPI inflation. One reason rural wages have stayed low is that authorities have not raised the MSP much in recent years. A lower MSP not only reins in food prices, but it also keeps a tab on wages (Chart 7, bottom panel). As such, unless the government decides to raise the MSP meaningfully this year, it will be difficult for rural wages to rise materially. On the urban side, the RBI survey on expectations for industrial salary and remunerations also depicts a similarly subdued outlook (Chart 10). Going forward, as tens of millions of young people continue to join the workforce every year, the broader wage picture in India is unlikely to change much. Subdued wage pressures will help keep a tab on the general inflationary pressures in the economy. On its own, India’s core CPI (i.e., CPI ex-food and ex-fuel) is largely a function of domestic money and credit trends. Global crude oil prices also matter to some extent. However, as discussed above, few of these variables are accelerating sharply. That means odds are low that core CPI will rise much more from the current levels. Indeed, our in-house model for core CPI, based on the variables just mentioned, points to a rather benign outlook (Chart 11). Chart 10Wage Pressures Are Absent, Entailing Core Inflation Will Stay Under Control Chart 11India's Inflation Outlook Is Sanguine   Does Inflation Hurt Indian Stocks? The primary drivers of Indian stocks are economic growth and corporate profits. Stock prices do not usually get hurt as long as CPI stays in low and mid-single digits. However, once CPI breaches the 8% mark sustainably, stocks typically sell off (Chart 12). Chart 12Indian Stocks Face Major Headwinds When CPI Breaches The 8% Mark Chart 13Indian Stocks Have A Positive Correlation With PPI, As Both Benefit From Global Growth The reason is that when inflation is sustainably high, meaningful monetary tightening ensues. Higher interest rates make it costlier to borrow for either consumption or investment purposes, and therefore depresses demand in the economy. That leads to a squeeze in profit margins, which in turn weighs on equity multiples and thus equity prices.  Interestingly, unlike CPI, which has no stable correlation with Indian stock prices, PPI has a robust positive correlation with stocks. The link is via corporate earnings. Indian PPI tracks the ebbs and flows in global commodity prices, and therefore global growth. Strong global growth boosts all corporate earnings, including that of India. Accelerating PPI is therefore a harbinger of higher Indian earnings and stock prices. Going forward, however, a decelerating PPI is pointing to lower stock prices in India (Chart 13). Is RBI Making A Policy Mistake? India’s central bank seems to be committing a policy mistake by raising interest rates to suppress commodity price-driven inflation when domestic demand is already very weak. This is negative for the economy and share prices. Chart 14Household Consumption Is Quite Weak; Domestic Production Is Far Below Trend The Reserve Bank of India surprised the market last week by raising policy rates by 40 basis points to 4.4%. They also raised commercial banks’ cash reserve ratio by 50 basis points to 4.5% in order to tighten banking sector liquidity. Monetary tightening, as a policy tool, works by stifling domestic demand. It makes borrowing for the purpose of investments and consumption more costly. It is, however, rather ineffective in resolving inflation caused by higher food and fuel prices – as is the case in India presently. Notably, high commodity inflation itself forces consumers to spend a lower amount on other core items – leading to weaker demand for the latter. Further monetary tightening would exacerbate that weakness. As explained before, Indian consumer prices are driven mostly by domestic factors, such as money supply and productivity (Chart 3, above), rather than global commodity prices. This distinction is important given that the central bank’s mandate is to manage CPI, not PPI. As such, monetary policy should ideally be based on mostly domestic dynamics. India’s domestic demand is extremely soft compared to the US where inflation has skyrocketed. Given the massive negative output gap that opened up in the Indian economy during the pandemic-related lockdowns, it will take a while before this economy sees genuine, sustained overheating. In view of this softness, any meaningful hike in interest rates (say another 100 basis points) could have a material negative impact on the recovery, and by extension, on stock prices:  Household consumption is quite weak − as is evident in local car and 2-wheeler sales (Chart 14, top panel). One reason for that is the subdued wage growth mentioned above. Pandemic-era fiscal stimulus, at less than 2% of GDP, has not been nearly enough to compensate for lost household income during the lockdowns. Consistent with lackluster household demand, manufacturing and other industrial productions are also languishing at far below the pre-pandemic trend (Chart 14, bottom panel). Robust capex is what spearheaded India’s post-pandemic recovery. But, now with decelerating corporate profits, capital investments have begun to slow. Higher costs of borrowing will further discourage capex plans. If so, lower investments will do more than shave off GDP growth in the coming quarters. If continued, this could be a major risk for India’s sustainable growth story, and its ill-effects may linger. Chart 15Higher Interest Rates Are A Headwind For Stock Prices All in all, given the nature of inflation in India in the current cycle, it will be a mistake to raise policy rates by any meaningful measure. Both consumption and investments will be hurt. Stock prices, which clearly benefit from lower interest rates, will be facing higher rates, and will therefore sell off (Chart 15). As such, it will be difficult for the RBI to continue to tighten monetary policy without causing a significant bear market in Indian stocks.   Investment Conclusions Equities: The Indian profit outlook has deteriorated meaningfully as a result of falling margins and an impending growth slowdown. This bourse is also very expensive relative to its EM peers. Higher interest rates will add to the headwinds. Absolute return investors should avoid this market. Asset allocators should stay underweight in EM and Emerging Asian equity portfolios. Currency And Bonds: The Indian rupee could depreciate marginally along with a likely sell-off in Indian stocks. Given that higher interest rates will likely be detrimental to a growth recovery, it will discourage capital inflows, and will therefore be negative for the rupee. As the rupee could be weaker, and bond yields could rise marginally with tighter banking sector liquidity, investors should stay neutral on India in EM and Emerging Asian bond portfolios. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes 1     Also called ‘wholesale prices.’ 2     CPI for Fuel & Light has a 6.8% weight in the CPI basket. Transportation & Communication has 8.6% weight. 3    Edible oil has a weight of 3.6% in India’s CPI basket.​​​​​​​

Executive Summary The Declining Value Of An Old Friendship India may buy cheap oil from Russia, but oil alone cannot expand this partnership. India needs to maintain a balance of power against China and Pakistan. With Russia’s heft set to decline, India will be compelled to explore a configuration with America. India will slowly yet surely move into America’s sphere of influence. Strong geopolitical as well as economic incentives exist for both sides to develop partnership. The US’s grand strategy will continue to collide with that of Russia and China. China will increasingly align with Russia and is doomed to stay entangled in a strategic conflict with India. With India a promising emerging market set to cleave to America, we reiterate our strategic buy call on India. Tactically however we are bearish on India. We also recommend investors go strategically long Indian tech / short Chinese tech. This pair trade is likely to keep rising on a secular basis. Trade Recommendation Inception Date Return LONG INDIAN TECH / CHINESE TECH EQUITIES 2022-04-21   Bottom Line: For reasons of geopolitics as well as macroeconomics, we maintain our constructive view on India and our negative view on China on a strategic time frame. On a tactical timeframe, we remain sellers of India given cyclical political and macro risks. Feature Russia’s invasion of Ukraine has forced all players at the global geopolitical table to show their hand. The one major player at the table who is yet to show her cards is India. Which side India choses matters. Its geopolitical rise is one of the many reasons we live in a brave new multipolar world. India will gain influence in the global economy as a large buyer of oil and guns and as a user of tech platforms and capital. Related Report  Geopolitical StrategyFrom Nixon-Mao To Putin-Xi The situation is complicated by mixed signals. India has played a geopolitically neutral or “non-aligned” role for most of its time since independence in 1947. Those who believe India will stay neutral point to the fact that India has continued buying oil from Russia and has abstained from voting on both anti-Russia and anti-Ukrainian resolutions at the United Nations. Those who predict that India will side with Russia have trouble explaining how India will get along with China, which committed to a “no limits” strategic partnership with Russia prior to the invasion. Those who speculate that India will align with the US have trouble explaining India’s persistent ties with Russia and the Biden administration’s threat of punishment for those who help Russia circumvent US sanctions. In this report we argue that the Indo-Russian friendship is destined to fade over a long-term, strategic horizon. The reason is simple: Russia’s geopolitical power is fading and hence it can no longer help India meet its regional security goals. The growing Russia-China alignment will only alienate India further. Hence, we expect the relationship between India and Russia to be reduced to a transactional status – mainly trade in oil and guns over the next few years, while strategic realities will drive India to tighten relations with the US and its Asian allies. Three geopolitical forces will break down the camaraderie between India and Russia, namely: (1) A collision in the grand strategies of America with that of both China and Russia, (2) India’s need to align with the US to underwrite its own regional security, and (3) China’s rising distrust of India as India aligns with the US and its allies. In fact, we expect China and India to stay embroiled in a strategic conflict over the next few years. Any thaw in their relations will be temporary at best. The rest of this report explains and quantifies these forces. We conclude with actionable investment conclusions. Let’s dive straight in. US Versus China-Russia: A Grand Strategy Collision “For the enemy is the communist system itself – implacable, insatiable, unceasing in its drive for world domination … For this is not a struggle for supremacy of arms alone – it is also a struggle for supremacy between two conflicting ideologies: freedom under God versus ruthless, Godless tyranny. “ – John F. Kennedy, Remarks at Mormon Tabernacle, Utah (September 1960) Chart 1China’s Is An Export-Powered Economic Heavyweight It’s been six decades since these words were spoken and today the quotation is more relevant than at any time since the Cold War ended in 1991. The excerpt captures how the Biden administration has positioned itself with respect to Russia and China, only replacing “communist” with “autocratic” in Russia’s case. The Ukraine war helps America advance its grand strategy with respect to Russia. The Ukraine war is steadily draining Russia’s already limited economic might. Western sanctions aim to weaken Russia further. Russia’s military capabilities are now in greater doubt than before, so that its only remaining geopolitical strengths are nuclear weapons and, significantly, its leverage as an energy supplier. With Russia weakened, yet capable of reinforcing China, America will focus more intensely on China over the coming years and the breakdown in US-China relations will only accelerate. China is a genuine economic competitor to the United States (Chart 1). Its strategic rise worries America. To make matters worse, America poses a unique threat to China. China relies heavily on energy imports (Chart 2) from the Middle East (Chart 3). This is a source of great vulnerability as China’s fuel imports must traverse seas that America controls (Map 1). During peace time, and periods of robust US-China strategic engagement, this vulnerability is not an issue. But China is acutely aware that America has the capability to choke China’s energy access at will in the event of hostilities, just as it did to Japan in World War II. Russia has managed to wage war in Ukraine, against US wishes, since it is a net energy supplier to Europe and the global economy. Chart 2China And India Rely On Imports For Energy​​​​​ Chart 3India And China Both Depend On Middle East For Oil​​​​​​ Map 1US Military Footprint In Middle East Threatens China … Yet US Presence In South Asia Is Weak Atop China’s fuel-supply related insecurities, America has begun a strategic pivot to Asia in recent years. For instance, America has pulled troops out of Iraq and Afghanistan, declared a trade war on China, and strengthening strategic alliances and partnerships with regional geopolitical powers like India and Australia (Table 1). The US has retained its alliance with the Philippines despite an adverse government there, while South Korea has just elected a pro-American president again. With Japan, South Korea and Australia aligned militarily with the US, China’s naval power pales in comparison (Chart 4). Table 1America’s Influence In Asia Is Rising Chart 4China’s Naval Power Pales Versus US Allies In Asia Now China cannot watch America refurbish its grand strategy in Asia silently. Given China’s need for supply security, geopolitical independence, and regional influence, Beijing will double down on building its influence in Asia and in the eastern hemisphere. Against this backdrop of US-China competition, military conflict becomes increasingly likely, especially in the form of “proxy wars” involving China’s neighbors but conceivably even in the form of US-China naval warfare. China’s plans to modernize and enhance its economic prowess will add to America’s worries (Chart 5). A bipartisan consensus of American lawmakers is focused on reviving America’s economic strength but simultaneously limiting China’s benefit by restricting Chinese imports and American high-tech exports (Chart 6). Since Beijing cannot afford to base its national strategy on the hope of lingering American engagement, US-China trade relations will weaken regardless of which party controls the White House. Chart 5China’s Growing Might Worries America​​​​​​ Chart 6US Growth Does Not Equal Growth In Imports From China ​​​​​​ The consensus in global financial media (which we never bought) held that the Biden administration would reduce tensions with China – but the détente never occurred and the remaining window for détente is limited by the uncertainty of the 2024 election. The US is currently occupied with Russia but threatening to impose secondary sanctions on China if it provides military assistance or circumvents sanctions. The Russo-Ukrainian war has led to an energy price shock that hurts an industrial economy like China’s. For the rest of this year China’s leaders will be consumed with managing the energy shock, a nationwide Covid-19 outbreak, and the important political reshuffle this fall. Only in 2023 will Beijing have room for maneuver when it comes to the US. But the US cannot return to engagement, which strengthens China’s economy, while China cannot open up to the US economy and become more exposed to future US sanctions. Bottom Line: A grand strategy collision between the US and China is certain. US dominance of sea routes that China uses for energy imports necessarily intimidates China. America’s pivot to Asia threatens China’s regional influence. This will prompt China to restrict American advances in strategic geographies —and not only the Taiwan Strait but also, as we will see, in South Asia. US-India Strategic Alignment: Only A Matter Of Time “If they [nation states] wish to survive, they must be willing to go to war to preserve a balance against the growing hegemonic power of the period.” – Nicholas J. Spykman, America's Strategy in World Politics (Harcourt, Brace and Co, 1942) For reasons of strategy, China will continue to build its influence in South Asia. South Asia offers prospects of sea access to the Indian Ocean, namely via Pakistan. This factor could ease China’s fuel supply insecurities. Also, penetrating northern India helps China set up a noose around India’s neck, thus neutralizing a potential enemy and US ally. In short China will pursue a two-pronged strategy of Eurasian development and naval expansion, both of which threaten India. Against this backdrop, India needs US support to counter Pakistan to its west, China’s latest intrusions into its eastern flank (Map 2), and China’s maritime challenge. India has historically spent generously on defense, but its military might pales in comparison to that of China. Even partial support from America would help India make some progress toward a balance of power in South Asia (Chart 7). Map 2China’s Newfound Interest In India’s Eastern Flank Chart 7America Can Provide Military Heft To India​​​​​​ Chart 8US Is A Key Trading Partner For India​​​​​​ There’s another reason why US alignment makes sense for India. Much like China, India is highly import-dependent for its fuel needs (Chart 2). Given India’s high reliance on the Middle East for energy, India stands to benefit from America’s solid military footprint in this region (Map 1). The US too has a motive in exploring this alliance. India can provide a strategic foothold on the Eurasian rimland. America will value this new access route to Eurasia because America knows that its military footprint in South Asia is surprisingly weak – a weakness it needs to address against the backdrop of China’s increasing influence in the region (Map 1). Meaningful economic interests also underpin the US-India relationship. India and the US appear like sparring partners from time to time. The US may raise issues of human rights violations in India and the two may bicker over trade. However there exist strong economic incentives for the two countries to keep their differences under check and develop a long-term strategic partnership. The US is a major user of India’s software services and buys nearly a fifth of India’s merchandise exports. The trading relationship that India shares with the US is far more developed than India’s trading relationship with China and Russia (Chart 8). Capital is a factor of production that India desperately needs to finance its high growth. America and its allies are also major suppliers of capital to India (Chart 9). India is averse to granting China the political influence that would go along with major capital infusions and direct investments. Chart 9US And Its Allies Are Major Suppliers Of Capital To India​​​​​​ Chart 10India Offers US Firms Access To High Growth​​​​​​ Chart 11India Is A Key Market For American Big Tech India on its part is a large marketplace which offers high growth prospects (Chart 10) and remains open and accessible to American corporations (unlike say Russia or China). The growth element is something that American firms will value more over time, as the American economy is mature and has a lower potential growth rate. Most importantly if the US imposes sanctions on India, then two key business lobbies are sure to mitigate the damage. In specific: Since India is a key potential market for American tech firms (Chart 11), Big Tech will always desire amicable Indo-US relations. Since India is the third largest buyer of defense goods globally, American defense suppliers will have similar intentions. In both cases, US policy planners will support these industries’ lobbying efforts due to the grand strategic considerations outlined above. Bottom Line: India will slowly yet surely move into America’s sphere of influence. Notwithstanding persistent differences, the Indo-US relationship will strengthen over a strategic timeframe. Strong geopolitical motives as well as notable economic incentives exist for both sides to develop this alignment. Indo-Russian Alignment: Destined To Fade The Indo-Russian friendship can be traced back to the second half of the 20th century. The fulcrum was the fact that Russia was a formidable land-based power and provided an offset against threats from China and Pakistan (Chart 12). The finest hour of this friendship perhaps came in 1971 when Russia sided with India in its war with Pakistan. India’s citizens hold an unusually favorable opinion of Russia (Chart 13). Chart 12The Declining Value Of An Old Friendship​​​​​​ Chart 13Indians Hold A Favorable Opinion Of Russians ​​​​​​ Despite this rich past, the Indo-Russia friendship is doomed to fade over a strategic timeframe. Even if  Russia’s share in Indian oil rises from current low levels of 2%, this glue alone cannot hold the Indo-Russian relationship together for one key reason: Russia’s geopolitical might has been waning and Russia can no longer help India establish a balance of power against China and Pakistan (Table 2). In fact, since 2006, the Russo-Indian partnership has been commanding lower geopolitical power than that of China (Chart 12). Table 2Russia’s Military Heft Is Of Limited Use To India Today Managing regional security is a key strategic concern for India. As Russia’s geopolitical power wanes so will India’s utility of Russia as an effective guarantor of India’s security. Russia’s war in Ukraine is ominous in this regard, as Russian armed forces were forced to retreat from Kyiv, while the country’s already bleak economic prospects have worsened under western sanctions. The solidification of the China-Russia axis will alienate India further (Chart 14). China is essential to Russia’s economy now while Moscow is essential to China’s Eurasian strategy of bypassing American naval dominance to reduce its supply insecurity. Russia holds the keys to Central Asia, from a military-security point of view, and hence also to the Middle East. Furthermore, limited economic bonds exist to prevent India and Russia from falling out. Russia accounts for a smidgen of India’s trade (Chart 8). India is Russia’s largest arms client (accounting for +20% of its arms sales) but this reliance could also decline over time: The Indian government has been pursuing a range of policies to increase the indigenous production of arms. This is a strategic goal that would also reinforce India’s economic need for more effective manufacturing capabilities. Russia’s own defense franchise had been coming under pressure, even before the Ukraine war (Chart 15). On the contrary, Western arms manufacturers’ franchise has been steadily growing. Chart 14China-Russia Axis Will Alienate India ​​​​​ Chart 15The Rise & Rise Of Western Arms Manufacturers ​​​​​​ While the US may look the other way in the short term when India buys arms from Russia, over a period of time the US is bound to pull India away by using a combination of sticks (mild sanctions) and carrots (heavy discounts). Two aforementioned external factors will also work against the Indo-Russia relationship namely (1) The Russo-Chinese alignment and its clash with US grand strategy and (2) The coming-to-life of a US-India strategic alignment. Bottom Line: India’s need for cheap oil will preserve basic Indo-Russian relations for some time. But oil alone cannot drive a deeper strategic alignment. Regional security concerns are paramount for India. Russia’s geopolitical decline will force India to explore an alignment with America, which will offer India security in the Indian Ocean and Persian Gulf in the face of China’s emergence in this region. Is A Realignment In Indo-China Relations Possible? But why should India not join the other Asian giants to balance against America’s threat of global dominance? Would such a bloc not secure India’s interests? And what if the US imposes harsh sanctions for India’s continued trade with Russia and strategic neutrality? Or what if a future US administration grows restless and attempts to force India to choose sides sooner rather than later? Even if the US offends India, it will only lead to a temporary improvement in India’s ties with the China-Russia alliance. This is because America stands to lose if India cleaves towards the Sino-Russian alliance and would thus quickly correct its policy. In specific: Security Interests: America will risk losing all influence in South Asia if India were to cleave towards China. India provides a key foothold for America to control China’s regional ascendance especially given that the US has now withdrawn from Afghanistan and its bilateral relations with Pakistan are weak. Business Interests: India’s movement into the China-Russia sphere of influence can have adverse business implications for American corporations and US allies, given that the US is abandoning the Chinese market over time, while India is a large and fast-growing consumer of American tech exports and services. India could emerge as a major buyer of American defense goods and will import more and more energy provided by the US and its partners in the Persian Gulf. These business groups will lobby for the withdrawal of US sanctions on India given India’s long-term potential. Meanwhile any improvement in Indo-Chinese relations will have a limited basis. In specific: Ascendant Nationalism In China And India: China’s declining potential GDP is motivating a rise in nationalism and an assertive foreign policy. Meanwhile India’s inability to create plentiful jobs for a young and growing population is also fuelling a wave of nationalism. A historic turn toward Sino-Indian economic engagement would require the domestic political ability to embrace and promote each other’s well-being. Pakistan Factor: India’s eastern neighbor Pakistan is controlled by its military. The military’s raison d'être is enforced by maintaining an aggressive stance towards India, while pursuing economic development through whatever other means are available. As long as Pakistan’s military stays influential its stance towards India will be hostile. And as long as Pakistan’s economy remains weak (Chart 16), its reliance on China will remain meaningful (Chart 17). Chart 16Pakistan: High Military Influence, Low Economic Vigor ​​​​​​ Chart 17China & Pakistan: Iron Brothers?​​​​​​ Chart 18Indians View China And Pakistan Negatively   China also benefits from its alliance with Pakistan because it provides an alternative entry point into India and access to the Indian Ocean. Fundamental Distrust: For reasons of history, Indians harbor a negative opinion of both Pakistan and China (Chart 18). This factor reinforces the first point that any Indian administration will see limited political dividends from developing a long-term alignment with China or with Pakistan. Bottom Line: If any Indo-Chinese détente materializes owing to harsh US sanctions, which we do not expect, the result will be temporary. America has limited incentives to push India towards the Sino-Russian camp. More importantly, China and India will stay entangled in a strategic conflict for reasons of both history and geography. Investment Conclusions Chart 19Sell India Tactically But Buy India On A Strategic Horizon The historic Indo-Russia relationship will weaken over the next few years as India and Russia explore new alignments with USA and China respectively. The relationship may not collapse entirely but has limited basis to grow given Russia’s declining geopolitical clout. Indo-American economic interests are set to deepen not just for reasons of security. India may consider looking for alternatives to Russian arms in the American defense industry while American Big Tech will be keen to grow their footprint in India. With India set to cleave to America, a country whose geopolitical power remains unparalleled today, we reiterate our constructive long-term investment view on India (Chart 19). However, tactically we remain worried about near-term geopolitical and macro headwinds that India must confront. China will strengthen relations with Russia over the next few years. It needs Russia’s help to execute its Eurasian strategy and to diversify its sources of fuel supply, over the long run. Given that the US and its allies will be engaged in a conflict with China over a strategic horizon, we reiterate our strategic sell call on China. Tactically we are neutral on Chinese stocks, given that they have already sold off sharply in accordance with our views over the past two years. In view of both these calls, we urge clients with a holding period mandate of more than 12 months to reduce exposure to Chinese assets and increase exposure to Indian assets. We also recommend investors go strategically long Indian tech / short Chinese tech. This pair trade is likely to keep rising on a secular basis.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

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

Executive Summary Major EM’s Defense Spends Will Be Comparable To That Of Developed Countries​​​​ Tectonic geopolitical trends are taking shape in Emerging Markets (EMs) today that will leave an indelible imprint on the next decade. First, EMs have gone on a relatively unnoticed public debt binge at a time when the economic prospects of the median EM citizen have deteriorated. This raises the spectre of sudden fiscal populism, aggressive foreign policy or social unrest in EMs. China, Brazil and Saudi Arabia appear most vulnerable to these risks. Second, the defense bill of major EMs could be comparable to that of the top developed countries of the world in a decade from now. Investors must brace for EMs to play a central role in the defense market and in wars, in the coming years. To profit from ascendant geopolitical risks in China, we reiterate shorting TWD-USD and the CNY against an equal-weighted basket of Euro and USD. To extract most from the theme of EM militarization, we suggest a Long on European Aerospace & Defense relative to European Tech stocks.   Trade Recommendation Inception Date Return LONG EUROPEAN AEROSPACE & DEFENSE / EUROPEAN TECH EQUITIES (STRATEGIC) 2022-03-18   Bottom Line: Even as EMs are set to emerge as protagonists on the world stage, investors must prepare for these countries to exhibit sudden fiscal expansions, bouts of social unrest or a newfound propensity to initiate wars. The only way to dodge these volatility-inducing events is to leverage geopolitics to foresee these shocks. Feature Only a few weeks before Russia’s war with Ukraine broke out, a client told us that he was having trouble seeing the importance of geopolitics in investing. “It seems like geopolitics was a lot more relevant a few years back, with the European debt crisis, Brexit, and Trump. Now it does not seem to drive markets at all”, said the client. To this we gave our frequent explanation which is, “Our strategic themes of Great Power Struggle, Hypo-Globalization, and Nationalism/Populism are now embedded in the international system and responsible for an observable rise in geopolitical risk that is reshaping markets”. In particular we highlighted our pessimistic view on both Russia and Iran, which have incidentally crystallized most clearly since we had this client conversation. Related Report  Geopolitical StrategyBrazil: The Road To Elections Won't Be Paved With Good Intentions Globally key geopolitical changes are afoot with Russia at war. In the coming weeks and months, we will write extensively about the dramatic changes we see taking shape in the realm of geopolitics and investing. We underscored the dramatic geopolitical realignment taking place as Russia severs ties with the West and throws itself into China’s arms in a report titled “From Nixon-Mao To Putin-Xi”. In this Special Report we highlight two key geopolitical themes that will affect emerging markets (EMs) over the coming decade. The aim is to help investors spot these trends early, so that they can profit from these tectonic changes that are sure to spawn a new generation of winners and losers in financial markets. (For BCA Research’s in-depth views on EMs, do refer to the Emerging Markets Strategy (EMS) webpage). Trend #1: Beware The Wrath Of EMs On A Debt Binge Chart 1The Pace Of Debt Accumulation Has Accelerated In Major EMs Investors are generally aware of the debt build-up that has taken place in the developed world since Covid-19. The gross public debt held by the six most developed countries of the world (spanning US, Japan, Germany, UK, France and Italy) now stands at an eye-watering $60 trillion or about 140% of GDP. This debt pile is enormous in both absolute and relative terms. But at the same time, the debt simultaneously being taken on by EMs has largely gone unnoticed. The cumulative public debt held by eight major EMs today (spanning China, Taiwan, Korea, India, Brazil, Russia, Saudi Arabia and Turkey) stands at $20tn i.e., about 70% of GDP. Whilst the absolute value of EM debt appears manageable, what is worrying is the pace of debt accumulation. The average public debt to GDP ratio of these EMs fell over the early 2000s but their public debt ratios have now doubled over the last decade (Chart 1). EMs have been accumulating public debt at such a rapid clip that the pace of debt expansion in EMs is substantially higher than that of the top six developed countries (Chart 1). These six DMs have a larger combined GDP than the eight EMs with which they are compared. Related Report  Geopolitical StrategyIndia's Politics: Know When To Hold 'Em, Know When To Fold 'Em (For in-depth views on China’s debt, do refer to China Investment Strategy (CIS) report here). Now developed countries taking on more debt makes logical sense for two reasons. Firstly, most developed countries are ageing, and their populations have stopped growing. So one way to prop up falling demand is to get governments to spend more using debt. Secondly, this practice seems manageable because developed country central banks have deep pockets (in the form of reserves) and their central banks are issuers of some of the safest currencies of the world. But EMs using the same formula and getting addicted to debt at an earlier stage of development is risky and could prove to be lethal in some cases. Also distinct from reasons of macroeconomics, the debt binge in EMs this time is problematic for geopolitical reasons. This Time Is Different EMs getting reliant on debt is problematic this time because their median citizen’s economic prospects have deteriorated. Growth is slowing, inflation is high, and job creation is stalling; thereby creating a problematic socio-political backdrop to the EM debt build-up. Growth Is Slowing: In the 2000s EMs could hope to grow out of their social or economic problems. The cumulative nominal GDP of eight major EMs more than quadrupled over the early 2000s but a decade later, these EMs haven not been able to grow their nominal GDP even at half the rate (Chart 2). Inflation Remains High: Despite poorer growth prospects, inflation is accelerating. Inflation was high in most major EMs in 2021 (Chart 3) i.e., even before the surge seen in 2022. Chart 2Major EM’s Growth Engine Is No Longer Humming Like A Well-Tuned Machine​​​​​ Chart 3Despite Slower Growth, Inflation In Major EMs Remains High​​​​​ Rising Unemployment: Employment levels have improved globally from the precipice they had fallen into in 2020. But unemployment today is a far bigger problem for major EMs as compared to developed markets (Chart 4). If the economic miseries of the median EM citizen are not addressed, then they can produce disruptive sociopolitical effects that will fan market volatility. This problem of rising economic misery alongside a rapid debt build-up, can also be seen for the next tier of EMs i.e. Mexico, Indonesia, Iran, Poland, Thailand, Nigeria, Argentina, Egypt, South Africa and Vietnam. While the average public debt to GDP ratios of these EMs fell over the early 2000s, the pace of debt accumulation has almost doubled over the last decade (Chart 5). Furthermore, the growth engine in these smaller EMs is no longer humming like a well-tuned machine and inflation remains at large (Chart 5). Chart 4Unemployment - A Bigger Problem In Major EMs Today​​​​​ Chart 5Smaller EMs Must Also Deal With Rising Debt, Alongside Slowing Growth​​​​​ Chart 6The Debt Surge In EMs This Time, Poses Unique Challenges History suggests that periods of economic tumult are frequently followed by social unrest. The eruption of the so-called Arab Spring after the Great Recession illustrated the power of this dynamic. Then following the outbreak of Covid-19 in 2020 we had highlighted that Turkey, Brazil, and South Africa are at the greatest risk of significant social unrest. We also showed that even EMs that looked stable on paper faced unrest in the post-Covid world, including China and Russia. In this report we take a decadal perspective which reveals that growth is slowing, and debt is growing in EMs. Given that EMs suffer from rising economic miseries alongside growing debt and lower political freedoms (Chart 6), it appears that some of these markets could be socio-political tinderboxes in the making. Policy Implications Of The EM Debt Surge “As it turns out, we don't 'all' have to pay our debts. Only some of us do.” – David Graeber, Debt: The First 5,000 Years (Melville House Publishing, 2011) The trifecta of fast-growing debt, slowing growth and/or low political freedoms in EMs can add to the volatility engendered by EMs as an asset class. Given the growing economic misery in EMs today, politicians will be wary of outbreaks of social unrest. To quell this unrest, they may resort broadly to fiscal expansion and/or aggressive foreign policy. Both of these policy choices can dampen market returns in EMs. Chart 7India's Performance Had Flatlined Post Mild Populist Tilt Policy Choice #1: More Fiscal Spending Despite High Debt Policymakers in some EMs may respond by de-prioritizing contentious structural reforms and prioritizing fiscal expansion. The Indian government’s decision to repeal progressive changes to farm laws in late 2021, launch a $7 billion home-building program in early 2022 and withholding hikes in retail prices of fuel, illustrates how policymakers are resorting to populism despite high public debt levels. As a result, it is no surprise that MSCI India had been underperforming MSCI EM even before the war in Ukraine broke out (Chart 7). Brazil is another EM which falls into this category, while China’s attempts to run tighter budgets have failed in the face of slowing growth. Policy Choice #2: Foreign Policy Aggression EMs may also adopt an aggressive foreign policy stance. Russia’s decision to invade Ukraine, Turkey’s interventions in several countries, and China’s increasing assertiveness in its neighboring seas and the Taiwan Strait provide examples. Wars by EMs are known to dampen returns as the experience of the Russian stock market shows. Russian stocks fell by 14% during its invasion of Georgia in 2008 and are down 40% from 24 February 2022 until March 9, 2022, i.e. when MSCI halted trading. If politicians fail to pursue either of these policies, then they run the risk of social unrest erupting due to tight fiscal policy or domestic political disputes. In fact, early signs of social discontent are already evident from large protests seen in major EMs over the last year (see Table 1). Table 1Social Unrest In Major EMs Is Already Ascendant Bottom Line: The last decade has seen major EMs go on a relatively unnoticed public debt binge. This is problematic because this debt surge has come at a time when economic prospects of the median EM citizen have deteriorated. Politicians will be keen to quell the resultant discontent. This raises the specter of excessive fiscal expansion, aggressive foreign policy, and/or social unrest. All three outcomes are negative from an EM volatility perspective. Trend #2: The Rise And Rise Of EM Defense Spends Great Power Rivalry is an outgrowth of the multipolar structure of international relations. This theme will drive higher defense spending globally. In this report we highlight that even after accounting for a historic rearmament in developed countries following Russia’s invasion of Ukraine, a decade from now EMs will play a key role in driving global military spends. The defense bill of the six richest developed countries of the world (the US, Japan, Germany, UK, France and Italy) will increasingly be rivaled by that of the top eight EMs (China, Taiwan, Korea, India, Brazil, Russia, Saudi Arabia and Turkey). While key developed markets like Japan and Germany in specific (and Europe more broadly) are now embarking on increasing defense spends, the unstable global backdrop will force EMs to increase their military budgets as well. The combination of these forces could mean that the top eight EM’s defense spends could be comparable to that of the top six developed markets in a decade from now i.e., by 2032 (Chart 8). This is true even though the six DMs have a larger GDP. The assumptions made while arriving at the 2032 defense spend projections include: Substantially Higher Pace Of Defense Spends For Developed Countries: To reflect the fact that Russia’s invasion of Ukraine will trigger a historical wave of armament in developed markets we assume that: (a) NATO members France, Germany and Italy (who spent about 1.5% of GDP on an average on defense spends in 2019) will ramp up defense spending to 2% of GDP by 2032, (b) US and UK i.e. NATO members who already spend substantially more than 2% of GDP on defense spends will still ‘increase’ defense spends by another 0.4% of GDP each by 2032 and finally (c) Japan which spends less than 1% of GDP on defense spends today, in a structural break from the past will increase its spending which will rise to 1.5% of GDP by 2032. China And Hence Taiwan As Well As India Will Boost Spends: To capture China’s increasingly aggressive foreign policy stance and the fact that India as well as Taiwan will be forced to respond to the Chinese threat; we assume that China increases its stated defense spends from 1.7% of GDP in 2019 to 3% by 2032. Taiwan follows in lockstep and increases its defense spends from 1.8% of GDP in 2019 to 3% by 2032. India which is experiencing a pincer movement from China to its east and Pakistan to its west will have no choice but to respond to the high and rising geopolitical risks in South Asia. The coming decade is in fact likely to see India’s focus on its naval firepower increase meaningfully as it feels the need to fend off threats in the Indo-Pacific. India currently maintains high defense spends at 2.5% of GDP and will boost this by at least 100bps to 3.5% of GDP by 2032. Defense Spending Trends For Five EMs: For the rest of the EMs (namely Russia, Saudi Arabia, South Korea and Brazil), the pace of growth in defense spending seen over 2009-19 is extrapolated to 2032. For Turkey, we assume that defense spends as a share of GDP increases to 3% of GDP by 2032. Extrapolation Of Past GDP Growth For All Countries: For all 14 countries, we extrapolate the nominal GDP growth calculated by the IMF for 2022-26 as per its last full data update, to 2032. This tectonic change in defense spending patterns has important historical roots. Back in 1900, UK and Japan i.e., the two seafaring powers were top defense spenders (Chart 9). Developed countries of the world continued to lead defense spending league tables through the twentieth century as they fought expensive world wars. Chart 8Major EM’s Defense Spends Will Be Comparable To That Of Developed Countries​​​​​​ Chart 9Back In 1900, Developed Countries Like UK And Japan Were Top Military Spenders​​​​​​ Chart 10By 2000, EMs Had Begun Spending Generously On Armament But things began changing after WWII. Jaded by the world wars, developed countries began lowering their defense spending. By the early 2000s EMs had now begun spending generously on armament (Chart 10). The turn of the century saw growth in developed markets fade while EMs like China and India’s geopolitical power began rising (Chart 11). Then a commodities boom ensued, resulting in petro-states like Saudi Arabia establishing their position as a high military spender. The confluence of these factors meant that by 2020 EMs had becomes major defense spenders in both relative and absolute terms too (Chart 12). Going forward, we expect the coming renaissance in DM defense spending in the face of Russian aggression, alongside rising geopolitical aspirations of China, to exacerbate this trend of rising EM militarization. Chart 11The 21st Century Saw Developed Countries’ Geopolitical Power Ebb Chart 12EMs Today Are Top Military Spenders, Even In Absolute Terms Why Does EM Weaponizing Matter? History suggests that wars are often preceded by an increase in defense spends: Well before WWI, a perceptible increase in defense spending could be seen in Austria-Hungary, Germany, and Italy (Chart 13). These three countries would go on to be known as the Triple Alliance in WWI. Correspondingly France, Britain and Russia (i.e., countries that would constitute the Triple Entente) also ramped up military spending before WWI (Chart 14). Chart 13Well Before WWI; Austria-Hungary, Germany, And Italy Had Begun Ramping Up Defense Spends​​​​​​ Chart 14The ‘Triple Entente’ Too Had Increased Defense Spends In The Run Up To WWI​​​​​​ History tragically repeated itself a few decades later. Besides Japan (which invaded China in 1937); Germany and Italy too ramped up defense spending well before WWII broke out (Chart 15). These three countries would come to be known as the Axis Powers and initiated WWII. Notably, Britain and Russia (who would go on to counter the Axis Powers) had also been weaponizing since the mid-1930s (Chart 16). Chart 15Axis Powers Had Been Increasing Defense Spends Well Before WWII​​​​​ Chart 16Allied Powers Too Had Been Increasing Defense Spends In The Run Up To WWII​​​​​ Chart 17Militarily Active States Have Been Ramping Up Defense Spends Russia, Ukraine, Turkey and Gulf Arab states like Iraq have been involved in wars in the recent past and noticeably increased their defense budgets in the lead-up to military activity (Chart 17). Given that a rise in military spending is often a leading indicator of war and given that EMs are set to spend more on defense, it appears that significant wars are becoming more rather than less likely, which Russia’s invasion of Ukraine obviously implies. A large number of “Black Swan Risks” are clustered in the spheres of influence of Russia, China, and Iran, which are the key powers attempting to revise the US-led global order today (Map 1). Map 1Black Swan Risks Are Clustered Around China, Russia & Iran Distinct from major EMs, eight small countries pose meaningful risks of being involved in wars over the next. These countries are small (in terms of their nominal GDPs) but spend large sums on defense both in absolute terms (>$4 billion) and in relative terms (>4% of GDP). Incidentally all these countries are located around the Eurasian rimland and include Israel, Pakistan, Algeria, Iran, Kuwait, Oman, Ukraine and Morocco (Map 2). In fact, the combined sum of spending undertaken by these countries is so meaningful that it exceeds the defense budgets of countries like Russia and UK (Chart 18). Map 2Eight Small Countries That Spend Generously On Defense Chart 188 Countries Located Near The Eurasian Rimland, Spend Large Sums On Defense​​​​ Bottom Line: As EM geopolitical power and aspirations rise, the defense bill of top developed countries will be challenged by the defense spending undertaken by major EMs. On one hand this change will mean that certain EMs may be at the epicenter of wars and concomitant market volatility. On the other hand, this change could spawn a new generation of winners amongst defense suppliers. Investment Conclusions In this section we highlight strategic trades that can be launched to play the two trends highlighted above. Trend #1: Beware The Wrath Of EMs On A Debt Binge Investors must prepare for EMs to witness sudden fiscal expansions, unusually aggressive foreign policy stances, and/or bouts of social unrest over the next few years. The only way to dodge these volatility-inducing events in EMs is to leverage geopolitics to foresee socio-political shocks. Using a simple method called the “Tinderbox Framework” (Table 2), we highlight that: Table 2Tinderbox Framework: Identifying Countries Most Exposed To Socio-Political Risks Within the eight major EMs; China, Brazil, Russia and Saudi Arabia face elevated socio-political risks. Amongst the smaller ten EMs, these risks appear most elevated for Egypt, South Africa and Argentina. It is worth noting that Brazil, South Africa and Turkey appeared most vulnerable as per our Covid-19 Social Unrest Index that we launched in 2020. We used the tinderbox framework in the current context to fade out effects of Covid-19 and to add weight to the debt problem that is brewing in EMs. Client portfolios that are overweight on most countries that fare poorly on our “Tinderbox Framework” should consider actively hedging for volatility at the stock-specific level. To profit from ascendant geopolitical risks in China, we reiterate shorting TWD-USD and the CNY against an equal-weighted basket of Euro and USD. China’s public debt ratio is high and social pressures may be building with limited valves in place to release these pressures (Table 2). The renminbi has performed well amid the Russian war, which has weighed down the euro, but China faces a confluence of domestic and international risks that will ultimately drag on the currency, while the euro will benefit from the European Union’s awakening as a geopolitical entity in the face of the Russian military threat. Trend #2: EM’s Will Drive Wars In The 21st Century Wars are detrimental to market returns.1 Furthermore, as the history of world wars proves, even the aftermath of a war often yields poor investment outcomes as wars can be followed by recessions. It is in this context that investors must prepare for the rise of EMs as protagonists in the defense market, by leveraging geopolitics to identify EMs that are most likely to be engaged in wars. While we are not arguing that WWIII will erupt, investors must brace for proxy wars as an added source of volatility that could affect EMs as an asset class. To profit from these structural changes underway we highlight two strategic trades namely: 1.  Long Global Aerospace & Defense / Broad Market Thanks to the higher spending on defense being undertaken by major EMs, global defense spends will grow at a faster rate over the next decade as compared to the last. We hence reiterate our Buy on Global Aerospace & Defense relative to the broader market. 2.  Long European Aerospace & Defense / European Tech Up until Russia invaded Ukraine and was hit with economic sanctions, Russia was the second largest exporter of arms globally accounting for 20% global arms exports. With Russia’s ability to sell goods in the global market now impaired, the two other major suppliers of defense goods that appear best placed to tap into EM’s demand for defense goods are the US (37% share in the global defense exports market) and Europe (+25% share in the global defense exports market). Chart 19American Defense Stocks Have Outperformed, European Defense Stocks Have Underperformed​​​​​​ Chart 20Defense Market: Russia’s Loss Could Be Europe’s Gain​​​​​ But given that (a) American aerospace & defense stocks have rallied (Chart 19) and given that (b) France, Germany, and Italy are major suppliers of defense equipment to countries that Russia used to supply defense goods to (Chart 20), we suggest a Buy on European Aerospace & Defense relative to European Tech stocks to extract more from this theme. In fact, this trade also stands to benefit from the pursuance of rearmament by major European democracies which so far have maintained lower defense spends as compared to America and UK. This view from a geopolitical perspective is echoed by our European Investment Strategy (EIS) team too who also recommend a Long on European defense stocks and a short on European tech stocks. Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1      Please see: Andrew Leigh et al, “What do financial markets think of war in Iraq?”, NBER Working Paper No. 9587, March 2003, nber.org.  David Le Bris, “Wars, Inflation and Stock Market Returns in France, 1870-1945”, Financial History Review 19.3 pp. 337-361, December 2012, ssrn.com. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary Profit Margins Are Headed Lower; So Are Equity Multiples The post pandemic profit recovery in India was driven by a one-off revival of demand from very depressed levels, which led to a spike in profit margins as companies’ sales outpaced their costs (hiring costs and financing cost). The glacial pace of job creation since the pandemic and the muted wage growth is to blame for weak household income, which in turn is hurting consumption. Indian growth is wobbling as household consumption is losing steam, and capital investments are decelerating. The Ukraine crisis and the resulting oil / commodity price surge will hurt Indian firms’ margins and profits even more in the months to come. Indian stocks are still expensive, and future profit expectations are elevated – especially relative to their EM and emerging Asian counterparts. This has set the stage for profit disappointment. Bottom Line: Indian growth is decelerating amid high stock valuations. Higher for longer commodity prices will hurt as well. Equity investors should downgrade Indian stocks tactically from neutral to underweight in EM and emerging Asian portfolios. Domestic bond investors should book profits on their Indian exposure, and downgrade to neutral in EM and emerging Asian baskets. Feature Chart 1Indian Stocks Are Headed For A Turbulent Time​​​​​​ Long COVID is a condition that manifests itself after a person recovers from the acute phase of the disease. The Indian economy is showing similar signs: after an initial post-COVID recovery, household consumption and investment have begun to disappoint. This is happening at a time when Indian equity valuations and investors’ profit expectations are much higher than those of the rest of the EM. As such, Indian share prices are set for a turbulent time ahead. Equity investors should tactically downgrade this bourse to underweight in EM and emerging Asian portfolios (Chart 1). Domestic bond investors should book profits on their Indian exposure, and downgrade it to neutral in EM and emerging Asian baskets. Consumer Spending During and in the immediate aftermath of the pandemic, the Indian government did not supplement lost household income caused by the lockdowns and the layoffs by any good measure. Tangible fiscal stimulus (i.e., excluding government guarantees etc.) amounted to less than 2% of GDP. Post-pandemic, jobs have been growing at a glacial pace. In fact, India’s total employment is estimated to be still 8% lower as of the end of 2021 compared to the first quarter of 2020, as per Oxford Economics data. Consistently, wage growth has been very poor as well – in both urban and rural areas (Chart 2). Wages in real terms (deflated by CPI) have been contracting. Household income has therefore remained severely impaired. The consequences of meagre household incomes can now be seen in persistently weak consumer durable sales. Chart 3 shows that passenger cars and 2-wheeler sales are languishing at much lower levels than they were in the pre-pandemic period. Chart 2Subdued Employment And Poor Wage Growth Sapped Household Income … Chart 3… Leading To Impaired Household Consumption Chart 4Signs Of Softening Business Activity The overall growth in India was seen to be softening even before the Ukraine crisis. The economy grew at a 5.4% YoY rate in the last quarter of 2021, down from 8.5% in the previous quarter. The trend appears to be continuing into this year. Corroborating evidence comes in the form of the number of E-way bills1 issued – which is a barometer of business activity. The number peaked in October last year and has been struggling since (Chart 4). Persistently weak consumer demand is a crucial reason why manufacturing production is also struggling to get back to the pre-pandemic trend – which would be a good 10% higher than the current level (Chart 4, bottom panel). Industrial production will face difficulty gaining traction should weakness in consumer demand linger. On the whole, the post-pandemic economic recovery in India was a rapid one initially; but is now gradually losing steam as joblessness remains high and wages remain low. Looming Energy Tax Ominously, odds have risen that core (non-oil) consumer demand could be even weaker in the months ahead. The sharp rise in crude prices will soon mean that Indian consumers and businesses will have to shell out more for their energy-related purchases. Chart 5 shows that retail gasoline and diesel prices in India did not keep pace with the global crude prices in recent months. Hence, if some or all of the rise is passed on to the consumers, domestic fuel prices could go up by about 10 - 20%. If so, that would be a major tax on the economy. Higher expenses on fuel and transportation – which make up about 15% of consumer spending – will force households to curtail their non-oil spending elsewhere. That means non-energy firms would see lower sales. Those firms would also see their own operating and raw material costs going up given the higher oil and other commodity prices. Together, these will have a pronounced negative impact on these firms’ profit margins. Lower margins are a harbinger of lower stock multiples (Chart 6). Chart 5Retail Gasoline And Diesel Prices Could Rise Materially Chart 6Profit Margins Are Headed Lower; So Are Equity Multiples Notably, Indian corporate profit margins had surged to decade high levels last year thanks mainly to cost cutting. Wage bills had gone down as businesses slashed employees; and were slow to re-hire them. Interest expenses had also gone down – both relative to sales and profits – as the central bank cut interest rates aggressively. When sales revived after the lockdowns, the higher/rising margins led to surging profits. But now, both sales and margins are in jeopardy as weak consumer demand is hurting the former, while rising raw materials cost will hurt the latter. Profits are set to disappoint as a result. Related Report  Emerging Markets StrategyEquity Capitulation, A Commodity Shock And Geopolitics What’s more, faltering profits could also lead to a premature slowdown in India’s capital investments. Firms’ capex plans are highly contingent on profit growth; and therefore, the former may see a dip in the coming months with dwindling profits (Chart 7). This potential development could be a major negative for India’s sustainable growth story, and its ill-effects may linger. What makes this episode of oil/commodity shock particularly negative for India is that it is taking place when consumer demand is already sluggish. Previous oil shocks in 2007-08 and 2011-12 took place when the underlying growth was quite robust. Stronger underlying growth allows for the absorption of negative exogenous shocks like higher oil & energy prices. Overall, rising oil prices have historically been bearish for Indian stocks’ relative performance. That correlation had broken down since the onset of the pandemic two years ago (Chart 8). However, now with the crude price hovering around $100 a barrel, India’s relative equity outperformance versus the EM benchmark will give up some of its gains of the past two years. Chart 7Dwindling Profits Could Lead To A Slowdown In Caital Expenditure Chart 8India’s Relative Equity Outperformance Cannot Continue With $100 Oil How About Inflation? Chart 9Global Commodity Prices Dictate Indian PPI, But Not So Much CPI India’s producer price inflation (PPI) is highly geared to global commodity prices. As such, one can expect PPI to re-accelerate in the months ahead. That said, commodity prices are not a major driver of India’s consumer price inflation (CPI). The latter will therefore likely remain more well behaved than PPI would (Chart 9). Historically, the two primary drivers of India’s CPI have been the economy’s productivity growth rate and broad money (M3) growth rate. Since productivity trends do not change much in the near term, it’s money supply that determines the short-term trajectory of CPI (Chart 10). Chart 10Money Supply Determines India’s CPI Over Cyclical Horizon Chart 11Drivers Of India’s Money Supply Will See Only A Mediocre Growth Money growth has been quite mediocre recently; and will likely stay that way. This is because neither of the two main drivers of money supply, bank credit and fiscal expenditure, are set to rise very strongly. In the proposed fiscal budget for April 2022 – March 2023, the government is planning to raise current expenditure2 by just 1% in nominal terms; and the total expenditure by 5%. Meanwhile, non-interest government spending growth has already come back to normal levels following the one-off surge during the pandemic (Chart 11, top panel). Bank credit has also slowed on the margin this year. That it has barely grown in real terms in the past couple of years is also dampening inflationary pressures (Chart 11, bottom panel). All this means that any rise in consumer price inflation will be limited. Notably, a marginal rise in consumer price inflation is unlikely to lead to policy tightening by the central bank. This is because the source of inflation would be supply driven, rather than demand driven. The central bank would recognize that higher commodity prices will exacerbate the already weak consumer demand; and therefore, any further policy tightening could decimate growth. On the whole, very sluggish wage growth and contained core CPI support the fact that there are no genuine demand-driven inflationary pressures in the country (Chart 12). A rise in global food prices should also not impact India much as the country is not a big importer of food grains and most of its food is domestically grown. All in all, the RBI is likely to ignore the slight pickup in CPI, and will refrain from raising rates. How Much Downside In Stocks? Indian stocks have been in a trading range relative to their EM counterparts since we downgraded them to neutral in October last year. In absolute terms also they have not fallen much so far – even though foreign investors have exited this market en masse over the past several months. The missing piece of the puzzle for this apparent dichotomy is the massive purchases by domestic mutual funds in recent months. This local demand is what prevented this bourse from tanking (Chart 13). Chart 12India’s Consumer Inflation Will Not Rise By Too Much Chart 13The Massive Purchases Of Mutual Funds Will Wane With Profit Disappointment Chart 14Indian Stock Multiples Are Still Very High Relative To Their Counterparts Going forward, however, those domestic purchases are likely to wane as growth and profits slow, and local investors become wary of their equity exposures. That would lead to a sell-off in stock prices. Notably, Indian stocks are still quite pricey when compared to both their EM and emerging Asian counterparts based on the cyclically adjusted P/E ratio (Chart 14). As explained above, Indian stock multiples are set to fall materially as firms’ profit margins are squeezed in the months to come. Investors have paid high equity multiples as they have extrapolated the strong profit recovery post-pandemic into the future. However, the profit recovery post-pandemic was driven by a one-off revival of demand from very depressed levels and a one-off spike in profit margins as companies’ sales outpaced their costs (hiring costs and financing cost). As and when investors realize that a sustainable profit growth rate is much lower than the initial post-pandemic trajectory, multiples will shrink somewhat. At the same time, firms’ topline will also wobble as non-oil consumer spending sees forced retrenchment. Weakish topline, multiplied by lower margins, entails weak earnings growth. That would be another drag (besides shrinking multiples) on Indian share prices. Notably, a sell-off in Indian stocks usually comes with a depreciating rupee – thereby compounding woes for foreign investors in Indian stocks. All in all, this bourse could witness a major down leg in absolute USD terms in the months to come. Relative to other EM and emerging Asian markets also they will trade on the weaker side. Book Profits On Domestic Bonds We have been overweight India in EM local currency bond portfolios given Indian bonds’ rather high yields, and the country’s prudent fiscal policy, benign inflation outlook, and a cheap currency. The call has worked out well (Chart 15, top panel). However, following the sharp rise in EM bond yields, Indian bond yields are no longer attractive in relative terms (Chart 15, bottom panel). A less sanguine rupee outlook over the short term is another cause for concern. Besides, rising US bond yields would make Indian bonds look less attractive. Considering all, we recommend EM local currency bond investors take profits on their overweight India exposure and reduce the allocation to neutral in EM and emerging Asian baskets. Investment Recommendations Equities: Indian firms’ profit outlook has deteriorated significantly given odds of disappointing margins and still high equity valuations. Investors should tactically downgrade this market from neutral to underweight in EM and emerging Asian equity portfolios. Absolute return investors should avoid this market outright. Currency and Bonds: The Indian rupee is at a risk of mild depreciation along with a sell-off in the Indian stock markets. However, given that the currency is cheap, its relapse will not be large (Chart 16). Chart 15Indian Domestic Bonds Are Not As Attractive Any More; Book Profits Chart 16Indian Rupee Is Cheap, And Hence Has Only A Limited Downside Indian government bonds have outperformed their EM counterparts over the past four years; but are no longer as attractive as the yield advantage has disappeared and the rupee has a weaker near-term outlook. Investors should book profits on their overweight allocations, and downgrade them to neutral relative to EM and emerging Asian baskets. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1     E-way bills are issued as part of Goods & Services Tax (GST) collection mechanism. 2     The rest is capital expenditure – which the government is planning to raise by 24%, albeit from a much smaller base (2.6% of GDP) compared to current expenditure (13.6% of GDP).