Elections

Executive Summary China's Unemployment Over the past week we have been visiting clients along the US west coast. In this report we hit some of the highlights from the most important and frequently asked questions. Xi Jinping is seizing absolute power just as the country’s decades-long property boom turns to bust. He will stimulate the economy but Chinese stimulus is less effective than it used to be. The US and Israel are underscoring their red line against Iranian nuclear weaponization. If Iran does not freeze its nuclear program, the Middle East will begin to unravel again. The UK’s domestic instability is returning, with Scotland threatening to leave the union. Brexit, the pandemic, and inflation make a Scottish referendum a more serious risk than in the past. Shinzo Abe’s assassination makes him a martyr for a vision of Japan as a “normal country” – i.e. one that is not pacifist but capable of defending itself. Japan’s rearmament, like Germany’s, points to the decline of the WWII peace settlement and the return of great power competition. Bottom Line: Investors need a new global balance to be achieved through US diplomacy with Russia, China, and Iran. That is not forthcoming, as the chief nations face instability at home and a stagflationary global economy. Feature The world is becoming less stable as stagflation combines with great power competition. Global uncertainty is through the roof. From a macroeconomic perspective, investors need to know whether central banks can whip inflation without triggering a recession. From a geopolitical perspective, investors need to know whether Russia’s conflict with the West will expand, whether US-China and US-Iran tensions will escalate in a damaging way, and whether domestic political rotations in the US and China this fall will lead to more stable and productive economies. China: What Will Happen At The Communist Party Reshuffle? General Secretary Xi Jinping will cement another five-to-10 years in power while promoting members of his faction into key positions on the Politburo and Politburo Standing Committee. By December Xi will roll out a pro-growth strategy for 2023 and the government will signal that it will start relaxing Covid-19 restrictions. But China’s structural problems ensure that this good news for global growth will only have a fleeting effect. China’s governance is shifting from single-party rule to single-person rule. It is also shifting from commercially focused decentralization to national security focused centralization. Xi has concentrated power in himself, in the party, and in Beijing at the expense of political opponents, the private economy, and outlying regions like Hong Kong, the South China Sea, and Xinjiang. The subordination of Taiwan is the next major project, ensuring that China will ally with Russia and that the US and China cannot repair or deepen their economic partnership. Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Xi and the Communist Party began centralizing political power and economic control shortly after the Great Recession. At that time it became clear that a painful transition away from export manufacturing and close relations with the United States was necessary. The transition would jeopardize China’s long-term economic, social, political, and geopolitical stability. The Communist Party believed it needed to revive strongman leadership (autocracy) rather than pursuing greater liberalization that would ultimately increase the odds of political revolution (democratization). The Xi administration has struggled to manage the country’s vast debt bubble, given that total debt standing has surged to 287% of GDP. The global pandemic forced the government to launch another large stimulus package, which it then attempted to contain. Corporate and household deleveraging ensued. The property and infrastructure boom of the past three decades has stalled, as the regime has imposed liquidity and capital requirements on banks and property developers to try to avoid a financial crisis. Regulatory tightening occurred in other sectors to try to steer investment into government-approved sectors and reduce the odds of technological advancement fanning social dissent. China’s draconian “zero Covid” policy sought to limit the disease’s toll, improve China’s economic self-reliance, and eliminate the threat of social protest during the year of the twentieth party congress. But it also slammed the brakes on growth. China is highly vulnerable to social instability for both structural and cyclical reasons. Chinese social unrest was our number one “Black Swan” for this year and it is now starting to take shape in the form of angry mortgage owners across the country refusing to make mortgage payments on houses that were pre-purchased but not yet built and delivered (Chart 1). Chart 1China: Mortgage Payment Boycott The mortgage payment boycott is important because it is stemming from the outstanding economic and financial imbalance – the property sector – and because it is a form of cross-regional social organization, which the Communist Party will disapprove. There are other social protests emerging, including low-level bank runs, which must be monitored very closely. Local authorities will act quickly to stop the spread of the mortgage boycott. But unhappy homeowners will be a persistent problem due to the decline of the property sector and industry. China’s property sector looks uncomfortably like the American property sector ahead of the 2006-08 bust. Prices for existing homes are falling while new house prices are on the verge of falling (Chart 2). While mortgages only make up 15% of bank assets, and household debt is only 62% of GDP, households are no longer taking on new debt (Chart 3). Chart 2China's Falling Property Prices​​​​​​ Chart 3China's Property Crisis​​​​​​ Chart 4China's Unemployment Most likely China’s property sector is entering the bust phase that we have long expected – if not, then the reason will be a rapid and aggressive move by authorities to expand monetary and fiscal stimulus and loosen economic restrictions. That process of broad-based easing – “letting 100 flowers bloom” – will not fully get under way until after the party congress, say in December. Unemployment is rising across China as the economy slows, another point of comparison with the United States ahead of the 2008 property collapse (Chart 4). Unemployment is a manipulated statistic so real conditions are likely worse. There is no more important indicator. China’s government will be forced to ease policy, creating a positive impact on global growth in 2023, but the impact will be fleeting. Bottom Line: The underlying debt-deflationary context will prevail before long in China, weighing on global growth and inflation expectations on a cyclical basis. Middle East: Why Did Biden Go And What Will He Get? President Biden traveled to Israel and now Saudi Arabia because he wants Saudi Arabia and the Gulf Arab members of OPEC to increase oil production to reduce gasoline prices at the pump for Americans ahead of the midterm elections (Chart 5). Chart 5Biden Goes To Israel And Saudi Arabia True, fears of recession are already weighing on prices, but Biden embarked on this mission before the growth slowdown was fully appreciated and he is not going to lightly abandon the anti-inflation fight before the midterm election. Biden also went because one of his top foreign policy priorities – the renegotiation of the 2015 nuclear deal with Iran – is falling apart. The Iranians do not want to freeze their nuclear program because they want regime survival and security. While Biden is offering a return to the 2015 deal, the conditions that produced the deal are no longer applicable: Russia and China are not cooperating with the US and EU to isolate Iran. Russia is courting Iran, oil prices are high and sanction enforcement is weak (unlike 2015). The Iranians now know, after the Trump administration, that they cannot trust the Americans to give credible security guarantees that will last across parties and administrations. The war in Ukraine also underscores the weakness of diplomatic security guarantees as opposed to a nuclear deterrent. Hence the joint US and Israeli declaration that Iran will never be allowed to obtain nuclear weapons. The good news is that this kind of joint statement is precisely what needed to occur – the underscoring of the red line – to try to change Ayatollah Ali Khamenei’s calculus regarding his drive to achieve nuclear breakout. In 2015 Khamenei gave diplomacy a chance to try to improve the economy, stave off social unrest, prepare the way for his eventual leadership succession process, and secure the Islamic Republic. The bad news is that Khamenei probably cannot make the same decision this time, as the hawkish faction now runs his government, the Americans are unreliable, and Russia and China are offering an alternative strategic orientation. The Saudis will pump more oil if necessary to save the global business cycle but not at the beck and call of a US president. The drop in oil prices reduces their urgency. The Americans can reassure the Saudis and Israel as long as the deal with Iran is not going forward. That looks to be the case. But then the US and Israel will have to undertake joint actions to underline their threat to Iran – and Iran will have to threaten to stage attacks across the region so as to deter any attack. Bottom Line: If a US-Iran deal does not materialize at the last minute, Middle Eastern instability will revive and a new source of oil supply constraint will plague the global economy. We continue to believe a US-Iran deal is unlikely, with only 40% odds of happening. Europe: Will Russia Turn Back On The Natural Gas? Russia’s objective in cutting off European natural gas is to inflict a recession on Europe. It wants a better bargaining position on strategic matters. Therefore we assume Russia will continue to squeeze supplies from now through the winter, when European demand rises and Russian leverage will peak. If Russia allows some flow to return, then it will be part of the negotiating process and will not preclude another cutoff before winter. It is possible that Russia is merely giving Europe a warning and will revert back to supplying natural gas. The problem is that Russia’s purpose is to achieve a strategic victory in Ukraine and in negotiations over NATO’s role in the Nordic countries. Russia has not achieved these goals, so natural gas cutoff will likely continue. Russia also hopes that by utilizing its energy leverage – while it still has it – it will bring forward the economic pain of Europe’s transition away from reliance on Russian energy. In that case European countries will experience recession and households will begin to change their view of the situation. European governments will be more likely to change their policies, to become more pragmatic and less confrontational toward Russia. Or European governments will be voted out of power and do the same thing. Other states could join Hungary in saying that Europe should never impose a full natural gas embargo on Russia. Russia would be able to salvage some of its energy trade with Europe over the long run, despite the war in Ukraine and the inevitable European energy diversification. In recent months we highlighted Italy as the weakest link in the European chain and the country most likely to see such a shift in policy occur. Italy’s national unity coalition had lost its reason for being, while the combination of rising bond yields and natural gas prices weighed on the economy. The Italian bond spread over German bunds has long served as our indicator of European political stress – and it is spiking now, forcing the European Central Bank to rush to plan an anti-fragmentation strategy that would theoretically enable it to tighten monetary policy while preventing an Italian debt crisis (Chart 6). The European Union remains unlikely to break up – Russian aggression was always one of our chief arguments for why the EU would stick together. But Italy will undergo a recession and an election (due by June 2023 but that could easily happen this fall), likely producing a new government that is more pragmatic with regard to Russia so as to reduce the energy strain. Chart 6Italy's Crisis Points To EU Divisions On Russia Italy’s political turmoil shows that European states are feeling the energy crisis and will begin to shift policies to reduce the burden on households. Households will lose their appetite for conflict with Russia on behalf of Ukrainians, especially if Russia begins offering a ceasefire after completing its conquest of the Donetsk area. If Russia expands its invasion, then Europe will expand sanctions and the risk of further strategic instability will go up. But most likely Russia will seek to quit while it is ahead and twist Europe’s arm into foisting a ceasefire onto Ukraine. Bottom Line: A change of government in Italy will increase the odds that the EU will engage in diplomacy with Russia in the coming year, if Russia offers, so as to reach a new understanding, restore natural gas flows, and salvage the economy. This would leave NATO enlargement unresolved but a shift in favor of a ceasefire in Ukraine in 2023 would be less negative for European assets and the euro. UK: Who Will Replace Boris Johnson? Last week UK Prime Minister Boris Johnson fell from power and now the Conservative Party is engaging in a leadership competition to replace him. We gave up on Johnson after he survived his no-confidence vote and yet it became clear that he could not recover in popular opinion. The inflation outburst destroyed his premiership and wiped away whatever support he had gained from executing Brexit. In fact it reinforced the faction that believed Brexit was the wrong decision. Going forward the UK will be consumed with domestic political turmoil as the cost of stagflation mounts, and geopolitical turmoil as Scotland attempts to hold a second independence referendum, possibly by October 2023. Global investors should focus primarily on Scotland’s attempt to secede, since the breakup of the United Kingdom would be a momentous historical event and a huge negative shock for pound sterling. While only 44.7% of Scots voted for independence in 2014, now they have witnessed Brexit, Covid-19, and stagflation, producing tailwinds for the Scots nationalist vote (Chart 7). Chart 7Forget Bojo's Exit, Watch Scotland There are still major limitations on Scotland exiting, since its national capabilities are limited, it would need to join the European Union, and Spain and possibly others will threaten to veto its membership in the European Union for fear of feeding their own secessionist movements. But any new referendum – including one done without the approval of Westminster – should be taken very seriously by investors. Bottom Line: Johnson’s removal will only marginally improve the Tories’ ability to manage the rebellion brewing in the north. A snap election that brings the Labour Party back into power would have a greater chance of keeping Scotland in the union, although it is not clear that such a snap election will happen in time to affect any Scottish decision. The UK faces economic and political turmoil between now and any referendum and investors should steer clear of the pound. (Though we still favor GBP over eastern European currencies). Britain will remain aggressive toward Russia but its ability to affect the Russian dynamic will fall, leaving the US and EU to decide the fate of Russian relations. Japan: What Is The Significance Of Shinzo Abe’s Assassination? Former Japanese Prime Minister Shinzo Abe was assassinated by a lone fanatic with a handmade gun. The significance of the incident is that Abe will become a martyr for a certain vision of Japan – his vision of Japan, which is that Japan can become a “normal country” that moves beyond the shackles of the guilt of its imperial aggression in World War II. A normal country is one that is economically stable and militarily capable of defending itself – not a pacifist country mired in debt-deflation. Abe stood for domestic reflation and a proactive foreign policy, along with the normalization of the Japanese Self-Defense Forces (JSDF). True, economic policy can become less dovish if necessary to deal with inflation. Some changes at the Bank of Japan may usher in a less dovish shift in monetary policy in particular. But monetary policy cannot become outright hawkish like it was before Abe. And Abe’s fiscal policy was never as loose as it was made out to be, given that he executed several hikes to the consumption tax. Japan’s structural demographic decline and large debt burden will continue to weigh on economic activity whenever real rates and the yen rise. The government will be forced to reflate using monetary and fiscal policy whenever deflation threatens to return. Debt monetization will remain an option for future Japanese governments, even if it is restrained during times of high inflation. Chart 8Shinzo Abe's Legacy ​​​​​​​ This is not only because Japanese households will become depressed if deflation is left unchecked but also because economic growth must be maintained in order to sustain the nation’s new and growing national defense budgets. Japan’s growing need for self defense stems from China’s strategic rise, Russia’s aggression, and North Korea’s nuclearization, plus uncertainty about the future of American foreign policy. These trends will not change anytime soon. Indeed the Liberal Democratic Party’s popularity has increased under Abe’s successor, Prime Minister Fumio Kishida, who will largely sustain Abe’s vision. The Diet still has a supermajority in favor of constitutional revision so as to enshrine the self-defense forces (Chart 8). And the de facto policy of rearmament continues even without formal revision. Bottom Line: Any Japanese leader who attempts to promote a hawkish BoJ, and a dovish JSDF, will fail sooner rather than later. The revolving door of prime ministers will accelerate. As Japan’s longest-serving prime minister, Shinzo Abe opened up the reliable pathway, which is that of a dovish BoJ and a hawkish foreign policy. This is important for the world, as well as Japan, because a more hawkish Japan will increase China’s fears of strategic containment. The frozen conflicts in Asia will continue to thaw, perpetuating the secular rise in geopolitical risk. We remain long JPY-KRW, since the BoJ may adjust in the short term and Chinese stimulus is still compromised, but that trade is on downgrade watch. Investment Takeaways Russia’s energy cutoff is aimed at pushing Europe into recession so as to force policy changes or government changes in Europe that will improve Russia’s position at the negotiating table over Ukraine, NATO, and other strategic disputes. Hence Russia is unlikely to increase the natural gas flow until it believes it has achieved its strategic aims and multiple veto players in the EU will prevent the EU from ever implementing a full-blown natural gas embargo. Chinese stimulus cannot be fully effective until it relaxes Covid-19 restrictions, likely beginning in December or next year when Xi Jinping uses his renewed political capital to try to stabilize the economy. However, China’s government powers alone are insufficient to prevent the debt-deflationary tendency of the property bust. The Middle East faces rising geopolitical tensions that will take markets by surprise with additional energy supply constraints. The implication is continued oil volatility given that global growth is faltering. Once global demand stabilizes, the Middle East’s turmoil will add to existing oil supply constraints to create new price pressures. The odds are not very high of the Federal Reserve achieving a “soft landing” in the context of a global energy shock and a stagflationary Europe and China.   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 "Batting Average": Geopolitical Strategy Trades () Section II: Special (EDIT this Header) Section III: Geopolitical Calendar

Executive Summary China: GeoRisk Indicator A new equilibrium between NATO, which now includes Sweden and Finland, and Russia needs to be reestablished before geopolitical risks in Europe subside. Russia aims to inflict a recession on the EU which will revive dormant geopolitical risks embedded in each country. Investors should ignore the apparent drop in China’s geopolitical risk as it could rise further until Xi Jinping consolidates power at the Party Congress this fall. Stay on the sideline on Brazilian, South African, Australian, and Canadian equities despite the commodity bull market, at least until China’s growth stabilizes. Korean risk will rise, albeit by less than Taiwanese risk. The US political cycle ensures that Biden may take further actions against adversaries in Europe, Middle East, and East Asia, putting a floor under global geopolitical risk. Tactical Recommendation Inception Date Return LONG GLOBAL AEROSPACE & DEFENSE / BROAD MARKET EQUITIES 2020-11-27 9.3% Bottom Line: Geopolitical risk will rise in the near term. Stay long gold and global defensive stocks. Feature This month we update our GeoRisk Indicators and make observations about the status of political risk for each territory, and where risks are underrated or overrated by global financial markets. Russia GeoRisk Indicator Our “Original” quantitative measure of Russian political risk – the Russian “geopolitical risk premium” shown in the dotted red line below – has fallen to new lows (Chart 1). One must keep in mind that this geopolitical premium is operating under the assumption of a “free market” but the Russian market in the past few months had been anything but free. The Russian government and central bank had been manipulating the ruble and preventing capital outflows. Hence, Russian assets and any indicator derived from it does not reflect its true risk premium, merely the resolve of its government in the geopolitical struggle. Chart 1Russia: GeoRisk Indicator While the Russia Risk Premium accurately detected the build-up in tensions before the invasion of Ukraine this year, today it gives the misleading impression that Russian geopolitical risk is low. In reality the risk level remains high due to the lack of strategic stability between Russia and the West, particularly the United States, and particularly over the question of NATO enlargement. Our “Old” Russia GeoRisk Indicator remains elevated but has slightly fallen back. This measure failed to detect the rise in risk ahead of this year’s invasion of Ukraine. We predicted the war based on non-market variables, including qualitative analysis. As a result of the failure of our indicator, we devised a “New” Russia GeoRisk Indicator after this year’s invasion, shown as the green line below. This measure provides the most accurate reading. It is pushing the upper limits, which we truncated at 4, as it did during the invasion of Georgia in 2008 and initial invasion of Ukraine in 2014. Related Report  Geopolitical StrategyThird Quarter Geopolitical Outlook: Thunder And Lightning Has Russian geopolitical risk peaked for Europe and the rest of the world? Not until a new strategic equilibrium is established between the US and Russia. That will require a ceasefire in Ukraine and a US-Russia understanding about the role of Finland and Sweden within NATO. However, Hungary is signaling that the EU should impose no further sanctions on Russia. Russia’s cutoff of natural gas exports to Europe will create economic hardship that will start driving change in European governments or policies. A full ban on Russian natural gas may not be implemented in the coming years due to lack of EU unanimity. Still, the EU cannot lift sanctions on Russia because that would enable economic recovery and hence military rehabilitation, which could enable new aggression. Also, Russia will not relinquish the territories it has taken from Ukraine even if President Putin exits the scene. No Russian leader will have the political capital to do that given the sacrifices that Russia has made. Bottom Line: Russia’s management of the ruble is distorting some of our risk indicators. Russia remains un-investable for western investors. Substantial sanction relief will not come until late in the decade, if at all. UK GeoRisk Indicator British political risk is rising, and it may surpass the peaks of the Brexit referendum period in 2016 now that Scotland is pursuing another independence referendum (Chart 2). Chart 2United Kingdom: GeoRisk Indicator New elections are not due until January 25, 2025 and the ruling Conservative Party has every reason to avoid an election over the whole period so that inflation can come down and the economy can recover. But an early election is possible between now and 2025. Prime Minister Boris Johnson has become a liability to his party but he is still a more compelling leader than the alternatives. If Johnson is replaced, then the change of leadership will only temporarily boost the Tories’ public approval. It will ultimately compound the party’s difficulties by dividing the party without resolving the Scottish question.  Regardless, the Tories face stiff headwinds in the coming referendum debate and election, having been in power since 2010 and having suffered a series of major shocks (Brexit, the pandemic, inflation). Bottom Line: The US dollar is not yet peaking against pound sterling, As from a global geopolitical perspective it can go further. Investors should stay cautious about the pound in the short term. But they should prefer the pound to eastern European currencies exposed to Russian instability. Germany GeoRisk Indicator German political risk spiked around the time of the 2021 election and has since subsided, including over the course of the Ukraine war (Chart 3). However, risk will rise again now that Germany has declared that it is under “economic attack” from Russia, which is cutting natural gas in retaliation to Germany’s oil embargo. Chart 3Germany: GeoRisk Indicator This spike in strategic tensions should not be underrated. Germany is entering a new paradigm in which Russian aggression has caused a break with the past policy of Ostpolitik, or economic engagement. Germany will have to devote huge new resources to energy security and national defense and will have to guard against Russia for the foreseeable future. Domestic political risk will also rise as the economy weakens and industrial activity is rationed. Germany does not face a general election until October 26, 2025. Early elections are rare but cannot be ruled out over the next few years. The ruling coalition does not have a solid foundation. It only has a 57% majority in the Bundestag and consists of an ideological mix of parties (a “traffic light” coalition of Social Democrats, Greens, and Free Democrats). Still, Germany’s confrontation with Russia will keep the coalition in power for now. Bottom Line: From a geopolitical point of view, there is not yet a basis for the dollar to peak and roll over against the euro. That is not likely until there is a ceasefire in Ukraine and/or a new NATO-Russia understanding. France GeoRisk Indicator French political risks are lingering at fairly high levels in the wake of the general election and will only partially normalize given the likelihood of European recession and continued tensions around Russia (Chart 4). Chart 4France: GeoRisk Indicator President Emmanuel Macron was re-elected, as expected, but his Renaissance party (previously En Marche) lost its majority and Macron will struggle to win over 39 deputies to gain a majority of 289 seats in the Assembly. He will, however, be able to draw from an overall right-wing ideological majority – especially the Republicans – when it comes to legislative compromises. The election produced some surprises. The right-wing, anti-establishment National Rally of Marine Le Pen, which usually performs poorly in legislative elections, won 89 seats. The left-wing alliance (NUPES) underperformed opinion polls and has not formed a unified bloc within the Assembly. Still, the left will be a powerful force as it will command 151 seats (the sum of the left-wing anti-establishment leader Jean-Luc Mélenchon’s La France Insoumise party and the Communists, Socialists, and Greens). Macron’s key reform – raising the average retirement age from 62 to 65 – will require an ad hoc majority in the Assembly. The Republicans, with 74 seats, can provide the necessary votes. But some members have already refused to side with Macron on this issue. Macron will most likely get support from the populist National Rally on immigration, including measures to make it harder to be naturalized or obtain long-term residence permits, and measures making it easier to expel migrants whose asylum applications have been refused. France will remain hawkish on immigration, but Macron will be able to rein in the populists. On energy and the environment, Macron may be able to cooperate with the Left on climate measures, but ultimately any cooperation will be constrained by the fact that Mélenchon opposes nuclear power. The Republicans and the National Rally will support Macron’s bid to shore up France’s nuclear energy sector. Popular opinion will hold up for France’s energy security in the face of Russian weaponization of natural gas. Macron and Mélenchon will clash on domestic security. Police violence has emerged as a major source of controversy since the Yellow Vest protests. Macron and the Right will protect the police establishment while the Left will favor reforms, notably the concept of “proximity police,” which would entail police officers patrolling in a small area to create stronger, more personal links between the police and the population; officers being under the control of the mayor and prefect; and ultimately most officers not carrying lethal weapons, and the ban of physically dangerous arrest techniques. Grievances over the police as well as racial inequality will likely erupt into significant social unrest in the coming years. As a second-term president without a single-party majority, Macron will increasingly focus on foreign policy. He will aim to become the premier European leader on the world stage. He will seek to revive France’s historic role as a leading diplomatic power and arbiter of Europe. He will strengthen France’s position in the EU and NATO, keep selling arms to the Middle East, and maintain a French military presence in the Sahel. Macron will favor Ukraine’s membership in the EU but also a ceasefire with Russia. He will face a difficult decision on whether to join Israeli and American military action against Iran should the latter reach nuclear breakout capacity and pursue weaponization. Bottom Line: The outperformance of French equities is stretched relative to EMU counterparts. But France will not underperform until the EU’s natural gas crisis begins to subside and a new equilibrium is established with Russia. Italy GeoRisk Indicator Italy is perhaps the weakest link in Europe both economically and strategically (Chart 5). Elections are due by June 2023 but could come earlier as the ruling coalition is showing strains. A change of government would likely compromise the EU’s attempt to maintain a unified front against Russia over the war in Ukraine. Chart 5Italy: GeoRisk Indicator Before the war Italy received 40% of its natural gas from Russia and maintained pragmatic relations with the Putin administration. Now Russia is reducing flows to Italy by 50%, forcing the country into an energy crisis at a time when expected GDP growth had already been downgraded to 2.3% this year and 1.7% in 2023. Meanwhile Italian sovereign bond spreads over German bunds have risen by 64 basis points YTD as a result of the global inflation. The national unity coalition under Prime Minister Mario Draghi came together for two purposes. First, to distribute the EU’s pandemic recovery funds across the country, which amounted to 191.5 billion euros in grants and cheap loans for Italy, 27% of the EU’s total recovery fund and 12% of Italy’s GDP. Second, to elect an establishment politician in the Italian presidency to constrain future populist governments (i.e. re-electing President Sergio Mattarella). Now about 13% of the recovery funds have been distributed in 2021, the economy is slowing, Russia is cutting off energy, and elections are looming. The coalition is no longer stable. Coalition members will jockey for better positioning and pursue their separate interests. The anti-establishment Five Star Movement has already split, with leader Luigi di Maio walking out. Five Star’s popular support has fallen to 12%. The most popular party in the country is now the right-wing, anti-establishment Brothers of Italy, who receive 23% support in polling. Matteo Salvini, leader of the League, another right-wing populist party, has seen its public support fall to 15% and will be looking for opportunities. On the whole, far-right parties command 38% of popular voting intentions, while far-left parties command 17% and centrist parties command 39%. Italy’s elections will favor anti-incumbent parties, especially if the country falls into recession. These parties will be more pragmatic toward Russia and less inclined to expand the EU’s stringent sanctions regime. Implementing a ban on Russian natural gas by 2027 will become more difficult if Italy switches. Italy will be more inclined to push for a ceasefire. A substantial move toward ceasefire will improve investor sentiment, although, again, a durable new strategic equilibrium cannot be established until the US and Russia come to an understanding regarding Finland, Sweden, and NATO enlargement. Bottom Line: Investors should steer clear of Italian government debt and equities until after the next election. Spain GeoRisk Indicator Infighting and power struggles within the People’s Party (PP) have provided temporary relief for the ruling Socialist Worker’s Party (PSOE) and Spanish Prime Minister Pedro Sanchez. However, with Alberto Nunez Feijoo elected as the new leader of PP on April 2, the People’s Party quickly recovered from its setback. It not only retook the first place in the general election polling, but also scored a landslide victory in the Andalusia regional election. Andalusia is the most populous autonomous community in Spain, contributing 17% of the seats in the lower house. The Andalusian regional election was a test run for the parties before next year’s general election. Historically, Andalusia was PSOE’s biggest stronghold, but it was ousted by the center-right People’s Party-Citizens coalition in 2018. Since then, the People’s party has consolidated their presence and popularity in Andalusia. The snap election in June, weeks after Feijoo was elected as the new national party leader, expanded PP’s seats in the regional parliament. It now has an absolute majority in the regional parliament while the Socialists suffered its worst defeat. With the sweeping victory in Andalusia, the People’s Party is well positioned for next year’s general election. In addition, the ruling Socialist Worker’s Party continues to suffer from the stagflationary economic condition. In May, Spain recorded the second highest inflation figure in more than 30 years, slightly below its March number. Furthermore, the recent deadly Melilla incident which resulted in dozens of migrants’ death, also caused some minor setbacks within Sanchez’s ruling coalition. His far-left coalition partner joined the opposition parties in condemning Sanchez for being complacent toward the Moroccan police. The pressure is on the Socialists now, and political risk will rise in the coming months, till after the election (Chart 6). Chart 6Spain: GeoRisk Indicator Bottom Line: Domestic political risk will remain elevated in this polarized country, as elections are due by December 2023 and could come sooner. Populism may return if Europe suffers a recession. Russia aims to inflict a recession on the EU which is negative for cyclical markets like Spain, but Spain benefits from Europe’s turn to liquefied natural gas and has little to fear from Russia. Investors should favor Spanish stocks relative to Italian stocks. Turkey GeoRisk Indicator Turkey faces extreme political and economic instability between now and the general election due by June 2023 (Chart 7). Chart 7Turkey: GeoRisk Indicator Almost any country would see the incumbent ruling party thrown from power under Turkey’s conditions. The ruling Justice and Development Party has been in charge since 2002, the country’s economy has suffered over that period, and today inflation is running at 73% while unemployment stands at 11%. However, President Recep Tayyip Erdoğan is doing everything he can with his recently expanded presidential powers to stay in office. He is making amends with the Gulf Arab states and seeking their economic support. He is also warming relations with Israel, as Turkey seeks to diversify away from Russian gas and Israel/Egypt are potential suppliers. He is doubling down on military distractions across the Middle East and North Africa. And he waged a high-stakes negotiation with the West over Finnish and Swedish accession to NATO. Russian aggression poses a threat to Turkish national interests. Turkey ultimately agreed to Finnish and Swedish membership after a show of Erdoğan strong hands in negotiating with the West over their membership, to show his domestic audience that he is one of the big boys ahead of the election. A risk to this view is that Erdoğan stages military operations against Greek-controlled Cyprus. This would initiate a crisis within NATO and put Finnish and Swedish accession on hold for a longer period. Bottom Line: Investors should not attempt to bottom-feed Turkish lira or stocks and should sell any rallies ahead of the election. A decisive election that removes Erdoğan from power is the best case for Turkish assets, while a decisive Erdoğan victory is second best. Worse scenarios include indecisive outcomes, a contested or stolen election, a constitutional breakdown, or a military coup. China GeoRisk Indicator China’s geopolitical risk is falling and relative equity performance is picking up now that the government has begun easing monetary, fiscal, and regulatory policy to try to secure the economic recovery (Chart 8). Chart 8China: GeoRisk Indicator Easing regulation on Big Tech has spurred a rebound in heavily sold Chinese tech shares, while the Politburo will likely signal a pro-growth turn in policy at its July economic meeting. The worst news of the country’s draconian “Covid Zero” policy is largely priced, while positive news regarding domestic vaccines, vaccine imports, or anti-viral drugs could surprise the market. However, none of these policy signals are reliable until Xi Jinping consolidates power at the twentieth national party congress sometime between September and November (likely October). Chinese stimulus could fail to pick up as much as the market hopes and policy signals could reverse or could continue to contradict themselves. After the party congress, we expect the Xi administration to intensify its efforts to stabilize the economy. The economic work conference in December will release a pro-growth communique. The March legislative session will provide more government support for the economy if needed. However, short-term measures to stabilize growth should not be mistaken for a major reacceleration, as China will continue to struggle with debt-deflation as households and corporations deleverage and the economic model transitions to a post-manufacturing model. Bottom Line: A Santa Claus rally in the fourth quarter, and/or a 2023 rally, is likely, both for offshore and onshore equities. But long-term investors, especially westerners, should steer clear of Chinese assets. China’s reversion to autocracy and confrontation with the United States will ultimately result in tariffs and sanctions and geopolitical crises and will keep risk premiums high. Taiwan GeoRisk Indicator Taiwan’s geopolitical risk has spiked as expected due to confrontation with China. Tensions will remain high through the Taiwanese midterm election on November 26, the Chinese party congress, and the US midterm (Chart 9). But China is not ready to stage a full-scale military conflict over Taiwan yet – that risk will grow over in the later 2020s and 2030s, depending on whether the US and China provide each other with adequate security assurances. Chart 9Taiwan: GeoRisk Indicator Still, Taiwan is the epicenter of global geopolitical risk. China insists that it will be unified with the mainland eventually, by force if not persuasion. China’s potential growth is weakening so it is losing the ability to absorb Taiwan through economic attraction over time. Meanwhile the Taiwanese people do not want to be absorbed – they have developed their own identity and prefer the status quo (or independence) over unification. Taiwan does not have a mutual defense treaty with the United States and yet the US and Taiwan are trying to strengthen their economic and military bonds. This situation is both threatening to China and yet not threatening enough to force China to forswear the military option. At some point China could believe it must assert control over Taiwan before the US increases its military commitment. Meanwhile China, the US, Japan, South Korea, and Europe are all adopting policies to promote semiconductor manufacturing at home, and/or outside Taiwan, so that their industries are not over-reliant on Taiwan. That means Taiwan will lose its comparative advantage over time. Bottom Line: Structurally remain underweight Taiwanese equities. Korea GeoRisk Indicator The newly elected President Yoon reaffirmed the strong military tie between Korea and the US, when he hosted President Biden in Seoul in May. Both Presidents expressed interests in expanding cooperation into new areas like semiconductors, economic security, and stability in the Indo-Pacific region. The new administration is also finding ways to improve relations with Japan, which soured in the past few years over the issue of forced labor during the Japanese occupation of Korea. A way forward is yet to be found, but a new public-private council will be launched on July 4 to seek potential solutions before the supreme court ruling in August which could further damage bilateral ties. President Yoon’s various statements throughout the NATO summit in Madrid on wanting a better relationship with Japan and to resolve historical issues showed this administration’s willingness towards a warming of the relations between the two countries, a departure from the previous administration. On the sideline of the NATO summit, Yoon also engaged with European leaders, dealing Korean defense products, semiconductors, and nuclear technologies, with a receptive European audience eager to bolster their defense, secure supply chain, and diversify energy source. North Korea ramped up its missile tests this year as it tends to do during periods of political transitions in South Korea. It is also rumored to be preparing for another nuclear test. Provocations will continue as the North is responding to the hawkish orientation of the Yoon administration. Investors should expect a rise in geopolitical risk in the peninsular, but on a relative basis, due to its strong alliance network, Korean risk will be lower compared to Taiwan (Chart 10). Korea will benefit from a rebound in China in the near term, but in the long-term, it is a secure source of semiconductors and high-tech exports, as Greater China will be mired in long-term geopolitical instability. Chart 10Korea: GeoRisk Indicator Bottom Line: Overweight South Korean equities relative to emerging markets as a play on Chinese stimulus. Overweight Korea versus Taiwan. Australia GeoRisk Indicator Australia’s Labor Party ultimately obtained a one-seat majority in the House of Representatives following the general election in May (77 seats where 76 are needed). It does not have a majority in the Senate, where it falls 13 seats short of the 39 it needs. It will rely on the Green Party (12 seats) and a few stragglers to piece together ad hoc coalitions to pass legislation. Hence Prime Minister Anthony Albanese’s domestic agenda will be heavily constrained. Pragmatic policies to boost the economy are likely but major tax hikes and energy sector overhauls are unlikely (Chart 11). Chart 11Australia: GeoRisk Indicator Fortunately for Albanese, his government is taking power in the wake of the pandemic, inflation, and Chinese slowdown, so that there is a prospect for the macroeconomic context to improve over his term in office. This could give him a tailwind. But for now he is limited. Like President Biden in the US, Albanese can attempt to reduce tensions with China after Xi Jinping consolidates power. But also like Biden, he will not have a basis for broad and durable re-engagement, since China’s regional ambitions threaten Australian national security over the long run. Global commodity supply constraints give Australia leverage over China. Bottom Line: Stay neutral on Australian currency and equities until global and Chinese growth stabilize. Brazil GeoRisk Indicator It would take a bolt of lightning to prevent former President Lula da Silva from winning re-election in Brazil’s October 2 first round election. Lula is more in line with the median voter than sitting President Jair Bolsonaro. Bolsonaro’s term has been marred with external shocks, following on a decade of recession and malaise. Polls may tighten ahead of the election but Lula is heavily favored. While ideologically to the left, Lula is a known quantity to global investors (Chart 12). However, Bolsonaro may attempt to cling to power, straining the constitutional system and various institutions. A military coup is unlikely but incidents of insubordination cannot be ruled out. Once Lula is inaugurated, a market riot may be necessary to discipline his new administration and ensure that his policies do not stray too far into left-wing populism. Chart 12Brazil: GeoRisk Indicator Brazil’s macroeconomic context is less favorable than it was when Lula first ruled. During the 2000s he rode the wave of Chinese industrialization and a global commodity boom. Today China is slipping into a balance sheet recession and the next wave of industrialization has not yet taken off. Brazil’s public debt dynamics discourage a structural overweight on Brazil within emerging markets. At least Brazil is geopolitically secure – far separated from the conflicts marring Russia, East Europe, China, and East Asia. It also has a decade of bad news behind it that is already priced. Bottom Line: Stay neutral Brazilian assets until global and Chinese growth stabilize and the crisis-prone election season is over. South Africa GeoRisk Indicator South Africa’s economy continues to face major headwinds amid persistent structural issues that have yet to be adequately addressed and resolved by policy makers. The latest bout of severe energy supply cuts by the state-run energy producer, Eskom, serve as a reminder to investors that South Africa’s economy is still dealing with a major issue of generating an uninterrupted supply of electricity. Each day that electricity supply is cut to businesses and households, the local economy stalls. Among other macroeconomic issues such as high unemployment and rising inflation, low-income households which are too the median voter, are facing increasing hardships. The political backdrop is geared toward further increases in political risk going forward (Chart 13). Chart 13South Africa: GeoRisk Indicator Fiscal reform and austerity are underway but won’t last long enough to make a material difference in government finances. The 2024 election is not that far out and the ruling political party, the ANC, will look to quell growing economic pressures to shore up voter support and reinforce its voter base. Fiscal austerity will unwind. Meanwhile, the bull market in global metal prices stands to moderate on weakening global growth, which reduces a tailwind for the rand, South African equities relative to other emerging markets, and government coffers, reducing our reasons for slight optimism on South Africa until global growth stabilizes. Bottom Line: Shift to a neutral stance on South Africa until global and Chinese growth stabilize. Canada GeoRisk Indicator Canadian political risk has spiked since the pandemic (Chart 14). Populist politics can grow over time in Canada, especially if the property sector goes bust. However, the country is geopolitically secure and benefits from proximity to the US economy. Chart 14Canada: GeoRisk Indicator Global commodity supply constraints create opportunities for Canada as governments around the world pursue fiscal programs directed at energy security, national defense, and supply chain resilience. Bottom Line: Stay neutral Canadian currency and equities. While Canada benefits from the high oil price and robust US economy, rising interest rates pose a threat to its high-debt model, while US growth faces disappointments due to Europe’s and China’s troubles.     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Yushu Ma Research Analyst yushu.ma@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.kuri@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 Russia Squeezes EU Natural Gas Major geopolitical shocks tend to coincide with bear markets, so the market is getting closer to pricing this year’s bad news. But investors are not out of the woods yet. Russia is cutting off Europe’s natural gas supply ahead of this winter in retaliation to Europe’s oil embargo. Europe is sliding toward recession. China is reverting to autocratic rule and suffering a cyclical and structural downshift in growth rates. Only after Xi Jinping consolidates power will the ruling party focus exclusively on economic stabilization. The US can afford to take risks with Russia, opening up the possibility of a direct confrontation between the two giants before the US midterm election. A new strategic equilibrium is not yet at hand. Tactical Recommendation Inception Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 18.3% Bottom Line: Maintain a defensive posture in the third quarter but look for opportunities to buy oversold assets with long-term macro and policy tailwinds. Feature 2022 is a year of geopolitics and supply shocks. Global investors should remain defensive at least until the Chinese national party congress and US midterm election have passed. More fundamentally, an equilibrium must be established between Russia and NATO and between the US and Iran. Until then supply shocks will destroy demand. Checking Up On Our Three Key Views For 2022 Our three key views for the year are broadly on track: 1.  China’s Reversion To Autocracy: For ten years now, the fall in Chinese potential economic growth has coincided with a rise in neo-Maoist autocracy and foreign policy assertiveness, leading to capital flight, international tensions, and depressed animal spirits (Chart 1). Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Rising incomes provided legitimacy for the Communist Party over the past four decades. Less rapidly rising incomes – and extreme disparities in standards of living – undermine the party and force it to find other sources of public support. Fighting pollution and expanding the social safety net are positives for political stability and potentially for economic productivity. But converting the political system from single-party rule to single-person rule is negative for productivity. Mercantilist trade policy and nationalist security policy are also negative. China’s political crackdown, struggle with Covid-19, waning exports, and deflating property market have led to an abrupt slowdown this year. The government is responding by easing monetary, fiscal, and regulatory policy, though so far with limited effect (Chart 2). Economic policy will not be decisive in the third quarter unless a crash forces the administration to stimulate aggressively. Chart 1China's Slowdown Leads To Maoism, Nationalism​​​​​​ Chart 2Chinese Policy Easing: Limited Effect So Far​​​​​ Chart 3Nascent Rally In Chinese Shares Will Be Dashed Once General Secretary Xi Jinping secures another five-to-ten years in power at the twentieth national party congress this fall, he will be able to “let 100 flowers bloom,” i.e. ease policy further and focus exclusively on securing the economic recovery in 2023. But policy uncertainty will remain high until then. The party may have to crack down anew to ensure Xi’s power consolidation goes according to plan. China is highly vulnerable to social unrest for both structural and cyclical reasons. The US would jump to slap sanctions on China for human rights abuses. Hence the nascent recovery in Chinese domestic and offshore equities can easily be interrupted until the political reshuffle is over (Chart 3). If China’s economy stabilizes and a recession is avoided, investors will pile into the rally, but over the long run they will still be vulnerable to stranded capital due to Chinese autocracy and US-China cold war. If the Politburo and Politburo Standing Committee are stacked with members of Xi’s faction, as one should expect, then the reduction in policy uncertainty will only be temporary. Autocracy will lead to unpredictable and draconian policy measures – and it cannot solve the problem of a shrinking and overly indebted population. If the Communist Party changes course and stacks the Politburo with Xi’s factional rivals, to prevent China from going down the Maoist, Stalinist, and Putinist route, then global financial markets will cheer. But that outcome is unlikely. Hawkish foreign policy means that China will continue to increase its military threats against Taiwan, while not yet invading outright. Beijing has tightened its grip over Tibet, Xinjiang, and Hong Kong since 2008; Taiwan and the South China Sea are the only critical buffer areas that remain to be subjugated. Taiwan’s midterm elections, US midterms, and China’s party congress will keep uncertainty elevated. Taiwan has underperformed global and emerging market equities as the semiconductor boom and shortage has declined (Chart 4). Hong Kong is vulnerable to another outbreak of social unrest and government repression. Quality of life has deteriorated for the native population. Democracy activists are disaffected and prone to radicalization. Singapore will continue to benefit at Hong Kong’s expense (Chart 5). Chart 4Taiwan Equity Relative Performance Peaked​​​​​​ Chart 5Hong Kong Faces More Troubles​​​​​​ Chart 6Japan Undercuts China China and Japan are likely to engage in clashes in the East China Sea. Beijing’s military modernization, nuclear weapons expansion, and technological development pose a threat to Japanese security. The gradual encirclement of Taiwan jeopardizes Japan’s vital sea lines of communication. Prime Minister Fumio Kishida is well positioned to lead the Liberal Democratic Party into the upper house election on July 10 – he does not need to trigger a diplomatic showdown but he would not suffer from it. Meanwhile China is hungry for foreign distractions and unhappy that Japan is reviving its military and depreciating its currency (Chart 6). A Sino-Japanese crisis cannot be ruled out, especially if the Biden administration looks as if it will lose its nerve in containing China. Financial markets would react negatively, depending on the magnitude of the crisis. North Korea is going back to testing ballistic missiles and likely nuclear weapons. It is expanding its doctrine for the use of such weapons. It could take advantage of China’s and America’s domestic politics to stage aggressive provocations. South Korea, which has a hawkish new president who lacks parliamentary support, is strengthening its deterrence with the United States. These efforts could provoke a negative response from the North. Financial markets will only temporarily react to North Korean provocations unless they are serious enough to elicit military threats from Japan or the United States. China would be happy to offer negotiations to distract the Biden administration from Xi’s power grab. South Korean equities will benefit on a relative basis as China adds more stimulus. 2.  America’s Policy Insularity: President Biden’s net approval rating, at -15%, is now worse than President Trump’s in 2018, when the Republicans suffered a beating in midterm elections (Chart 7). Biden is now fighting inflation to try to salvage the elections for his party. That means US foreign policy will be domestically focused and erratic in the third quarter. Aside from “letting” the Federal Reserve hike rates, Biden’s executive options are limited. Pausing the federal gasoline tax requires congressional approval, and yet if he unilaterally orders tax collectors to stand down, the result will be a $10 billion tax cut – a drop in the bucket. Biden is considering waiving some of former President Trump’s tariffs on China, which he can do on his own. But doing so will hurt his standing in Rust Belt swing states without reducing inflation enough to get a payoff at the voting booth – after all, import prices are growing slower from China than elsewhere (Chart 8). He would also give Xi Jinping a last-minute victory over America that would silence Xi’s critics and cement his dictatorship at the critical hour. Chart 7Democrats Face Shellacking In Midterm Elections​​​​​​ Chart 8Paring Trump Tariffs Won't Reduce Inflation Much​​​​​​ Chart 9Only OPEC Can Help Biden - And Help May Come Late Biden is offering to lift sanctions on Iran, which would free up 1.3 million barrels of oil per day. But Iran is not being forced to freeze its nuclear program by weak oil prices or Russian and Chinese pressure – quite the opposite. If Biden eases sanctions anyway, prices at the pump may not fall enough to win votes. Hence Biden is traveling to Saudi Arabia to make amends with Crown Prince Mohammed bin Salman. OPEC’s interest lies in producing enough oil to prevent a global recession, not in flooding the market on Biden’s whims to rescue the Democratic Party. Saudi and Emirati production may come but it may not come early in the third quarter. Lifting sanctions on Venezuela is a joke and Libya recently collapsed again (Chart 9). Even in dealing with Russia the Biden administration will exhibit an insular perspective. The US is not immediately threatened, like Europe, so it can afford to take risks, such as selling Ukraine advanced and long-range weapons and providing intelligence used to sink Russian ships. If Russia reacts negatively, a direct US-Russia confrontation will generate a rally around the flag that would help the Democrats, as it did under President John F. Kennedy in 1962 – one of the rare years in which the ruling party minimized its midterm election losses (Chart 10). The Cuban Missile Crisis counted more with voters than the earlier stock market slide. 3.  Petro-States’ Geopolitical Leverage: Oil-producing states have immense geopolitical leverage this year thanks to the commodity cycle. Russia will not be forced to conclude its assault on Ukraine until global energy prices collapse, as occurred in 2014. In fact Russia’s leverage over Europe will be greatly reduced in the coming years since Europe is diversifying away from Russian energy exports. Hence Moscow is cutting natural gas flows to Europe today while it still can (Chart 11). Chart 10Biden Can Afford To Take Risks With Russia​​​​​​ Chart 11Russia Squeezes EU's Natural Gas​​​​​​ Chart 12EU/China Slowdown Will Weigh On World Russia’s objective is to inflict a recession and cause changes in either policy or government in Europe. This will make it easier to conclude a favorable ceasefire in Ukraine. More importantly it will increase the odds that the EU’s 27 members, having suffered the cost of their coal and oil embargo, will fail to agree to a natural gas embargo by 2027 as they intend. Italy, for example, faces an election by June 2023, which could come earlier. The national unity coalition was formed to distribute the EU’s pandemic recovery funds. Now those funds are drying up, the economy is sliding toward recession, and the coalition is cracking. The most popular party is an anti-establishment right-wing party, the Brothers of Italy, which is waiting in the wings and can ally with the populist League, which has some sympathies with Russia. A recession could very easily produce a change in government and a more pragmatic approach to Moscow. The Italian economy is getting squeezed by energy prices and rising interest rates at the same time and cannot withstand the combination very long. A European recession or near-recession will cause further downgrades to global growth, especially when considering the knock-on effects in China, where the slowdown is more pronounced than is likely reported. The US economy is more robust but it will have to be very robust indeed to withstand a recession in Europe and growth recession in China (Chart 12). Russia does not have to retaliate against Finland and Sweden joining NATO until Turkey clears the path for them to join, which may not be until just before the Turkish general election due in June 2023. But imposing a recession on Europe is already retaliation – maybe a government change will produce a new veto against NATO enlargement. Russian retaliation against Lithuania for blocking 50% of its shipments to the Kaliningrad exclave is also forthcoming – unless Lithuania effectively stops enforcing the EU’s sanctions on Russian resources. Russia cannot wage a full-scale attack on the Baltic states without triggering direct hostilities with NATO since they are members of NATO. But it can retaliate in other ways. In a negative scenario Moscow could stage a small “accidental” attack against Lithuania to test NATO. But that would force Biden to uphold his pledge to defend “every inch” of NATO territory. Biden would probably do so by staging a proportionate military response or coordinating with an ally to do it. The target would be the Russian origin of attack or comparable assets in the Baltic Sea, the Black Sea, Ukraine, Belarus, or elsewhere. The result would be a dangerous escalation. Russia could also opt for cyber-attacks or economic warfare – such as squeezing Europe’s natural gas supply further. Ultimately Russia can afford to take greater risks than the US over Kaliningrad, other territories, and its periphery more broadly. That is the difference between Kennedy and Biden – the confrontation is not over Cuba. Russia is also likely to take a page out of Josef Stalin’s playbook and open a new front – not so much in Nicaragua as in the Middle East and North Africa. The US betrayal of the 2015 nuclear deal with Iran opens the opportunity for Russia to strengthen cooperation with Iran, stir up the Iranians’ courage, sell them weapons, and generate a security crisis in the Middle East. The US military would be distracted keeping peace in the Persian Gulf while the Europeans would lose their long-term energy alternative to Russia – and energy prices would rise. The Iranians – who also have leverage during a time of high oil prices – are not inclined to freeze their nuclear program. That would be to trade their long-term regime survival for economic benefits that the next American president can revoke unilaterally. Bottom Line: Xi Jinping is converting China back into an autocracy, the Biden administration lacks options and is willing to have a showdown with Russia, and the Putin administration is trying to inflict a European recession and political upheaval. Stay defensive. Checking Up On Our Strategic Themes For The 2020s As for our long-term themes, the following points are relevant after what we have learned in the second quarter: 1.  Great Power Rivalry: The war in Ukraine has reminded investors of the primacy of national security. In an anarchic international system, if a single great nation pursues power to the neglect of its neighbors’ interests, then its neighbors need to pursue power to defend themselves. Before long every nation is out for itself. At least until a new equilibrium is established. For example, Russia’s decision to neutralize Ukraine by force is driving Germany to abandon its formerly liberal policy of energy cooperation in order to reduce Russia’s energy revenues and avoid feeding its military ambitions. Russia in turn is reducing natural gas exports to weaken Europe’s economy this winter. Germany will re-arm, Finland and Sweden will eventually join NATO, and Russia will underscore its red line against NATO bases or forces in Finland and Sweden. If this red line is violated then a larger war could ensue. Chart 13China Will Shift To Russian Energy Until Russia and NATO come to a new understanding, neither Europe nor Russia can be secure. Meanwhile China cannot reject Russia’s turn to the east. China believes it may need to use force to prevent Taiwan independence at some point, so it must prepare for the US and its allies to treat it the same way that they have treated Russia. It must secure energy supply from Russia, Central Asia, and the Middle East via land routes that the US navy cannot blockade (Chart 13). Beijing must also diversify away from the US dollar, lest the Treasury Department freeze its foreign exchange reserves like it did Russia’s. Global investors will see diversification as a sign of China’s exit from the international order and preparation for conflict, which is negative for its economic future. However, the Russo-Chinese alliance presents a historic threat to the US’s security, coming close to the geopolitical nightmare of a unified Eurasia. The US is bound to oppose this development, whether coherently or not, and whether alone or in concert with its allies. After all, the US cannot offer credible security guarantees to negotiate a détente with China or Iran because its domestic divisions are so extreme that its foreign policy can change overnight. Other powers cannot be sure that the US will not suffer a radical domestic policy change or revolution that leads to belligerent foreign policy. Insecurity will drive the US and China apart rather than bringing them together. For example, Russia’s difficulties in Ukraine will encourage Chinese strategists to go back to the drawing board to adjust their plans for military contingencies in Taiwan. But the American lesson from Ukraine is to increase deterrence in Taiwan. That will provoke China and encourage the belief that China cannot wait forever to resolve the Taiwan problem. Until there is a strategic understanding between Russia and NATO, and the US and China, the world will remain in a painful and dangerous transitional phase – a multipolar disequilibrium. Chart 14Hypo-Globalization: Globalizing Less Than Potential 2.  Hypo-Globalization: If national security rises to the fore, then economics becomes a tool of state power. Mercantilism becomes the basis of globalization rather than free market liberalism. Hypo-globalization is the result. The term is fitting because the trade intensity of global growth is not yet in a total free fall (i.e. de-globalization) but merely dropping off from its peaks during the phase of “hyper-globalization” in the 1990s and early 2000s (Chart 14). Hypo-globalization is probably a structural rather than cyclical phenomenon. The EU cannot re-engage with Russia and ease sanctions without rehabilitating Russia’s economy and hence its military capacity – which could enable Russia to attack Europe again. The US and China can try to re-engage but they will fail. Russo-Chinese alliance ensures that the US would be enriching not one but both of its greatest strategic rivals if it reopened its doors to Chinese technology acquisition and intellectual property theft. Iran will see its security in alliance with Russia and China. China has an incentive to develop Iran’s economy so as not to depend solely on Russia and Central Asia. Russia has an incentive to develop Iran’s military capacity so as to deprive Europe of an energy alternative. Both Russia and China wish to deprive the US of strategic hegemony in the Middle East. By contrast the US and EU cannot offer ironclad security guarantees to Iran because of its nuclear ambitions and America’s occasional belligerence. Thus the world can see expanding Russian and Chinese economic integration with Eurasia, and expanding American and European integration with various regions, but it cannot see further European integration with Russia or American integration with China. And ultimately Europe and China will be forced to sever links (Chart 15). Globalization will not cease – it is a multi-millennial trend – but it will slow down. It will be subordinated to national security and mercantilist economic theory. 3.  Populism/Nationalism: In theory, domestic instability can cause introversion or extroversion. But in practice we are seeing extroversion, which is dangerous for global stability (Chart 16). Chart 15Global Economic Disintegration​​​​​​ Chart 16Internal Sources Of Nationalism​​​​​​ Russia’s invasion of Ukraine derived from domestic Russian instability – and instability across the former Soviet space, including Belarus, which the Kremlin feared could suffer a color revolution after the rigged election and mass protests of 2020-21. The reason the northern European countries are rapidly revising their national defense and foreign policies to counter Russia is because they perceive that the threat to their security is driven by factors within the former Soviet sphere that they cannot easily remove. These factors will get worse as a result of the Ukraine war. Russian aggression still poses the risk of spilling out of Ukraine’s borders. China’s Maoist nostalgia and return to autocratic government is also about nationalism. The end of the rapid growth phase of industrialization is giving way to the Asian scourge: debt-deflation. The Communist Party is trying to orchestrate a great leap forward into the next phase of development. But in case that leap fails like the last one, Beijing is promoting “the great rejuvenation of the Chinese nation” and blaming the rest of the world for excluding and containing China. Taiwan, unfortunately, is the last relic of China’s past humiliation at the hands of western imperialists. China will also seek to control the strategic approach to Taiwan, i.e. the South China Sea. China’s claim that the Taiwan Strait is sovereign sea, not international waters, will force the American navy to assert freedom of passage. American efforts to upgrade Taiwan relations and increase deterrence will be perceived as neo-imperialism. The United States, for its part, could also see nationalism convert into international aggression. The US is veering on the brink of a miniature civil war as nationalist forces in the interior of the country struggle with the political establishment in the coastal states. Polarization has abated since 2020, as stagflation has discredited the Democrats. But it is now likely to rebound, making congressional gridlock all but inevitable. A Republican-controlled House will find a reason to impeach President Biden in 2023-24, in hopes of undermining his party and reclaiming the presidency. Another hotly contested election is possible, or worse, a full-blown constitutional crisis. American institutions proved impervious to the attempt of former President Trump and his followers to disrupt the certification of the Electoral College vote. However, security forces will be much more aggressive against rebellions of whatever stripe in future, which could lead to episodes in which social unrest is aggravated by police repression. If the GOP retakes the White House – especially if it is a second-term Trump presidency with a vendetta against political enemies and nothing to lose – then the US will return to aggressive foreign policy, whether directed at China or Iran or both. In short, polarization has contaminated foreign policy such that the most powerful country in the world cannot lead with a steady hand. Over the long run polarization will decline in the face of common foreign enemies but for now the trend vitiates global stability. Chart 17Germany And Japan Rearming It goes without saying that nationalism is also an active force in Iran, where 83-year-old Supreme Leader Ayatollah Khamenei is attempting to ensure the survival of his regime in the face of youthful social unrest and an unclear succession process. If Khamenei takes advantage of the commodity cycle, and American and Israeli disarray, he can make a mad dash for the bomb and try to achieve regime security. But if he does so then nationalism will betray him, since Israel and/or the US are willing to conduct air strikes to uphold the red line against nuclear weaponization. If any more proof of global nationalism is needed, look no further than Germany and Japan, the principal aggressors of World War II. Their pacifist foreign policies have served as the linchpins of the post-war international order. Now they are both pursuing rearmament and a more proactive foreign policy (Chart 17). Nationalism may be very nascent in Germany but it has clearly made a comeback in Japan, which exacerbates China’s fears of containment. The rise of nationalism in India is widely known and reinforces the trend. Bottom Line: Great power rivalry is intensifying because of Russia’s conflict with the West and China’s inability to reject Russia. Hypo-globalization is the result since EU-Russia and US-China economic integration cannot easily be mended in the context of great power struggle. Domestic instability in Russia, China, and the US is leading to nationalism and aggressive foreign policy, as leaders find themselves unwilling or unable to stabilize domestic politics through productive economic pursuits. Investment Takeaways BCA has shifted its House View to a neutral asset allocation stance on equities relative to bonds (Chart 18). Chart 18BCA House View: Neutral Stocks Versus Bonds Geopolitical Strategy remains defensively positioned, favoring defensive markets and sectors, albeit with some exceptions that reflect our long-term views. Tactically stay long US 10-year Treasuries, large caps versus small caps, and defensives versus cyclicals. Stay long Mexico and short the UAE (Chart 19). Strategically stay long gold, US equities relative to global, and aerospace/defense sectors (Chart 20). Among currencies favor the USD, EUR, JPY, and GBP. Chart 19Stay Defensive In Q3 2022​​​​​​ Chart 20Stick To Long-Term Geopolitical Trades​​​​​​ Chart 21Favor Semiconductors But Not Taiwan​​​​​ Chart 22Indian Tech Will Rebound Amid China's Geopolitical Risks​​​​​ Chart 23Overweight ASEAN Go long US semiconductors and semi equipment versus Taiwan broad market (Chart 21). While we correctly called the peak in Taiwanese stocks relative to global and EM equities, our long Korea / short Taiwan trade was the wrong way to articulate this view and remains deeply in the red. Similarly our attempt to double down on Indian tech versus Chinese tech was ill-timed. China eased tech regulations sooner than we expected. However, the long-term profile of the trade is still attractive and Chinese tech will still suffer from excessive government and foreign interference (Chart 22). Go long Singapore over Hong Kong, as Asian financial leadership continues to rotate (see Chart 5 above). Stay long ASEAN among emerging markets. We will also put Malaysia on upgrade watch, given recent Malaysian equity outperformance on the back of Chinese stimulus and growing western interest in alternatives to China (Chart 23).     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 Inflationary Pressures To Fade The biggest problem for the European economy is surging inflation. Inflation has eroded household real disposable income and is hurting consumption. Inflation is set to roll over this summer, which should allow European economies to begin recovering in the fourth quarter of 2022. The ECB is likely to pause after exiting negative interest rates in Q3. European credit is becoming more attractive, but the risks to our view of European growth could still cause major problems for this asset class. Swiss stocks are vulnerable to a pullback relative to German ones. In France, President Emmanuel Macron is likely to get a legislative majority in June.     Bottom Line: European growth should recover after inflation rolls over this summer. The peak in inflation will allow the ECB to pause after its deposit rate gets to zero. Despite this positive view, the large risks hanging over Europe suggest prudence is still warranted.   European assets are rebounding in conjunction with the decline in risk aversion visible around global markets. The euro is catching a welcome bid too. However, as we wrote last week, while the conditions are falling in place to see a rally in Europe, too many risks continue to lurk in the background.  Therefore, we maintain our conservative approach to European markets, and we still recommend a defensive portfolio. Related Report  European Investment StrategyDon’t Be A Hero To shift to a less defensive stance, we want first to observe a peak in European inflation. Inflation represents the greatest problem for the European economy. If inflation continues to surge, the purchasing power of households will deteriorate further and the ECB will ratchet up its hawkish rhetoric, which will cause considerable mayhem in the European economy.   A Reprieve For Europe? Only when the income suppressing impact of inflation recedes will European growth strengthen. Chart 1Paying More For The Same Higher prices continue to hurt European consumption. As witnessed in the US, European retail sales are rising in nominal terms (Chart 1). However, households are not consuming more; they are spending more to purchase the same amount of goods, which is illustrated by the stagnation in retail sales volumes over the past twelve months. Households are not increasing the size of their consumption baskets, because their incomes are not keeping up with inflation. Unlike in the US, Eurozone households never saw their real disposable income spike during the pandemic because European governments focused on preserving jobs rather than distributing large handouts to households. As a result, European real disposable income began to lag its pre-pandemic trend (Chart 2). As the economy recovered, disposable income did not converge back to trend. Now that food and energy prices have spiked, the gap between real disposable income and its trend is only widening. Wages are not coming to the rescue either. The European labor market has been incapable of generating the same kind of wage growth that the US labor market has enjoyed. Even the recent uptick in negotiated wages is not as strong as it seems. German workers benefited from a one-off payment that caused wages to spike by 6.7%, elevating the Euro Area average to 2.8% from 1.6%. However, without that adjustment, German underlying wage growth fell from 3.9% to 1.6% (Chart 3), which means that the underlying European wage only rose by 2%. Chart 2Inflation Destroys Purchasing Power Chart 3Not As Strong As It Seems The distinction between one-off payments and underlying wages matters. As per Milton Friedman’s permanent income hypothesis, households are unlikely to shift their consumption pattern based on a temporary boost to income. They will save it, or in today’s case, use their one-off payment to cover their food and energy price increases. If today’s wage boost is not repeated, but inflation remains elevated, consumption will suffer. Europe’s tourism industry would be another major beneficiary from the peak in inflation. Prior to the pandemic, tourism contributed to 13%, 14% and 9% of the Italian, Spanish, and French economies, respectively. This sector was decimated during the pandemic after travel came to a halt. We are seeing positive signs emerge on this front. In the spring of 2021, nights spent at hotels were 80% below their spring 2019 levels for the Euro Area (Chart 4). As of March 2022, this variable is now between 15% and 30% below their March 2019 levels in Italy and France, respectively. Moreover, Google Mobility indices for the retail and recreation sectors have almost fully recovered (Chart 5). Thus, we can expect these trends to gather steam once inflation slows, because it will free up household disposable income. Europe’s periphery is particularly well placed to benefit from this eventual positive development. Chart 4Improving Tourism Sector Chart 5Mobility Pick-Up Positively, European inflation will peak soon. Commodity prices remain elevated, but commodity inflation has decelerated significantly. Hence, the commodity impulse is consistent with an imminent decline in Euro Area HICP (Chart 6). A simulation using BCA’s Commodity & Energy forecast for Brent, which also assumes that European natural gas prices will continue to hover around EUR100/MWh and that EUR/USD will hit 1.1 by year-end, confirms that energy inflation will swoon (Chart 7). Even if we assume a sudden surge in energy prices due to a Russian natural gas cutoff, energy inflation will recede in the second half of 2022 after spiking this summer. Chart 6Peak Inflation? Chart 7Beware The Russia Cutoff Risk Chart 8Less Pressure From The Consumer Of Last Resort Beyond the energy market, global forces also point toward a peak in European inflation in the coming months. The surge in US goods consumption over the past 24 months was felt globally and generated inflationary pressures in Europe as well. However, US durable goods consumption is declining (Chart 8). As a result, this important driver of European inflation will recede. Bottom Line: European consumption will not recover until inflation peaks. Without a deceleration in inflation, household disposable income will remain weak and consumers will remain careful. The good news is that European inflation is still on track to begin its descent this summer, which will boost the prospect for consumer spending and tourism. ECB Update: A Fall Pause? In a blog post last Monday, ECB president Christine Lagarde confirmed that the central bank will lift interest rates in July and will push the deposit rate to zero by September. Chart 9Too Much Priced In The economy is likely able to handle those two rate hikes. Our ECB monitor highlights the need to remove monetary accommodation in the Eurozone (Chart 9). Moreover, the German 2-/10-year yield curve has steepened this year, despite the hawkish shift in the ECB’s rhetoric, which confirms that monetary conditions are extremely accommodative. We expect the ECB to pause its rate hike campaign after exiting negative rates this fall to reassess economic conditions. Constraints on the ECB remain potent. If the central bank ignores these limiting factors, a policy mistake will ensue. Inflation is likely to decelerate by the end of the summer, which will undercut the hawks driving the consensus at the Governing Council today. Inflation is the factor pushing the ECB Monitor higher right now, not growth conditions (Chart 9, second panel). Thus, the case for lifting rates will weaken considerably when inflation slows. Growth is unlikely to have recovered enough by September to justify additional rate hikes after inflation slows. The expected improvement in consumption and household finances discussed earlier will be embryonic by the end of the summer and will not offer a clear case to lift rates further. Instead, the ECB will still have to juggle the tightening in financial conditions created by wider bond spreads in the European periphery and the impact of China’s slowdown on European exports. Meanwhile, capex is unlikely to strengthen meaningfully as long as global trade softens. As a result, we stay long the June 2023 Euribor futures. An extended pause after the September meeting will prevent the ECB from hiking rates as much as money markets expect over the coming twelve months (Chart 9, bottom panel). If the ECB goes ahead and continues to lift rates in the fall and early winter, the European economy will weaken considerably more and the previous rate hikes will have to be undone. Both scenarios are bullish for the June 2023 Euribor contract. Bottom Line: The ECB is likely to pause after pushing its deposit rate to zero in the third quarter in order to reassess economic conditions. Inflation is the main factor behind higher rates, and it will peak this summer. Meanwhile, the economy is still not strong enough to justify significantly higher interest rates. The market’s pricing in the ESTR curve is much too aggressive considering this context. Stay long June 2023 Euribor futures. Credit Update: Don’t Be A Hero Chart 10Cautious In Absolute Terms, Positive On Relative Performance Credit markets are experiencing a second episode of spread widening this year. The first episode was triggered by the invasion of Ukraine by Russia. The current one reflects strong inflation, weaker growth prospects, and the ECB’s policy shift. Year-to-date, European investment grade and high-yield corporate bond option-adjusted spreads have widened by 74bps and 188bps, respectively (Chart 10, top panel). As we wrote last week, if the global economic situation were to stabilize, then European assets would be a buy at current levels. This is especially true for European credit. Beyond attractive valuations, corporate bond issuers’ balance sheets are in good shape and the default risk is low.   However, the same risks that prevent us from being buyers of the euro and European stocks today also hang over the credit market. Specifically, a further deterioration of the energy flows between Russia and the EU and/or a policy mistake, whereby the ECB delivers the seven rate hikes priced in the overnight index swap market, would cause spreads to widen meaningfully from their current elevated levels. Therefore, we recommend investors remain on the sidelines and wait for a safer entry point over the coming weeks. Once inflation has peaked and stagflation/recession fears recede, then credit spreads will have ample room to narrow, especially if the ECB decides to pause after lifting the deposit rate to 0% (Chart 10, second panel). In the meantime, expected policy rate differentials are still supportive of an overweight on European credit relative to US credit (Chart 10, bottom panel). Bottom Line: European spreads are most likely peaking. However, the same risks that hang over EUR/USD and European equities prevent us from buying this asset class just yet. Swiss Stocks Are Getting Expensive Chart 11Swiss Stocks Getting Ahead Of Earnings The defensive Swiss market has greatly outperformed its Euro Area counterpart this year. However, the recent bout of Swiss outperformance has been completely dissociated from the trend in Swiss EPS relative to those of the Euro Area (Chart 11). Now, Swiss equities are particularly expensive and sport multiples 45% greater than the P/E ratio of the Eurozone MSCI benchmark. This bifurcation between the relative performance of Swiss stocks and their relative earnings represents a trading opportunity. Specifically, Swiss shares look vulnerable against German ones, which have been seriously beaten down in recent years. Chart 12Priced For The Apocalypse Swiss stocks have been re-rated on the back of many forces. First, the valuations of Swiss stocks relative to German ones have risen in tandem with the Eurozone’s headline and core inflation (Chart 12, top and second panel). Swiss relative valuations have also benefited from the significant tailwind created by higher 2-year rates in the Eurozone (Chart 12, third panel) and from the weakness in the euro (Chart 12, fourth panel). Finally, Swiss relative valuations seem to have already priced in a significant deterioration in European manufacturing activity, which would have lifted their appeal as a defensive play (Chart 12, bottom panel). We recommend selling Swiss stocks against German ones. We anticipate European inflation to peak this summer. Our ECB view is consistent with a decline in Germany’s 2-year bond yields. We also expect the euro to bottom and, even though we have written about a deterioration in European manufacturing activity, the recent explosion of Swiss multiples relative to German ones looks overdone. This trade may be seen as our first attempt to dip our toe into cyclical assets, even if we generally favor capital preservation over risk taking at this juncture. Bottom Line: The outperformance of Swiss equities is overextended and is already pricing in a dire outcome for European economies. Selling Swiss shares relative to German stocks is an attractive way to add tentatively some risk to a European portfolio. France Update: Likely Legislative Majority For Macron Chart 13French Polls Suggest Macron Will Get His Legislative Majority President Emmanuel Macron’s political party, Renaissance (previously En Marche!), may surprise to the upside in this year’s legislative election. An aggregate of recent polls (Chart 13) suggests that the presidential coalition (which includes Renaissance and its allies) will obtain between 295 and 340 seats in the Assemblée Nationale, more than the 289 seats needed to achieve a majority. The odds of seeing an historically low voter turnout should also play in the French president’s favor. Chart 14Favor French Small-Caps & Avoid Consumer Stocks Macron will not have to compromise to build a coalition in favor of his reform agenda, which bodes well for French productivity and trend growth. This election should not have an impact on French assets beyond that. We continue to recommend investors favor French small-caps, as they will benefit from an improvement in domestic consumer confidence and an eventual strengthening in the euro (Chart 14). Meanwhile, we still see more downside for French consumer stocks (Chart 14, bottom panel).   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Jeremie Peloso, Editor/Strategist JeremieP@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Executive Summary Markets Priced For A Restrictive Level Of Australian Rates The neutral interest rate in Australia is lower than in past cycles, for several reasons: low potential growth, weak productivity, high household debt and inflated housing valuations. Interest rate markets are discounting a very aggressive monetary tightening cycle in Australia, with the RBA Cash Rate expected to reach 2.6% by end-2022 and 3.1% by end-2023. Australian inflation will peak in H2/2022, and the RBA will not need to raise rates beyond the midpoint of the RBA's estimated neutral range of 2-3%. The Australian dollar has not responded to rising interest rate expectations or high commodity prices, largely due to weak Chinese growth. The Aussie is cheap and has upside if China delivers more economic stimulus. The newly-elected Labor-led government will not be able to pursue its ambitious social and environmental agenda without finding more revenue to offset the inflationary impact of larger budget deficits. Expect modest fiscal stimulus, with increased spending, but also minor tax hikes for multinational corporations and high-income earners. Bottom Line: For global bond investors, an overweight allocation to Australian government bonds is warranted with the RBA likely to disappoint aggressive market rate hike expectations. For currency investors, the undervalued Australian dollar is an attractive play on an eventual rebound of Chinese growth. Feature The month of May has been eventful for investors in Australia. The Reserve Bank of Australia (RBA) delivered its first interest rate hike since 2010 on May 3, a move that markets had expected but which was much earlier than the RBA’s prior forward guidance. The May 21 federal election returned the Labor party to power for the first time since 2013. These events introduce new risks for the Australian economy and financial markets, altering a policy backdrop that had been highly stimulative - and, more importantly, highly predictable - during the pandemic but must now change in response to the new reality of high inflation. In this Special Report, jointly published by BCA Research Global Fixed Income Strategy, Foreign Exchange Strategy and Geopolitical Strategy, we discuss the investment implications of the start of the monetary tightening cycle and the new government in Australia. Our main conclusions: markets are somehow pricing in both too many RBA rate hikes and not enough currency upside for the Australian dollar, while expectations for major fiscal policy changes should be tempered. Will The RBA Kill The Economic Recovery? Australian government bonds have been one of the worst performers in the developed world so far in 2022 (Chart 1), delivering a total return of -9.1% in AUD terms, and -9% in USD-hedged terms, according to Bloomberg. The benchmark 10-year yield now sits at 3.20%, up +142bps since the start of the year but off the 8-year intraday high of 3.6% reached in early May. Australia has historically been a “high-beta” bond market that sees yields rise more when global bond yields are rising. That is a legacy of the days when the RBA had to push policy rates to levels that exceeded other major central banks like the Fed during global tightening cycles. But by the RBA’s own admission, the neutral policy interest rate is now lower than in previous years, perhaps no more than 0% in real terms according to RBA Governor Philip Lowe. Our RBA Monitor, which consists of economic and financial variables that typically correlate to pressure on the RBA to tighten or ease policy, has been signaling since mid-2021 that higher interest rates were increasingly likely (Chart 2). However, markets have moved to price in a very rapid and aggressive tightening, with a whopping 268bps of rate hikes discounted over the next year in the Australian overnight index swap (OIS) curve. Chart 1Australian Bond Yields Have Surged Vs Global Peers​​​​​ Chart 2Markets Expect Very Aggressive RBA Tightening​​​​​​ The growth component of the RBA Monitor will likely soon ease up with the OECD leading economic indicator for Australia in a clear downtrend (bottom panel). However, the inflation component of the RBA Monitor will stay elevated for longer given current high inflation - headline CPI inflation in Australia hit a 20-year high of 5.1% in Q1/2022 - and the tight Australian labor market. Even with those robust inflation pressures, markets are pricing in a peak level of interest rates that appears far more restrictive than the RBA is willing, and likely able, to deliver. We see three primary reasons for this. Weak Potential Growth Implies A Lower Neutral Rate The OIS curve is priced for the RBA Cash Rate staying between 3-4% over the next decade (Chart 3). The real policy rate (adjusted by CPI swap forwards as the proxy for inflation expectations), is expected to average around 1% over that same period. Those are the highest “terminal rate” estimates among the G10 economies. At the press conference following the May 3 rate hike, RBA Governor Lowe noted that “it’s not unreasonable to expect that the normalization of interest rates over the period ahead could see interest rates rise to 2.5%”. Lowe said that was the midpoint of the RBA’s 2-3% inflation target, thus the expected normalization of policy rates would take the inflation-adjusted real rate to 0%. That is a far cry from the more aggressive increase in real rates discounted in the Australian OIS and CPI swap curves. Lowe also noted that a real rate above 0% “over time […] would require stronger productivity growth in Australia.” On that front, the data is not suggesting that the RBA will need to reconsider its views on the neutral real interest rate anytime soon. The 5-year annualized growth rate of labor productivity is an anemic -0.8%, down from the mid-2010s peak of around 1.5% and far below the late-1990s peak of around 2.5% (Chart 4). Chart 3Markets Priced For A Restrictive Level Of Australian Rates​​​​​ Chart 4A Powerful Structural Reason For A Lower Australian Neutral Rate​​​​​ Chart 5The Australian Housing Cycle Is Peaking Assuming a pre-pandemic growth rate of the working age population of between 1-1.5%, and productivity around 0.5%, Australia’s potential GDP growth rate is, at best, around 2% (middle panel) and is likely even lower than that. The working-age population growth rate fell to 0% during the pandemic due to migration restrictions that have yet to be lifted. However, population growth had already been slowing pre-COVID due to falling birth rates and reduced worker visa caps in 2018-19. High Household Debt Raises Interest Rate Sensitivity Of Consumer Demand Sluggish trend growth is not the only reason why Australia’s neutral interest rate is lower than markets are discounting. Given elevated housing valuations and aggressive lending practices, highly indebted Australian households are now more sensitive to rate increases than in years past. Australian mortgage lenders began aggressively issuing shorter-term (typically 3-year) fixed rate mortgages in 2020 after the collapse in bond yields due to the initial COVID shock, to entice borrowers to lock in low interest rates. This raised the share of new fixed rate mortgages from a historic average around 15% of all new mortgages to nearly 50%. Since the RBA ended its yield curve control policy last November, which targeted 3-year bond yields, 3-year fixed mortgage rates have surged from 2.93% to 4.34%. That already has had an impact on housing demand - home price growth has peaked in the major cities according to CoreLogic, while building approvals are contracting on a year-over-year basis (Chart 5). As the surge of fixed rate mortgage loans begin to mature in 2023, Australian homeowners will see a major spike in refinancing costs, both for fixed rate and variable rate lending. This trend should weaken home demand, and house price inflation, even further. Inflation Will Soon Peak The RBA expects softer house price inflation to help slow overall Australian inflation rates. The central bank is projecting headline CPI inflation to fall from the latest 5.1% to 4.3% by June 2023 and 2.9% by June 2024 (Chart 6). That would still be a level near the top of the RBA target band, but the downtrend could be even faster than that. As in many other countries, the latest surge in Australian inflation has been led by a rapid increase in goods prices related to severe demand/supply mismatches at a time of global supply chain bottlenecks. Australian goods inflation hit an 31-year high of 6.6% in Q1/2022, essentially matching the housing component of the CPI index (Chart 7). Yet with US goods inflation having already peaked, as have global shipping costs, it is likely that Australia goods inflation will soon follow suit. This will lower headline Australian inflation to levels more consistent with services inflation, which reached 3% in Q1/2022. Chart 6The RBA Sees Persistent Above-Target Inflation That floor in more domestically-driven services inflation will also be influenced by the pace of wage growth in Australia. The latest reading on the best wage indicator Down Under, the Wage Price Index, showed that year-over-year wage growth only reached 2.4% in Q1/2022. Chart 7Australia Goods Inflation Should Soon Peak​​​​​ This is a surprisingly low outcome given the tightness of the Australian labor market with the unemployment rate at an all-time low of 3.9% (Chart 8). Depressed labor supply is not a factor keeping the unemployment rate low, as the labor force participation rate and hours worked are both above pre-pandemic levels. Prior to the rate hike at the May 3 policy meeting, the RBA had been highlighting soft wage growth as a reason to delay the start of the monetary tightening cycle. After the May meeting, RBA Governor Lowe noted that according to the RBA’s “liaison” surveys of Australian businesses, nearly 40% of respondents said they were giving wage increases above 3%. The RBA believes that wage growth in the 3-4% range is consistent with Australian inflation remaining within the RBA’s 2-3% target band, a condition that was deemed necessary before rate hikes could begin. The message from the RBA liaison surveys was enough to trigger the start of the tightening cycle. While the Australia OIS curve is priced for an aggressive series of rate hikes, and shorter-term interest rate expectations are elevated, there is less inflationary concern priced into medium-term inflation expectations. The 5-year/5-year forward Australia CPI swap is at 2.2%, down -15bps since the start of 2022 and barely within the RBA target band. Some of that is a global factor – the 5-year/5-year forward US TIPS breakeven has declined by -44bps over just the past month. However, the Australia 5-year/5-year forward CPI swap peaked at the start of the year, just as Australian interest rate expectations began to ratchet higher (the 2-year Australia government bond yield was 0.35% at the start of 2022 and now sits at 2.61%). An increasing amount of discounted rate hikes, occurring alongside falling inflation expectations, is a sign that markets are incrementally pricing in a restrictive monetary policy. We agree with RBA Governor Lowe’s assessment that the neutral nominal Cash Rate is, at best, 2.5%. Thus, the current discounted peak in the Cash Rate of 3.2% would be restrictive. Very strong consumer spending growth at a time when inflation was already high could be a sign that a restrictive monetary stance is now necessary. However, the outlook for Australian consumption is not without risks. Consumer confidence has plunged alongside declining purchasing power, as wage growth has lagged the inflation upturn (Chart 9). While the expectation is that inflation will peak and wage growth will pick up over the latter half of 2022, it is still uncertain if the relative moves will be large enough to give a meaningful lift to real wage growth and consumer spending power. Chart 8Medium-Term Inflation Expectations Falling, Despite Low Unemployment​​​​​​ Chart 9Headwinds For The Australian Consumer​​​​​​ The RBA believes that consumer spending will be supported by the high level of savings, with the household saving rate currently at 13.6%. Yet the high level of household debt means that debt service burdens will rise as interest rates move higher, which may limit the degree to which Australian consumers run down savings to fuel greater consumer spending. Another reason why a more restrictive monetary policy could be needed is if there was a substantial loosening of fiscal policy that was fueling faster growth, especially at a time when inflation was already overshooting. This makes an analysis of the latest election results highly relevant to the path of Australian interest rates. Bottom Line: Markets are pricing in a shift to a restrictive level of interest rates in Australia, an outcome that is not necessary with inflation set to peak at a time of high household leverage. Labor Party Takes Power With Limited Political Capital Australia’s federal election on May 21 brought a Labor Party government into power, headed by new Prime Minister Anthony Albanese. National policy is unlikely to change substantially. Australia has low political risk but high geopolitical risk – meaning that domestic politics are manageable for investors but China’s conflict with the West and other geopolitical events are revolutionizing Australia’s place in the world. The previous Liberal-National Coalition government had been in power since 2013, had never found a stable leader, and had been buffeted by a series of external shocks: a commodity bust, China trade conflict, the COVID-19 pandemic, and inflation. Hence it is no surprise that Labor came back to power – it almost did so in 2019. However, Labor’s popularity is questionable. The new government does not have a robust political mandate: Labor will fall short of a single-party majority (or will have a very thin majority at best): As we go to press, Labor won 74 seats out of 151 in the House of Representatives. A party needs 76 seats for a majority. Labor will likely rely on three Green Party seats and some of the 10 independents to pass legislation. These minor parties will have considerable influence. Labor’s popular vote share is underwhelming: Labor won 32.8% of the popular vote, down from 33.3% in 2019, and beneath the 36% of the vote won by the outgoing Liberal-National Coalition (Table 1). The Green Party rose to 12% of the vote. While this only translates to three seats in parliament, the Greens will hold the balance of power. Table 1Australian Federal Election Results, 2022 Labor does not control the Senate: A bill requires a majority vote in both the House and Senate for passage. A majority requires 38 seats, but Labor and the Greens are currently slated to fall short at 36 seats. Hence, as in the House, the Labor Party will rely on “cross-bench” votes from minor parties to get a majority for bills. Labor won through pragmatism and moderation: Having suffered a surprise defeat in 2019, the Labor Party adopted a more moderate and pragmatic tone in the current election. Prime Minister Albanese campaigned on a motto of “safe change,” declared that he was “not woke,” and adopted a relatively hawkish tilt on trade and foreign policy (China relations) and immigration (“boat people”). Labor has limited room for maneuver in international relations: China’s economy is slowing down and stimulus does not work as well as it used to. China’s political system is reverting to autocracy and the Xi Jinping administration is attempting to carve a sphere of influence in the region, increasing long-term security threats to Australia in Southeast Asia and the Pacific Islands. China has declared a “no limits” strategic partnership with a belligerent Russia, leaving the US no option but to pursue containment strategy against both powers. Prime Minister Albanese has already met with President Biden and the Quadrilateral Dialogue to emphasize Australia’s need to counter China’s newly assertive foreign policy. While Albanese may attempt to reduce trade tensions with China, any such moves will be heavily constrained. Inflation, not climate change, brought Labor to power: The media is hailing the election as a historic shift on the question of climate change and climate policy. But popular opinion has not changed much on this topic in recent years and the election results only partially support the thesis. A better explanation is that the pandemic and its inflationary aftermath galvanized opposition to the ruling Liberal-National Coalition. Hence both fiscal policy and climate policy – the most important areas of change – will be constrained by inflation. Chart 10Australia Cannot Cut Defense Amid China Challenge There are two key policy takeaways from the above assessment: First, on fiscal policy, the new Labor-led government will face limitations due to inflation and the macroeconomic cycle. It will likely respond to inflation – the crisis that got it elected – even though China’s slowdown will produce negative surprises for global and Australian growth. The government will not be able to cut defense spending given the geopolitical setting (Chart 10). That means it will also not be able to pursue its ambitious social and environmental agenda without finding more revenue to offset the inflationary impact of larger budget deficits. Tax hikes are coming for multinational corporations and high-income earners. In terms of the size of the fiscal impact, the Labor Party promised spending increases worth AUD$18.9 billion (1.0% of GDP), to be offset by tax hikes amounting to AUD$11.5 billion in new revenue (0.6% of GDP). The result would be an AUD$7.5 billion increase in the budget deficit (0.4% of GDP) – a net fiscal stimulus (Chart 11). Currently the IMF projects a 1.84% fiscal drag in the cyclically adjusted budget deficit for 2023, so Labor’s plans would reduce that drag by 0.4%. However, the fiscal plans will change once the new Treasurer James Chalmers produces a new budget proposal in October. Comparison with a like-minded economy is therefore useful to put the policy change into perspective. Canada’s politics shifted from center-right to center-left in 2015 and the left-leaning government at that time put forward an agenda similar to Australia’s Labor Party today. Ultimately the budget balance declined from 0.17% to -0.45% of GDP from peak to trough (Chart 12). This 0.62% of GDP stimulus provides a point of comparison. Yet inflation was not a constraint on government spending at that time. The new Australian government may not exceed that size of stimulus in an inflationary context. But it could easily surpass it if the global economy falls back into recession. Chart 11Australian Labor’s Proposed Fiscal Stimulus​​​​​​ Chart 12Canada Offers Clue To Size Of Australian Stimulus​​​​​​ Second, on climate policy, the new ruling coalition probably will pass major climate legislation, given the importance of Greens and left-leaning independents. But Labor will have to constrain the smaller parties’ climate ambitions to preserve popular support in areas where fossil fuel industries remain strong. Australia consumes substantially more carbon per capita than other developed economies and will continue to rely on fossil fuel exports for growth. In other words, climate policy will bring incremental rather than radical change. Bottom Line: If a global recession is avoided, then the new government’s counter-cyclical fiscal policies may work. If not, they will produce a double whammy for the Australian economy: new corporate and resource taxes on top of a slowdown in exports. The AUD As A Shock Absorber Despite a higher repricing of the interest rate curve in Australia, and elevated commodity prices, the Australian dollar (AUD) has been very soft. Part of the story is broad-based US dollar strength that has sapped any potential rebound in the AUD. More specifically, a survey of the key drivers of the AUD unveils the main source of currency weakness, by process of elimination: The divergence in monetary policy between the RBA and the Fed? No. Clearly, that has not been a driver this time around as the RBA is expected to lift rates to 3.2% over the next 12 months, in line with market pricing for rate hikes from the Federal Reserve. The commodity cycle? No. Commodity prices are softening, after being in a supply-driven bull market. As a premier resource producer, the Australian economy is intricately intertwined with the outlook for coal, iron ore, copper and even liquefied natural gas prices. As Chart 13 highlights, the AUD has massively deviated from the level implied by rising terms of trade for Australia. This is a departure from a historical correlation that has been in place since the end of the Bretton Woods system. Resource booms tend to be either demand or supply driven, or a combination of both. This time around supply restrictions have played a major role. The message from the AUD is that it responds much better to improving demand conditions. Global and relative growth dynamics? YES: The overarching driver of a weak AUD as hinted above has been slowing Chinese demand. The Zero COVID-19 policy in China has led to a drastic reduction in import volumes. This is hurting Australia’s external balance at the margin, as Chinese import volumes contract (Chart 14). Chart 13The AUD Has Lagged Terms Of Trade​​​​​ Chart 14The AUD Is Very Sensitive To China There are two key takeaways from the above analysis. First, the hawkish path for interest rates priced for the RBA is not yet reflected in a weak AUD. This implies that currency and bond markets are on a collision course. Either the RBA ratifies market pricing and triggers a coiled spring rebound in the AUD, or hawkish expectations will be tempered as inflationary pressures moderate. Second, the AUD will be very sensitive to any improvement in Chinese demand, the overarching driver of currency weakness. We expect the Chinese authorities to ramp up credit stimulus, to offset weakening demand from the Zero COVID-19 policy. The AUD has historically been very sensitive to changes in Chinese money and credit variables (Chart 15). From a fundamental perspective, a lot of pessimism is embedded in the Aussie dollar. Australian GDP has already recovered above pre-pandemic levels and could be on a path to achieve escape velocity if China recovers. Chinese fiscal and monetary policy should be eased going forward. Chinese bond yields have already dropped, reflecting an easing in domestic financial conditions. Meanwhile, Australia’s commodity exposure is well suited for a green energy shift. Besides being relatively competitive in supplying the types of raw materials that China needs and wants, (higher-grade ore, which is more expensive, but pollutes less, and is in high demand in China), Australia is a big exporter of liquefied natural gas, whose prices have been soaring in recent months and is critical in the Russia-Ukraine conflict and green energy shift (Chart 16). This will provide a multi-year tailwind for Australian export volumes and terms of trade. Chart 15The Chinese Economy Could Be Bottoming​​​​​ Chart 16Australia Is Resource Superstar​​​​​ Bottom Line: BCA Research Foreign Exchange Strategy went long AUD at 72 cents. In the near term, this position could prove quite volatile as markets try to discern a clear path for global growth. But given cheap valuations and beaten down sentiment, it should prove profitable in the longer term. Investment Conclusions For Fixed Income Investors Chart 17Australian Government Bond Investment Recommendations Our careful analysis of Australian growth, inflation, the RBA’s likely next moves leads us to the following investment conclusions for Australian bonds (Chart 17): Maintain neutral duration exposure within dedicated Australian bond portfolios (for now): On a forward basis, the entire Australian yield curve is converging to that discounted 3.5% peak in the Cash Rate (top panel). Eventually, Australian bond yields will fall once inflation clearly peaks in H2/2022 and markets realize that the RBA will not be hiking as fast as expected, justifying an above-benchmark duration tilt. Until then, Australian bond yields will be rangebound, especially with the RBA no longer buying bonds via quantitative easing, leaving more bond issuance to be absorbed by private investors. Underweight Australian inflation-linked bonds versus nominal-paying government bonds: Inflation will soon peak, and the discounted RBA stance is too hawkish – a recipe for lower inflation breakevens. Overweight Australian government bonds within global bond portfolios: Australia has returned to its “high-yield-beta” status, which means that an overweight stance is warranted when global bond yields are stable or falling. BCA Research Global Fixed Income Strategy’s Global Duration Indicator, a growth-focused leading indicator of the momentum of global bond yields, is signalling a more stable backdrop for global yields over the rest of 2022. The Duration Indicator is also a fine leading indicator of the relative return performance of Australian government bonds (middle panel) and is supportive of an overweight stance on Australian debt. Go Long December 2022 Australia Bank Bill futures: This is a tactical trade (i.e. investment horizon of no more than six months), based on the extreme pricing of rate hikes by year-end. The market price of the December 2022 futures contract is currently 97.11, or an implied interest rate of 2.89% compared to the current RBA Cash Rate of 0.35%. That contract is priced for far too many rate hikes than will be delivered over the remaining seven RBA meetings of 2022.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Chief Foreign Exchange Strategist ChesterN@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com

Informe especial

Executive Summary Markets Priced For A Restrictive Level Of Australian Rates The neutral interest rate in Australia is lower than in past cycles, for several reasons: low potential growth, weak productivity, high household debt and inflated housing valuations. Interest rate markets are discounting a very aggressive monetary tightening cycle in Australia, with the RBA Cash Rate expected to reach 2.6% by end-2022 and 3.1% by end-2023. Australian inflation will peak in H2/2022, and the RBA will not need to raise rates beyond the midpoint of the RBA's estimated neutral range of 2-3%. The Australian dollar has not responded to rising interest rate expectations or high commodity prices, largely due to weak Chinese growth. The Aussie is cheap and has upside if China delivers more economic stimulus. The newly-elected Labor-led government will not be able to pursue its ambitious social and environmental agenda without finding more revenue to offset the inflationary impact of larger budget deficits. Expect modest fiscal stimulus, with increased spending, but also minor tax hikes for multinational corporations and high-income earners. Bottom Line: For global bond investors, an overweight allocation to Australian government bonds is warranted with the RBA likely to disappoint aggressive market rate hike expectations. For currency investors, the undervalued Australian dollar is an attractive play on an eventual rebound of Chinese growth. Feature The month of May has been eventful for investors in Australia. The Reserve Bank of Australia (RBA) delivered its first interest rate hike since 2010 on May 3, a move that markets had expected but which was much earlier than the RBA’s prior forward guidance. The May 21 federal election returned the Labor party to power for the first time since 2013. These events introduce new risks for the Australian economy and financial markets, altering a policy backdrop that had been highly stimulative - and, more importantly, highly predictable - during the pandemic but must now change in response to the new reality of high inflation. In this Special Report, jointly published by BCA Research Global Fixed Income Strategy, Foreign Exchange Strategy and Geopolitical Strategy, we discuss the investment implications of the start of the monetary tightening cycle and the new government in Australia. Our main conclusions: markets are somehow pricing in both too many RBA rate hikes and not enough currency upside for the Australian dollar, while expectations for major fiscal policy changes should be tempered. Will The RBA Kill The Economic Recovery? Australian government bonds have been one of the worst performers in the developed world so far in 2022 (Chart 1), delivering a total return of -9.1% in AUD terms, and -9% in USD-hedged terms, according to Bloomberg. The benchmark 10-year yield now sits at 3.20%, up +142bps since the start of the year but off the 8-year intraday high of 3.6% reached in early May. Australia has historically been a “high-beta” bond market that sees yields rise more when global bond yields are rising. That is a legacy of the days when the RBA had to push policy rates to levels that exceeded other major central banks like the Fed during global tightening cycles. But by the RBA’s own admission, the neutral policy interest rate is now lower than in previous years, perhaps no more than 0% in real terms according to RBA Governor Philip Lowe. Our RBA Monitor, which consists of economic and financial variables that typically correlate to pressure on the RBA to tighten or ease policy, has been signaling since mid-2021 that higher interest rates were increasingly likely (Chart 2). However, markets have moved to price in a very rapid and aggressive tightening, with a whopping 268bps of rate hikes discounted over the next year in the Australian overnight index swap (OIS) curve. Chart 1Australian Bond Yields Have Surged Vs Global Peers​​​​​ Chart 2Markets Expect Very Aggressive RBA Tightening​​​​​​ The growth component of the RBA Monitor will likely soon ease up with the OECD leading economic indicator for Australia in a clear downtrend (bottom panel). However, the inflation component of the RBA Monitor will stay elevated for longer given current high inflation - headline CPI inflation in Australia hit a 20-year high of 5.1% in Q1/2022 - and the tight Australian labor market. Even with those robust inflation pressures, markets are pricing in a peak level of interest rates that appears far more restrictive than the RBA is willing, and likely able, to deliver. We see three primary reasons for this. Weak Potential Growth Implies A Lower Neutral Rate The OIS curve is priced for the RBA Cash Rate staying between 3-4% over the next decade (Chart 3). The real policy rate (adjusted by CPI swap forwards as the proxy for inflation expectations), is expected to average around 1% over that same period. Those are the highest “terminal rate” estimates among the G10 economies. At the press conference following the May 3 rate hike, RBA Governor Lowe noted that “it’s not unreasonable to expect that the normalization of interest rates over the period ahead could see interest rates rise to 2.5%”. Lowe said that was the midpoint of the RBA’s 2-3% inflation target, thus the expected normalization of policy rates would take the inflation-adjusted real rate to 0%. That is a far cry from the more aggressive increase in real rates discounted in the Australian OIS and CPI swap curves. Lowe also noted that a real rate above 0% “over time […] would require stronger productivity growth in Australia.” On that front, the data is not suggesting that the RBA will need to reconsider its views on the neutral real interest rate anytime soon. The 5-year annualized growth rate of labor productivity is an anemic -0.8%, down from the mid-2010s peak of around 1.5% and far below the late-1990s peak of around 2.5% (Chart 4). Chart 3Markets Priced For A Restrictive Level Of Australian Rates​​​​​ Chart 4A Powerful Structural Reason For A Lower Australian Neutral Rate​​​​​ Chart 5The Australian Housing Cycle Is Peaking Assuming a pre-pandemic growth rate of the working age population of between 1-1.5%, and productivity around 0.5%, Australia’s potential GDP growth rate is, at best, around 2% (middle panel) and is likely even lower than that. The working-age population growth rate fell to 0% during the pandemic due to migration restrictions that have yet to be lifted. However, population growth had already been slowing pre-COVID due to falling birth rates and reduced worker visa caps in 2018-19. High Household Debt Raises Interest Rate Sensitivity Of Consumer Demand Sluggish trend growth is not the only reason why Australia’s neutral interest rate is lower than markets are discounting. Given elevated housing valuations and aggressive lending practices, highly indebted Australian households are now more sensitive to rate increases than in years past. Australian mortgage lenders began aggressively issuing shorter-term (typically 3-year) fixed rate mortgages in 2020 after the collapse in bond yields due to the initial COVID shock, to entice borrowers to lock in low interest rates. This raised the share of new fixed rate mortgages from a historic average around 15% of all new mortgages to nearly 50%. Since the RBA ended its yield curve control policy last November, which targeted 3-year bond yields, 3-year fixed mortgage rates have surged from 2.93% to 4.34%. That already has had an impact on housing demand - home price growth has peaked in the major cities according to CoreLogic, while building approvals are contracting on a year-over-year basis (Chart 5). As the surge of fixed rate mortgage loans begin to mature in 2023, Australian homeowners will see a major spike in refinancing costs, both for fixed rate and variable rate lending. This trend should weaken home demand, and house price inflation, even further. Inflation Will Soon Peak The RBA expects softer house price inflation to help slow overall Australian inflation rates. The central bank is projecting headline CPI inflation to fall from the latest 5.1% to 4.3% by June 2023 and 2.9% by June 2024 (Chart 6). That would still be a level near the top of the RBA target band, but the downtrend could be even faster than that. As in many other countries, the latest surge in Australian inflation has been led by a rapid increase in goods prices related to severe demand/supply mismatches at a time of global supply chain bottlenecks. Australian goods inflation hit an 31-year high of 6.6% in Q1/2022, essentially matching the housing component of the CPI index (Chart 7). Yet with US goods inflation having already peaked, as have global shipping costs, it is likely that Australia goods inflation will soon follow suit. This will lower headline Australian inflation to levels more consistent with services inflation, which reached 3% in Q1/2022. Chart 6The RBA Sees Persistent Above-Target Inflation That floor in more domestically-driven services inflation will also be influenced by the pace of wage growth in Australia. The latest reading on the best wage indicator Down Under, the Wage Price Index, showed that year-over-year wage growth only reached 2.4% in Q1/2022. Chart 7Australia Goods Inflation Should Soon Peak​​​​​ This is a surprisingly low outcome given the tightness of the Australian labor market with the unemployment rate at an all-time low of 3.9% (Chart 8). Depressed labor supply is not a factor keeping the unemployment rate low, as the labor force participation rate and hours worked are both above pre-pandemic levels. Prior to the rate hike at the May 3 policy meeting, the RBA had been highlighting soft wage growth as a reason to delay the start of the monetary tightening cycle. After the May meeting, RBA Governor Lowe noted that according to the RBA’s “liaison” surveys of Australian businesses, nearly 40% of respondents said they were giving wage increases above 3%. The RBA believes that wage growth in the 3-4% range is consistent with Australian inflation remaining within the RBA’s 2-3% target band, a condition that was deemed necessary before rate hikes could begin. The message from the RBA liaison surveys was enough to trigger the start of the tightening cycle. While the Australia OIS curve is priced for an aggressive series of rate hikes, and shorter-term interest rate expectations are elevated, there is less inflationary concern priced into medium-term inflation expectations. The 5-year/5-year forward Australia CPI swap is at 2.2%, down -15bps since the start of 2022 and barely within the RBA target band. Some of that is a global factor – the 5-year/5-year forward US TIPS breakeven has declined by -44bps over just the past month. However, the Australia 5-year/5-year forward CPI swap peaked at the start of the year, just as Australian interest rate expectations began to ratchet higher (the 2-year Australia government bond yield was 0.35% at the start of 2022 and now sits at 2.61%). An increasing amount of discounted rate hikes, occurring alongside falling inflation expectations, is a sign that markets are incrementally pricing in a restrictive monetary policy. We agree with RBA Governor Lowe’s assessment that the neutral nominal Cash Rate is, at best, 2.5%. Thus, the current discounted peak in the Cash Rate of 3.2% would be restrictive. Very strong consumer spending growth at a time when inflation was already high could be a sign that a restrictive monetary stance is now necessary. However, the outlook for Australian consumption is not without risks. Consumer confidence has plunged alongside declining purchasing power, as wage growth has lagged the inflation upturn (Chart 9). While the expectation is that inflation will peak and wage growth will pick up over the latter half of 2022, it is still uncertain if the relative moves will be large enough to give a meaningful lift to real wage growth and consumer spending power. Chart 8Medium-Term Inflation Expectations Falling, Despite Low Unemployment​​​​​​ Chart 9Headwinds For The Australian Consumer​​​​​​ The RBA believes that consumer spending will be supported by the high level of savings, with the household saving rate currently at 13.6%. Yet the high level of household debt means that debt service burdens will rise as interest rates move higher, which may limit the degree to which Australian consumers run down savings to fuel greater consumer spending. Another reason why a more restrictive monetary policy could be needed is if there was a substantial loosening of fiscal policy that was fueling faster growth, especially at a time when inflation was already overshooting. This makes an analysis of the latest election results highly relevant to the path of Australian interest rates. Bottom Line: Markets are pricing in a shift to a restrictive level of interest rates in Australia, an outcome that is not necessary with inflation set to peak at a time of high household leverage. Labor Party Takes Power With Limited Political Capital Australia’s federal election on May 21 brought a Labor Party government into power, headed by new Prime Minister Anthony Albanese. National policy is unlikely to change substantially. Australia has low political risk but high geopolitical risk – meaning that domestic politics are manageable for investors but China’s conflict with the West and other geopolitical events are revolutionizing Australia’s place in the world. The previous Liberal-National Coalition government had been in power since 2013, had never found a stable leader, and had been buffeted by a series of external shocks: a commodity bust, China trade conflict, the COVID-19 pandemic, and inflation. Hence it is no surprise that Labor came back to power – it almost did so in 2019. However, Labor’s popularity is questionable. The new government does not have a robust political mandate: Labor will fall short of a single-party majority (or will have a very thin majority at best): As we go to press, Labor won 74 seats out of 151 in the House of Representatives. A party needs 76 seats for a majority. Labor will likely rely on three Green Party seats and some of the 10 independents to pass legislation. These minor parties will have considerable influence. Labor’s popular vote share is underwhelming: Labor won 32.8% of the popular vote, down from 33.3% in 2019, and beneath the 36% of the vote won by the outgoing Liberal-National Coalition (Table 1). The Green Party rose to 12% of the vote. While this only translates to three seats in parliament, the Greens will hold the balance of power. Table 1Australian Federal Election Results, 2022 Labor does not control the Senate: A bill requires a majority vote in both the House and Senate for passage. A majority requires 38 seats, but Labor and the Greens are currently slated to fall short at 36 seats. Hence, as in the House, the Labor Party will rely on “cross-bench” votes from minor parties to get a majority for bills. Labor won through pragmatism and moderation: Having suffered a surprise defeat in 2019, the Labor Party adopted a more moderate and pragmatic tone in the current election. Prime Minister Albanese campaigned on a motto of “safe change,” declared that he was “not woke,” and adopted a relatively hawkish tilt on trade and foreign policy (China relations) and immigration (“boat people”). Labor has limited room for maneuver in international relations: China’s economy is slowing down and stimulus does not work as well as it used to. China’s political system is reverting to autocracy and the Xi Jinping administration is attempting to carve a sphere of influence in the region, increasing long-term security threats to Australia in Southeast Asia and the Pacific Islands. China has declared a “no limits” strategic partnership with a belligerent Russia, leaving the US no option but to pursue containment strategy against both powers. Prime Minister Albanese has already met with President Biden and the Quadrilateral Dialogue to emphasize Australia’s need to counter China’s newly assertive foreign policy. While Albanese may attempt to reduce trade tensions with China, any such moves will be heavily constrained. Inflation, not climate change, brought Labor to power: The media is hailing the election as a historic shift on the question of climate change and climate policy. But popular opinion has not changed much on this topic in recent years and the election results only partially support the thesis. A better explanation is that the pandemic and its inflationary aftermath galvanized opposition to the ruling Liberal-National Coalition. Hence both fiscal policy and climate policy – the most important areas of change – will be constrained by inflation. Chart 10Australia Cannot Cut Defense Amid China Challenge There are two key policy takeaways from the above assessment: First, on fiscal policy, the new Labor-led government will face limitations due to inflation and the macroeconomic cycle. It will likely respond to inflation – the crisis that got it elected – even though China’s slowdown will produce negative surprises for global and Australian growth. The government will not be able to cut defense spending given the geopolitical setting (Chart 10). That means it will also not be able to pursue its ambitious social and environmental agenda without finding more revenue to offset the inflationary impact of larger budget deficits. Tax hikes are coming for multinational corporations and high-income earners. In terms of the size of the fiscal impact, the Labor Party promised spending increases worth AUD$18.9 billion (1.0% of GDP), to be offset by tax hikes amounting to AUD$11.5 billion in new revenue (0.6% of GDP). The result would be an AUD$7.5 billion increase in the budget deficit (0.4% of GDP) – a net fiscal stimulus (Chart 11). Currently the IMF projects a 1.84% fiscal drag in the cyclically adjusted budget deficit for 2023, so Labor’s plans would reduce that drag by 0.4%. However, the fiscal plans will change once the new Treasurer James Chalmers produces a new budget proposal in October. Comparison with a like-minded economy is therefore useful to put the policy change into perspective. Canada’s politics shifted from center-right to center-left in 2015 and the left-leaning government at that time put forward an agenda similar to Australia’s Labor Party today. Ultimately the budget balance declined from 0.17% to -0.45% of GDP from peak to trough (Chart 12). This 0.62% of GDP stimulus provides a point of comparison. Yet inflation was not a constraint on government spending at that time. The new Australian government may not exceed that size of stimulus in an inflationary context. But it could easily surpass it if the global economy falls back into recession. Chart 11Australian Labor’s Proposed Fiscal Stimulus​​​​​​ Chart 12Canada Offers Clue To Size Of Australian Stimulus​​​​​​ Second, on climate policy, the new ruling coalition probably will pass major climate legislation, given the importance of Greens and left-leaning independents. But Labor will have to constrain the smaller parties’ climate ambitions to preserve popular support in areas where fossil fuel industries remain strong. Australia consumes substantially more carbon per capita than other developed economies and will continue to rely on fossil fuel exports for growth. In other words, climate policy will bring incremental rather than radical change. Bottom Line: If a global recession is avoided, then the new government’s counter-cyclical fiscal policies may work. If not, they will produce a double whammy for the Australian economy: new corporate and resource taxes on top of a slowdown in exports. The AUD As A Shock Absorber Despite a higher repricing of the interest rate curve in Australia, and elevated commodity prices, the Australian dollar (AUD) has been very soft. Part of the story is broad-based US dollar strength that has sapped any potential rebound in the AUD. More specifically, a survey of the key drivers of the AUD unveils the main source of currency weakness, by process of elimination: The divergence in monetary policy between the RBA and the Fed? No. Clearly, that has not been a driver this time around as the RBA is expected to lift rates to 3.2% over the next 12 months, in line with market pricing for rate hikes from the Federal Reserve. The commodity cycle? No. Commodity prices are softening, after being in a supply-driven bull market. As a premier resource producer, the Australian economy is intricately intertwined with the outlook for coal, iron ore, copper and even liquefied natural gas prices. As Chart 13 highlights, the AUD has massively deviated from the level implied by rising terms of trade for Australia. This is a departure from a historical correlation that has been in place since the end of the Bretton Woods system. Resource booms tend to be either demand or supply driven, or a combination of both. This time around supply restrictions have played a major role. The message from the AUD is that it responds much better to improving demand conditions. Global and relative growth dynamics? YES: The overarching driver of a weak AUD as hinted above has been slowing Chinese demand. The Zero COVID-19 policy in China has led to a drastic reduction in import volumes. This is hurting Australia’s external balance at the margin, as Chinese import volumes contract (Chart 14). Chart 13The AUD Has Lagged Terms Of Trade​​​​​ Chart 14The AUD Is Very Sensitive To China There are two key takeaways from the above analysis. First, the hawkish path for interest rates priced for the RBA is not yet reflected in a weak AUD. This implies that currency and bond markets are on a collision course. Either the RBA ratifies market pricing and triggers a coiled spring rebound in the AUD, or hawkish expectations will be tempered as inflationary pressures moderate. Second, the AUD will be very sensitive to any improvement in Chinese demand, the overarching driver of currency weakness. We expect the Chinese authorities to ramp up credit stimulus, to offset weakening demand from the Zero COVID-19 policy. The AUD has historically been very sensitive to changes in Chinese money and credit variables (Chart 15). From a fundamental perspective, a lot of pessimism is embedded in the Aussie dollar. Australian GDP has already recovered above pre-pandemic levels and could be on a path to achieve escape velocity if China recovers. Chinese fiscal and monetary policy should be eased going forward. Chinese bond yields have already dropped, reflecting an easing in domestic financial conditions. Meanwhile, Australia’s commodity exposure is well suited for a green energy shift. Besides being relatively competitive in supplying the types of raw materials that China needs and wants, (higher-grade ore, which is more expensive, but pollutes less, and is in high demand in China), Australia is a big exporter of liquefied natural gas, whose prices have been soaring in recent months and is critical in the Russia-Ukraine conflict and green energy shift (Chart 16). This will provide a multi-year tailwind for Australian export volumes and terms of trade. Chart 15The Chinese Economy Could Be Bottoming​​​​​ Chart 16Australia Is Resource Superstar​​​​​ Bottom Line: BCA Research Foreign Exchange Strategy went long AUD at 72 cents. In the near term, this position could prove quite volatile as markets try to discern a clear path for global growth. But given cheap valuations and beaten down sentiment, it should prove profitable in the longer term. Investment Conclusions For Fixed Income Investors Chart 17Australian Government Bond Investment Recommendations Our careful analysis of Australian growth, inflation, the RBA’s likely next moves leads us to the following investment conclusions for Australian bonds (Chart 17): Maintain neutral duration exposure within dedicated Australian bond portfolios (for now): On a forward basis, the entire Australian yield curve is converging to that discounted 3.5% peak in the Cash Rate (top panel). Eventually, Australian bond yields will fall once inflation clearly peaks in H2/2022 and markets realize that the RBA will not be hiking as fast as expected, justifying an above-benchmark duration tilt. Until then, Australian bond yields will be rangebound, especially with the RBA no longer buying bonds via quantitative easing, leaving more bond issuance to be absorbed by private investors. Underweight Australian inflation-linked bonds versus nominal-paying government bonds: Inflation will soon peak, and the discounted RBA stance is too hawkish – a recipe for lower inflation breakevens. Overweight Australian government bonds within global bond portfolios: Australia has returned to its “high-yield-beta” status, which means that an overweight stance is warranted when global bond yields are stable or falling. BCA Research Global Fixed Income Strategy’s Global Duration Indicator, a growth-focused leading indicator of the momentum of global bond yields, is signalling a more stable backdrop for global yields over the rest of 2022. The Duration Indicator is also a fine leading indicator of the relative return performance of Australian government bonds (middle panel) and is supportive of an overweight stance on Australian debt. Go Long December 2022 Australia Bank Bill futures: This is a tactical trade (i.e. investment horizon of no more than six months), based on the extreme pricing of rate hikes by year-end. The market price of the December 2022 futures contract is currently 97.11, or an implied interest rate of 2.89% compared to the current RBA Cash Rate of 0.35%. That contract is priced for far too many rate hikes than will be delivered over the remaining seven RBA meetings of 2022.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Chief Foreign Exchange Strategist ChesterN@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com

Informe especial

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

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Executive Summary Favor ASEAN And The Philippines Southeast Asia is suffering from fading macro and geopolitical tailwinds but there are still investment opportunities on a relative basis. The peace dividend, globalization dividend, and demographic dividend are all eroding and will continue to erode, though there are relative winners and losers. The Philippines and Thailand are most secure; the Philippines and Indonesia are least dependent on trade; and the Philippines and Vietnam have the highest potential GDP growth. Geopolitical risk premiums have risen for Russia, Eastern Europe, China, and will rise for the Middle East. This leaves ASEAN states as relatively attractive emerging markets. Trade Recommendation Inception Date Return LONG PHILIPPINES / EM EQUITIES 2022-05-12   LONG ASEAN / ACW EQUITIES 2022-05-12   Bottom Line: ASEAN’s geopolitical outlook is less ugly than many other emerging markets. Cyclically, go long ASEAN versus global equities and long Philippine equities versus EM. Feature Chart 1Hypo-Globalization A Headwind For Trading States The Philippines elected its second “strongman” leader in a row on May 9, provoking the usual round of editorials about the death of liberalism. Investors know well by now that such political narratives do as much to occlude economic reality as to clarify it. Still, there is a fundamental need to understand the changing global political order since it will ultimately impact the investment landscape. If the global order stabilizes – e.g. US-Russia and US-China relations normalize – then trade and investment may recover from recent shocks. A new era of “Re-Globalization” could ensue. Asia Pacific would be a prime beneficiary as it is full of trading economies (Chart 1). Related Report  Geopolitical StrategySecond Quarter Outlook 2022: When It Rains, It Pours By contrast, if Great Power Rivalry escalates further, then trade and investment will suffer, the current paradigm of Hypo-Globalization will continue, and East Asia’s frozen conflicts from 1945-52 will thaw and heat up. Asian states will have to shift focus from trade to security and their economies will suffer relative to previous expectations. How will Southeast Asia fare in this context? Will it fall victim to great power conflict, like Eastern Europe? Or will it keep a balance between the great powers and extract maximum benefits? Three Dividends Three dividends have underpinned Southeast Asia’s growth and prosperity in recent decades: 1.  Peace Dividend – A relative lack of war and inter-state conflict. 2.  Globalization Dividend – Advantageous maritime geography and access to major economies. 3.  Demographic Dividend – Young demographics and strong potential GDP growth. All three of these dividends are eroding, so the macro and geopolitical investment case for ASEAN has weakened relative to twenty years ago. Nevertheless in a world where Russia, China, and the Gulf Arab markets face a higher and persistent geopolitical risk premium, ASEAN still offers attractive investment opportunities, particularly if the most geopolitically insecure countries are avoided. Peace Dividend Favors The Philippines And Thailand Since the end of the US and Chinese wars with Vietnam, military conflicts in Southeast Asia have been low intensity. Lack of inter-state conflict encouraged economic prosperity and security complacency. The five major Southeast Asian nations saw military spending decline since the 1990s and only Vietnam spends more than 2% of GDP (Chart 2). Chart 2Peace Brought Prosperity Unfortunately that is about to change. China has large import dependencies, an insufficient tradition of sea power, and feels hemmed in by its geography and the US alliance system. Beijing’s solution is to build and modernize its navy and prepare for potential conflict with the US, particularly over Taiwan. The result is rising tension across East Asia, including in Southeast Asia and the South China Sea. The ASEAN states fear China will walk over them, China fears they will league with the US against China, and the US tries to get them to do exactly that. Hence ASEAN’s defense spending has not kept up with its geopolitical importance and will have to rise going forward. Consider the following: Vietnam risks conflict with China. Vietnam has the most capable and experienced naval force within ASEAN due to its sporadic conflicts with China. Its equipment is supplied mainly by Russia, pitting it squarely against China’s Soviet or Soviet-inspired equipment. But Russia-China ties are tightening, especially after Russia’s divorce with Europe. While Vietnam will not reject Russia, it is increasingly partnering with the United States. The pandemic added to the Vietnamese public’s distrust of China, which is ancient but has ramped up in recent years due to clashes in the South China Sea. While Vietnam officially maintains that it will never host the US military, it is tacitly bonding with the US as a hedge against China. Yet Vietnam does not have a mutual defense treaty with the US, so it is vulnerable to Chinese military aggression over time. Indonesia distances itself from China. Rising security tensions are also forcing Indonesia to change its strategy toward China. Indonesia lacks experience in naval warfare and is not a claimant in the territorial disputes in the South China Sea. It is reluctant to take sides due to its traditionally non-aligned diplomatic status, its military culture of prioritizing internal stability (which is hard to maintain across thousands of islands), and China’s investment in its economy. However, China is encroaching on Indonesia’s exclusive economic zone and Indonesia has signaled its displeasure through diplomatic snubs and high-profile infrastructure contracts. Indonesia is trying to bulk up its naval and air capabilities, including via arms purchases from the West. Malaysia distances itself from China. Malaysia and the Philippines have the weakest naval forces and both face pressure from China’s navy and coast guard due to maritime-territorial disputes. But while the Philippines gets help from the US and its allies and partners, Malaysia has no such allies. Traditionally it was non-aligned. Instead it utilizes economic statecraft, as it has often done against more powerful countries. It recently paused Chinese economic projects in the country to conduct reviews and chose Ericsson over Huawei to build the 5G network. Ongoing maritime and energy disputes will motivate defense spending. The Philippines preserves alliance with United States. Outgoing President Rodrigo Duterte tried but failed to strengthen ties with China and Russia. Beijing continued to swarm the Philippines’ economic zone with ships and threaten its control of neighboring rocks and reefs. Ultimately Duterte renewed his country’s Visiting Forces Agreement with the US in July 2021. The newly elected President “Bong Bong” Marcos is even less likely to try to pivot away from the US. Instead the Philippines will work with the US to try to deter China. Thailand preserves alliance with United States. Thailand is the most insulated from the South China Sea disputes and often acts as mediator between China and other ASEAN states. However, Thailand is also a formal US defense ally and assisted with logistics during the Korean and Vietnamese wars. While US military aid was suspended after the 2014 military coup, non-military aid from the US continued. The State Department certified Thailand’s return to democracy in 2019, relations were normalized, and the annual Cobra Gold exercise resumed in 2020. The US’s hasty normalization shows Thailand’s importance to its regional strategy. On their own, the ASEAN states cannot counter China – they are simply outgunned (Chart 3). Hence their grand strategy of balancing Chinese trade relations with American security relations. Chart 3Outgunned By China Chart 4Opinion Shifts Against China In recent decades, with the US divided and distracted, they sought to entice China through commercial deals, in hopes that it would reduce its encroachments on the high seas. This strategy failed, as China’s expansion of economic and military influence in the region is driven by China’s own imperatives. Beijing’s lack of transparency about Covid-19 also sowed distrust. As a result, public opinion became more critical of China and defensive of national sovereignty (Chart 4). Southeast Asia will continue trading with China but changing public opinion, the US-China clash, and tensions in the South China Sea will inject greater geopolitical risk into this once peaceful and prosperous region. Military weakness will also lead the ASEAN states to welcome the US, EU, Japan, and Australia into the region as economic and security hedges against China. This trend risks inflaming regional tensions in the short run – and China may not be deterred over the long run, since its encroachments in the region are driven by its own needs and insecurities. Decades of under-investment in defense will result in ASEAN rearmament, which will weigh on fiscal balances and potentially economic competitiveness. Investors should not take the past three decades of peace for granted. Bottom Line: Vietnam (like Taiwan) is in a geopolitical predicament where it could provoke China’s wrath and yet lacks an American security guarantee. The Philippines and Thailand benefit from American security guarantees. Indonesia and Malaysia benefit from distance from China. All of these states will attempt to balance US and China relations – but in the future that means devoting more resources to national security, which will weigh on fiscal budgets and take away funds from human capital development. Waning Globalization Dividend Favors Indonesia And The Philippines All the ASEAN states rely heavily on both the US and China for export markets. This reliance grew as trade recovered in the wake of the global pandemic (Chart 5). Now global trade is slowing down cyclically, while US-China power struggle will weigh on the structural globalization process, penalizing the most trade-dependent ASEAN states relative to their less trade-dependent neighbors. So far US-China economic divorce is redistributing US-China trade in a way that is positive for Southeast Asia. China is rerouting exports through Vietnam, for example, while the US is shifting supply chains to other Asian states (Chart 6). The US will accelerate down this path because it cannot afford substantively to reengage with China’s economy for fear of strengthening the Russo-Chinese bloc. Chart 5Trade Rebounded But Hypo-Globalization Will Force Domestic Reliance​​​​​ Chart 6ASEAN’s Exports To US Surge Ahead Of China’s Hence the US will become more reliant on Southeast Asian exporters. Whatever the US stops buying from China will have to be sourced from other countries, so countries that export a similar basket of goods will benefit from the switch. Comparing the types of goods that China and ASEAN export to the US, Thailand is the closest substitute for China, whereas Malaysia is the farthest (Chart 7). That is not to say that Malaysia will suffer from US-China divorce. It is already ahead of China in exporting high-tech goods to the US, which is the very reason its export profile is so different. In 2020, 58% of Malaysia’s exports to the US are high-tech versus 35% for China’s. At the same time, Southeast Asian exports to China may not grow as fast as expected – cyclically China’s economy may accelerate on the back of current stimulus efforts, but structurally China is pursuing self-sufficiency and import substitution via a range of industrial policies (“Made in China 2025,” “dual circulation,” etc). These policies aim to make Chinese industrials competitive with European, US, Japanese, and Korean industrials. But they will also make China more competitive with medium-tech and fledging high-tech exports from Southeast Asia. Thus while China will keep importing low value products and commodities, such as unrefined ores, from Southeast Asia, imports of high-tech products will be limited due to China’s preference for indigenous producers. US export controls will also interfere with ASEAN’s ability to export high-tech goods to China. (In order to retain their US trade, in the face of Chinese import substitution, ASEAN states will have to comply with US export controls at least partially.) Even the low-to-medium tech goods that China currently imports from Southeast Asia may not grow as fast in the coming years as they have in the past. The ten provinces in China with the lowest GDP per capita exported a total of $129 billion to the world in 2020, whereas China’s imports from the top five ASEAN states amounted to $154 billion USD in 2020 (Chart 8). If Beijing insists on creating a domestic market for its poor provinces’ exports, then Southeast Asian exports to China will suffer. China might do this not only for strategic sufficiency but also to avoid US and western sanctions, which could be imposed for labor, environmental, human rights, or strategic reasons. Chart 7The US Sees Thailand And Vietnam As Substitutes For China​​​​​​ Chart 8China Threatens ASEAN With Import Substitution​​​​​​ Chart 9Trade Rebound Increased Exposure To US, China China, unlike the US during the 1990s and 2000s, cannot afford to open up its doors and become a ravenous consumer and importer of all Asia’s goods. This would be a way to buy influence in the region, as the US has done in Latin America. But China still has significant domestic development left to do. This development must be done for the sake of jobs and income – otherwise the Communist Party will face sociopolitical upheaval. Malaysia, Vietnam, and Thailand are the most vulnerable to China’s dual circulation strategy because of their sizeable exports to China, which stand at 12%, 15% and 7.6% of GDP respectively (Chart 9). Even though the Southeast Asian states have formed into a common market, and have joined major new trade blocs such as the CPTPP and RCEP, they will not see unfettered liberalization within these agreements – and they will not be drawn exclusively into China’s orbit. Instead they will face a China that wishes to expand export market share while substituting away from imports. The US and India, which are not part of these new trade blocs, will still increase their trade with ASEAN, as they will seek to substitute ASEAN for China, and ASEAN will be forced to substitute them for China. Thus globalization will weaken into regionalization and will not provide as positive of a force for Southeast Asia as it did over the 1980s-2000s. Going forward, the new paradigm of Hypo-Globalization will weigh on trade-dependent countries like Malaysia, Vietnam, and Thailand relative to their neighbors. Within this cohort, Malaysia and the Philippines will benefit from selling high-tech goods to the US, while Thailand and Vietnam will benefit from selling low- and mid-tech goods. China will remain a huge and critical market for ASEAN states but its autarkic policies will drive them to pursue other markets. Those with large and growing domestic markets, like Indonesia and the Philippines, will weather hypo-globalization better than their neighbors. Vietnam, Malaysia, and Thailand are all extremely dependent on foreign trade and hence vulnerable if international trade linkages weaken. Bottom Line: Global trade is likely to slow on a cyclical basis. Structurally, Hypo-Globalization is the new paradigm and will remove a tailwind that super-charged Southeast Asian development over the past several decades. Indonesia and the Philippines stand to suffer least and benefit most. Potential Growth Dividend Favors The Philippines And Vietnam Countries that can generate endogenous growth will perform the best under hypo-globalization. Indonesia, the Philippines, and Vietnam have the largest populations within ASEAN. But we must also take into account population growth, which contributes directly to potential GDP growth. A domestic market grows through population growth and/or income growth. For example, China benefitted from its growing population but now must switch to income generation as its population growth is stagnating. In Southeast Asia, the Philippines, Malaysia, and Indonesia have the highest population growth, while Thailand has the lowest. Thai population growth is even weak compared to China. The total fertility rate reinforces this trend – it is highest in Philippines but lowest in Thailand (Chart 10). A population that is too young or too old needs significant support that diverts resources away from the most productive age group. Philippines and Indonesia have the lowest median age, while Thailand has the highest. The youth of Indonesia and Philippines will come of age in the next decade, augmenting labor force and potential GDP growth. By contrast, Vietnam and especially Thailand, like China, will be weighed down by a shrinking labor force in the coming decade (Chart 11). Chart 10Fertility Rates Robust In ASEAN ​​​​​​ Chart 11Falling Support Ratio Weighs On Thailand, Vietnam​​​​​​ Hence Indonesia and Philippines will prosper while Thailand, and to some extent Vietnam, lack the ability to diversify away from trade through domestic market growth. Malaysia sits in the middle: it is trade dependent and has the smallest population, but it has a young and growing population, and its labor force is still growing. Yet falling population growth is not a disaster if productivity and income growth are high. Productivity trends often contrast with population trends: Indonesia had the weakest productivity growth despite having a large, young, and growing population, while Vietnam had the strongest growth, despite a population slowdown. In fact Vietnam has the strongest productivity growth in Southeast Asia, at a 5-year, pre-pandemic average of 6.3%, followed by the Philippines (Chart 12A). By comparison China’s productivity growth averaged between 3%-6.6%, depending on the data source. Chart 12AProductivity And Potential GDP​​​​​​ Chart 12BProductivity And Potential GDP​​​​​​ Chart 13Capital Formation Favors Philippines Productivity growth adds to labor force growth to form potential GDP. In 2019, Philippines had the highest potential GDP growth at 6.9%, followed by the Vietnam at 6.8%, Indonesia at 5.6%, Malaysia at 3.9% and Thailand at 2.3%. In comparison China’s potential GDP growth was 3.6%-5.9%, again depending on data. Thailand is undoubtedly the weakest from both a population and productivity standpoint, while the Philippines has strength in both (Chart 12B). Countries invest in their economies to increase productivity. In 2019, Vietnam recorded the highest growth in grossed fixed capital formation at around 10.6%, followed by Indonesia at 6.9%, Philippines at 6.3%, and Thailand at 2.2%. Gross fixed capital formation has rebounded from the contractions countries suffered during the pandemic lockdowns in 2020 (Chart 13). Bottom Line: The Philippines has strong potential GDP growth, but Indonesia is not far behind as it invests in its economy. Vietnam has the highest investment and productivity growth, but its demographic dividend is waning. Malaysia is slightly better than Thailand because it has a growing population, but it has stopped investing and it is as trade dependent as Thailand. Thailand is weak on all accounts: it is trade dependent, has a shrinking population, and has a low potential GDP growth. Investment Takeaways Bringing it all together, ASEAN is witnessing the erosion of key dividends (peace, globalization, and demographics). Yet it offers attractive investment opportunities on a relative basis, given the permanent step up in geopolitical risk premiums for other major emerging markets like Russia, eastern Europe, China, and (soon) the Gulf Arab states (Charts 14A & 14B). Indeed the long under-performance of ASEAN stocks as a bloc, relative to global stocks, has recently reversed. As investors recognize China’s historic confluence of internal and external risks, they increasingly turn to ASEAN despite its flaws. Chart 14AASEAN Will Continue To Outperform China The US and China will use rewards and punishments to try to win over ASEAN states as strategic and economic partners. Those that have a US security guarantee, or are most distant from potential conflict, will see a lower geopolitical risk premium. Chart 14BASEAN Will Continue To Outperform China​​​​​​ Chart 15Favor The Philippines The Philippines is the most attractive Southeast Asian market based on our criteria: it has an American security guarantee, domestic-oriented growth, and high productivity. Populism in the Philippines has come with productivity improvements and yet has not overthrown the US alliance. Philippine equities can outperform their emerging market peers (Chart 15). Indonesia is the second most attractive – it does not have direct territorial disputes with China, maintains defense ties with the West, is not excessively trade reliant, and keeps up decent productivity growth. It is vulnerable to nationalism and populism but its democracy is effective overall and the regime has maintained general political stability after near-dissolution in 1998. Thailand is geopolitically secure but lacking in potential growth. Vietnam has high potential growth but is geopolitically insecure over the long run. Investors should only pursue tactical investments in these markets. We maintain our long-term favorable view of Malaysia, although it is trade dependent and productivity has weakened. In future reports we will examine ASEAN markets in greater depth and with closer consideration of their domestic political risks.   Jesse Anak Kuri Associate Editor Jesse.Kuri@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 German GeoRisk Indicator Russia and Germany have begun cutting off each other’s energy in a major escalation of strategic tensions. The odds of Finland and Sweden joining NATO have shot up. A halt to NATO enlargement, particularly on Russia’s borders, is Russia’s chief demand. Tensions will skyrocket. China’s reversion to autocracy and de facto alliance with Russia are reinforcing the historic confluence of internal and external risk, weighing on Chinese assets. Geopolitical risk is rising in South Korea and Hong Kong, rising in Spain and Italy, and flat in South Africa. France’s election will lower domestic political risk but the EU as a whole faces a higher risk premium. The Biden administration is doubling down on its defense of Ukraine, calling for $33 billion in additional aid and telling Russia that it will not dominate its neighbor. However, the Putin regime cannot afford to lose in Ukraine and will threaten to widen the conflict to intimidate and divide the West. Trade Recommendation Inception Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 14.2% Bottom Line: Stay long global defensives over cyclicals. Feature Chart 1Geopolitical Risk And Policy Uncertainty Drive Up Dollar The dollar (DXY) is breaking above the psychological threshold of 100 on the back of monetary tightening and safe-haven demand. Geopolitical risk does not always drive up the dollar – other macroeconomic factors may prevail. But in today’s situation macro and geopolitics are converging to boost the greenback (Chart 1). Global economic policy uncertainty is also rising sharply. It is highly correlated with the broader trade-weighted dollar. The latter is nowhere near 2020 peaks but could rise to that level if current trends hold. A strong dollar reflects slowing global growth and also tightens global financial conditions, with negative implications for cyclical and emerging market equities. Bottom Line: Tactically favor US equities and the US dollar to guard against greater energy shock, policy uncertainty, and risk-aversion. Energy Cutoff Points To European Recession Chart 2Escalation With Russia Weighs Further On EU Assets Russia is reducing natural gas flows to Poland and Bulgaria and threatening other countries, Germany is now embracing an oil embargo against Russia, while Finland and Sweden are considering joining NATO. These three factors are leading to a major escalation of strategic tensions on the continent that will get worse before they get better, driving up our European GeoRisk indicators and weighing on European assets (Chart 2). Russia’s ultimatum in December 2021 stressed that NATO enlargement should cease and that NATO forces and weapons should not be positioned east of the May 1997 status quo. Russia invaded Ukraine to ensure its military neutrality over the long run.1 Finland and Sweden, seeing Ukraine’s isolation amid Russian invasion, are now reviewing whether to change their historic neutrality and join NATO. Public opinion polls now show Finnish support for joining at 61% and Swedish support at 57%. The scheduling of a joint conference between the country’s leaders on May 13 looks like it could be a joint declaration of their intention to join. The US and other NATO members will have to provide mutual defense guarantees for the interim period if that is the case, lest Russia attack. The odds that Finland and Sweden remain neutral are higher than the consensus holds (given the 97% odds that they join NATO on Predictit.org). But the latest developments suggest they are moving toward applying for membership. They fear being left in the cold like Ukraine in the event of an attack. Russia’s response will be critical. If Russia deploys nuclear weapons to Kaliningrad, as former President Dmitri Medvedev warned, then Moscow will be making a menacing show but not necessarily changing the reality of Russia’s nuclear strike capabilities. That is equivalent to a pass and could mark the peak of the entire crisis. The geopolitical risk premium would begin to subside after that. Related Report  Geopolitical StrategyLe Pen And Other Hurdles (GeoRisk Update) However, Russia has also threatened “military-political repercussions” if the Nordics join NATO. Russia’s capabilities are manifestly limited, judging by Ukraine today and the Winter War of 1939, but a broader war cannot entirely be ruled out. Global financial markets will still need to adjust for a larger tail risk of a war in Finland/Sweden in the very near term. Most likely Russia will retaliate by cutting off Europe’s natural gas. Clearly this is the threat on the table, after the cutoff to Poland and Bulgaria and the warnings to other countries. In the near term, several companies are gratifying Russia and paying for gas in rubles. But these payments violate EU sanctions against Russia and the intention is to wean off Russian imports as soon as possible. Germany says it can reduce gas imports starting next year after inking a deal with Qatar. Hence Russia might take the initiative and start reducing the flow earlier. Bottom Line: If Europe plunges into recession as a result of an immediate natural gas cutoff, then strategic stability between Russia and the West will become less certain. The tail risk of a broader war goes up. Stay cyclically long US equities over global equities and tactically long US treasuries. Stay long defense stocks and gold. Stay Short CNY At the end of last year we argued that Beijing would double down on “Zero Covid” policy in 2022, at least until the twentieth national party congress this fall. Social restrictions serve a dual purpose of disease suppression and dissent repression. Now that the state is doubling down, what will happen next? The economy will deteriorate: imports are already contracting at a rate of 0.1% YoY. The manufacturing PMI has fallen to 48.1  and the service sector PMI to 42.0, indicating contraction. Furthermore, social unrest could emerge, as lockdowns serve as a catalyst to ignite underlying socioeconomic disparities. Hence the national party congress is less likely to go smoothly, implying that investors will catch a glimpse of political instability under the surface in China as the year progresses. The political risk premium will remain high (Chart 3). Chart 3China's Confluence Of Domestic And Foreign Risk Weighs On Stocks And Currency While Chairman Xi Jinping is still likely to clinch another ten years in power, it will not be auspicious amid an economic crash and any social unrest. Xi could be forced into some compromises on either Politburo personnel or policy adjustments. A notable indicator of compromise would be if he nominated a successor, though this would not provide any real long-term assurance to investors given the lack of formal mechanisms for power transfer. After the party congress we expect Xi to “let 100 flowers bloom,” meaning that he will ease fiscal, regulatory, and social policy so that today’s monetary and fiscal stimulus can work effectively. Right now monetary and fiscal easing has limited impact because private sector actors are averse to taking risk. Easing policy to boost the economy could also entail a diplomatic charm offensive to try to convince the US and EU to avoid imposing any significant sanctions on trade and investment flows, whether due to Russia or human rights violations. Such a diplomatic initiative would only succeed, if at all, in the short run. The US cannot allow a deep re-engagement with China since that would serve to strengthen the de facto Russo-Chinese strategic alliance. In other words, an eruption of instability threatens to weaken Xi’s hand and jeopardize his power retention. While it is extremely unlikely that Xi will fall from power, he could have his image of supremacy besmirched. It is likely that China will be forced to ease a range of policies, including lockdowns and regulations of key sectors, that will be marginally positive for economic growth. There may also be schemes to attract foreign investment. Bottom Line: If China expands the range of its policy easing the result could be received positively by global investors in 2023. But the short-term outlook is still negative and deteriorating due to China’s reversion to autocracy and confluence of political and geopolitical risk. Stay short CNY and neutral Chinese stocks. Stay Short KRW South Koreans went to the polls on March 9 to elect their new president for a five-year term. The two top candidates for the job were Yoon Suk-yeol and Lee Jae-myung. Yoon, a former public prosecutor, was the candidate for the People Power Party, a conservative party that can be traced back to the Saenuri and the Grand National Party, which was in power from 2007 to 2017 under President Lee Myung-bak and President Park Geun-hye. Lee, the governor of the largest province in Korea, was the candidate for the Democratic Party, the party of the incumbent President Moon Jae-in. Yoon won by a whisker, garnering 48.6% of the votes versus 47.8% for Lee. The margin of victory for Yoon is the lowest since Korea started directly electing its presidents. President-elect Yoon will be inaugurated in May. He will not have control of the National Assembly, as his party only holds 34% of the seats. The Democratic Party holds the majority, with 172 out of 300 seats. The next legislative election will be in 2024, which means that President Yoon will have to work with the opposition for a good two years before his party has a chance to pass laws on its own. President-elect Yoon was the more pro-business and fiscally restrained candidate. His nomination of Han Duck-soo as his prime minister suggests that, insofar as any domestic policy change is possible, he will be pragmatic, as Han served under two liberal administrations. Yoon’s lack of a majority and nomination of a left-leaning prime minister suggest that domestic policy will not be a source of uncertainty for investors through 2024. Foreign policy, by contrast, will be the biggest source of risk for investors. Yoon rejects the dovish “Moonshine” policy of his predecessor and favors a strong hand in dealing with North Korea. “War can be avoided only when we acquire an ability to launch pre-emptive strikes and show our willingness to use them,” he has argued. North Korea responded by expanding its nuclear doctrine and resuming tests of intercontinental ballistic missiles with the launch of the Hwasong-17 on March 24 – the first ICBM launch since 2017. In a significant upgrade of North Korea’s deterrence strategy, Kim Yo Jong, the sister of Kim Jong Un, warned on April 4 that North Korea would use nuclear weapons to “eliminate” South Korea if attacked (implying an overwhelming nuclear retaliation to any attack whatsoever). Kim Jong Un himself claimed on April 26 that North Korea’s nuclear weapons are no longer merely about deterrence but would be deployed if the country is attacked. President-elect Yoon welcomes the possibility of deploying of US strategic assets to strengthen deterrence against the North. The hawkish turn is not surprising considering that North-South relations failed to make any substantive improvements during President Moon’s five-year tenure as a pro-engagement president. South Koreans, especially Yoon’s supporters, are split on whether inter-Korean dialogue should be continued. They are becoming more interested in developing their own nuclear weapons or at the very least deploying US nuclear weapons in South Korea. Half of South Korean voters support security through alliance with the US, while a third support security through the development of independent nuclear weapons. The nuclear debate will raise tensions on the peninsula. An even bigger change in South Korea’s foreign policy is its policy towards China. President-elect Yoon has accused President Moon of succumbing to China’s economic extortion. Moon had established a policy of “three No’s,” meaning no to additional THAAD missiles in South Korea, no to hosting other US missile defense systems, and no to joining an alliance with Japan and the United States. By contrast, Yoon’s electoral promises include deploying more THAAD and joining the Quadrilateral Dialogue (US, Japan, Australia, India). Polls show that South Koreans hold a low opinion of all of their neighbors but that China has slipped slightly beneath Japan and North Korea in favorability. Even Democratic Party voters feel more negative towards China. While negative attitudes towards China are not unique to Korea, there is an important difference from other countries: the Korean youth dislike China the most, not the older generations. Negative sentiment is less tied to old wounds from the Korean war and more related to ideology and today’s grievances. Younger Koreans, growing up in a liberal democracy and proud of their economic and cultural success, have been involved in campus clashes against Chinese students over Korean support for Hong Kong democrats. Negative attitudes towards China among the youth should alarm investors, as young people provide the voting base for elections to come, and China is the largest trading partner for Korea. Korea’s foreign policy will hew to the American side, at risk to its economy (Chart 4). Chart 4South Korean Geopolitical Risk Rising Under The Radar President-elect Yoon’s policies towards North Korea and China will increase geopolitical risk in East Asia. The biggest beneficiary will be India. Both Korea and Japan need to find a substitute to Chinese markets and labor, which have become less reliable in recent years. South Korea’s newly elected president is aligned with the US and West and less friendly toward China and Russia. He faces a rampant North Korea that feels emboldened by its position of an arsenal of 40-50 deliverable nuclear weapons. The North Koreans now claim that they will respond to any military attack with nuclear force and are testing intercontinental ballistic missiles and possibly a nuclear weapon. The US currently has three aircraft carriers around Korea, despite its urgent foreign policy challenges in Europe and the Middle East. Bottom Line: Stay long JPY-KRW. South Korea’s geopolitical risk premium will remain high. But favor Korean stocks over Taiwanese stocks. Stay Neutral On Hong Kong Stocks Hong Kong’s leadership change will trigger a new bout of unrest (Chart 5). Chart 5Hong Kong: More Turbulence Ahead On April 4, Hong Kong’s incumbent Chief Executive, Carrie Lam, confirmed that she would not seek a second term but would step down on June 30. John Lee, the current chief secretary of Hong Kong, became the only candidate approved to run for election, which is scheduled to be held on May 8. With the backing of the pro-Beijing members in the Election Committee, Lee is expected to secure enough nominations to win the race. Lee served as security secretary from when Carrie Lam took office in 2017 until June 2021. He firmly supported the Hong Kong extradition bill in 2019 and National Security Law in 2020, which provoked historic social unrest in those years. He insisted on taking a tough security stance towards pro-democracy protests. With Lee in power, Hong Kong will face more unrest and tougher crackdowns in the coming years, which will likely bring more social instability. Lee will provoke pro-democracy activists with his policy stances and adherence to Beijing’s party line. For example, his various statements to the news media suggest a dogmatic approach to censorship and political dissent. With the adoption of the National Security Law, Hong Kong’s pro-democracy faction is already deeply disaffected. Carrie Lam was originally elected as a popular leader, with notable support from women, but her popularity fell sharply after the passage of the extradition bill and National Security Law, as well as her mishandling of the Covid-19 outbreak. Her failure to handle the clashes between the Hong Kong people and Beijing damaged public trust in government. Trust never fully recovered when it took another hit recently from the latest wave of the pandemic. Putting another pro-Beijing hardliner in power will exacerbate the trend. Hong Kong equities are vulnerable not merely because of social unrest. During the era of US-China engagement, Hong Kong benefited as the middleman and the symbol that the Communist Party could cooperate within a liberal, democratic, capitalist global order. Hence US-China power struggle removes this special status and causes Hong Kong financial assets to contract mainland Chinese geopolitical risk. As a result of the 2019-2020 crackdown, John Lee and Carrie Lam were among a list of Hong Kong officials sanctioned by the US Treasury Department and State Department in 2020. Now, after the Ukraine war, the US will be on the lookout for any Hong Kong role in helping Russia circumvent sanctions, as well as any other ways in which China might further its strategic aims by means of Hong Kong. Bottom Line: Stay neutral on Hong Kong equities. Favor France Within European Equities French political risk will fall after the presidential election, which recommits the country to geopolitical unity with the US and NATO and potentially pro-productivity structural reforms (Chart 6). France is already a geopolitically secure country so the reduction of domestic political risk should be doubly positive for French assets, though they have already outperformed. And the Russia-West conflict is fueling a risk premium regardless of France’s positive developments. Chart 6France's Domestic Political Risk Will Subside But Russian War Will Keep Geopolitical Risk Elevated The French election ended with a solid victory for the political establishment as we expected. President Emmanuel Macron gaining 58% of the vote to Marine Le Pen’s 42%. Macron beat his opinion polling by 4.5pp while Le Pen underperformed her polls by 4.5pp. A large number of voters abstained, at 28%, compared to 25.5% in 2017. The regional results showed a stark divergence between overseas or peripheral France (where Marine Le Pen even managed to get over half of the vote in several cases) and the core cities of France (where Macron won handily). Macron had won an outright majority in every region in 2017. Macron did best among the young and the old, while Le Pen did best among middle-aged voters. But Macron won every age group except the 50 year-olds, who want to retire early. Macron did well among business executives, managers, and retired people, but Le Pen won among the working classes, as expected. Le Pen won the lowest paid income group, while Macron’s margin of victory rises with each step up the income ladder. Macron’s performance was strong, especially considering the global context. The pandemic knocked several incumbent parties out of power (US, Germany) and required leadership changes in others (Japan, Italy). The subsequent inflation shock now threatens to cause another major political rotation in rapid succession, leaving various political leaders and parties vulnerable in the coming months and years (Australia, the UK, Spain). Only Canada and now France marked exceptions, where post-pandemic elections confirmed the country’s leader. The Ukraine war constitutes yet another shock but it helped Macron, as Le Pen had objective links and sympathies with Russian President Vladimir Putin. Macron’s timing was lucky but his message of structural reform for the sake of economic efficiency still resonates in contemporary France, where change is long overdue – at least compared with Le Pen’s proposal of doubling down on statism, protectionism, and fiscal largesse. The French middle class was never as susceptible to populism as the US, UK, and Italy because it had been better protected from the ravages of globalization. Populism is still a force to be reckoned with, especially if left-wing populists do well in the National Assembly, or if right-wing populists find a fresher face than the Le Pen dynasty. But the failure of populism in the context of pandemic, inflation, and war suggests that France’s political establishment remains well fortified by the economic structure and the electoral system. Whether Macron can sustain his structural reforms depends on legislative elections to be held on June 12-19. Early projections are positive for his party, which should keep a majority. Macron’s new mandate will help. Le Pen’s National Rally and its predecessors may perform better than in the past but that is not saying much as their presence in the National Assembly has been weak. Bottom Line: France is geopolitically secure and has seen a resounding public vote for structural reform that could improve productivity depending on legislative elections. French equities can continue to outperform their European peers over the long run. Our European Investment Strategy recommends French equities ex-consumer stocks, French small caps over large caps, and French aerospace and defense.   Favor Spanish Over Italian Stocks Chart 7Italian And Spanish Political Risk Will Rise But Favor Spanish Stocks What about Spain? It is still a “divided nation” susceptible to a rise in political risk ahead of the general election due by December 10, 2023 (Chart 7). In the past few months, a series of strategic mistakes and internal power struggles have led to a significant decline in the popularity of Spain’s largest opposition party, the People’s Party. Due to public infighting and power struggle, Pablo Casado was forced to step down as the leader of the People’s Party on February 23, as requested by 16 of the party’s 17 regional leaders. It is yet to be seen if the new party leader, Alberto Nunez Feijoo, can reboot People’s Party. The far-right VOX party will benefit from the People Party’s setback. The latter’s misstep in a regional election (Castile & Leon) gave VOX a chance to participate in a regional government for the very first time. Hence VOX’s influence will spread and it will receive greater recognition as an important political force. Meanwhile the ruling Socialist Worker’s Party (PSOE) faces anger from the public amid inflation and high energy prices. However, Spanish Prime Minister Pedro Sanchez’s decision to send offensive military weapons to Ukraine is widely supported among major parties, including even his reluctant coalition partner, Unidas Podemos. The People’s Party’s recent infighting gives temporary relief to the ruling party. 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 Feijoo and a pre-test 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 problem for Sanchez and the Socialists is that the stagflationary backdrop will weigh on their support over time. Bottom Line: Spanish political risk is likely to spike sooner rather than later, though Spanish domestic risk it is limited in nature. Madrid faces low geopolitical risk, low energy vulnerability, and is not susceptible to trying to leave the EU or Euro Area. Favor Spanish over Italian stocks. Stay Constructive On South Africa The political and economic status quo is largely unchanged in South Africa and will remain so going into the 2024 national elections. Fiscal discipline will weaken ahead of the election, which should be negative for the rand, but the global commodity shortage and geopolitical risks in Russia and China will probably overwhelm any negative effects from South Africa’s domestic policies. Rising commodity prices have propped up the local equity market and will bring in much-needed revenue into the local economy and government coffers. But structural issues persist. Low growth outcomes amid weak productivity and high unemployment levels will remain the norm. The median voter is increasingly constrained with fewer economic opportunities on the horizon. Pressure will mount on the ruling African National Congress (ANC), fueling civil unrest and adding to overall political risk (Chart 8). Chart 8South Africa's Political Status Quo Is Tactically Positive For Equities And Currency Almost a year has passed since the civil unrest episode of 2021. Covid-19 lockdowns have lifted and the national state of disaster has ended, reducing social tensions. This is evident in the decline of our South Africa GeoRisk indicator from 2021 highs. While we recently argued that fiscal austerity is under way in South Africa, we also noted 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. Already, the ANC have committed to maintaining a special Covid-19 social-grant payment, first introduced in 2020, for another year. This grant, along with other government support, will feature in 2024 and possibly beyond. Unemployment is at 34.3%, its highest level ever recorded. The ANC cannot leave it unchecked. The most prevalent and immediate recourse is to increase social payments and transfers. Given the increasing number of social dependents that higher unemployment creates, government spending will have to increase to address rising unemployment. President Cyril Ramaphosa is still a positive figurehead for the ANC, but the 2021 local elections showed that the ANC cannot rely on the Ramaphosa effect alone. The ANC is also dealing with intra-party fighting. Ramaphosa has yet to assert total control over the party elites, distracting the ANC from achieving its policy objectives. To correct course, Ramaphosa will have to relax fiscal discipline. To this outcome, investors should expect our GeoRisk indicator to register steady increases in political risk moving into 2024. The only reason to be mildly optimistic is that South Africa is distant from geopolitical risk and can continue to benefit from the global bull market in metals. Bottom Line: Maintain a cyclically constructive outlook on South African currency and assets. Tight global commodity markets will support this emerging market, which stands to benefit from developments in Russia and China. Investment Takeaways Stay strategically long gold on geopolitical and inflation risk, despite the dollar rally. Stay long US equities relative to global and UK equities relative to DM-ex-US. Favor global defensives over cyclicals and large caps over small caps. Stay short CNY, TWD, and KRW-JPY. Stay short CZK-GBP. Favor Mexico within emerging markets. Stay long defense and cyber security stocks. We are booking a 5% stop loss on our long Canada / short Saudi Arabia equity trade. We still expect Middle Eastern tensions to escalate and trigger a Saudi selloff.   Matt Gertken Chief Geopolitical Strategist mattg@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 Footnotes 1   The campaign in the south suggests that Ukraine will be partitioned, landlocked, and susceptible to blockade in the coming years. If Russia achieves its military objectives, then Ukraine will accept neutrality in a ceasefire to avoid losing more territory. If Russia fails, then it faces humiliation and its attempts to save face will become unpredictable and aggressive. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Geopolitical Calendar

Dear Client, Next week, there will not be a written European Investment Strategy report; instead we will host a Webcast on April 26 with Chester Ntonifor, BCA’s Foreign Exchange Strategist. Regards, Mathieu Savary Executive Summary Cyclicals Are Not Cheap Enough Global growth remains fragile as China’s economy becomes increasingly affected by COVID containment measures. The US economy is likely to slow down significantly in the coming months, while Europe flirts with a recession. This time around, monetary policy is unlikely to provide a relief valve. While European equities may inch higher in the coming months, cyclical stocks do not offer the necessary valuation discount relative to defensive equities to compensate investors against these risks.  Heed the rotational patterns to guide near-term country and sector allocation. The French election remains an important source of risk, even though President Emmanuel Macron is still the favorite.   Bottom Line: Maintain a modest positive bias toward equities, but overweight defensive stocks at the expense of cyclicals. Focus on short-term capital protection by favoring small-cap over momentum stocks, materials over energy, and UK equities over French ones.     Chart 1So Far, Defensives Win European equities have experienced a very volatile first quarter, with a maximum drawdown of nearly 23%. Since their March 7th low, they have rebounded 18% but remain 13% below the January 5th high. Apart from the energy sector, defensives have been running the show so far this year (Chart 1). We wrote four weeks ago that the European market is likely to have made its low for the year,  but that the volatility of the first quarter of 2022 is likely to continue. We still hold this view. For now, we recommend investors stay long European equities, but defensive sector and country stances are appropriate. Cyclical stocks have corrected, but front-loaded global economic risks create additional downside. Economic Risks Abound The global economic environment remains fragile as headwinds continue to build. Cyclical equities do not seem to have fully discounted this threat. China’s economic outlook constitutes the first hindrance to global growth. COVID cases in Shanghai are surging and many Chinese cities are also witnessing an acceleration in new cases (Chart 2). The Communist Party is still adamant about its zero-tolerance policy, which suggests that these severe lockdowns will become the norm around the country. This situation creates significant downside for Chinese domestic demand, which will prompt a growth slowdown. The service sector is already feeling the pain from the lockdowns. The March import numbers also highlight an abrupt slowdown in the goods sector (Chart 3). In CNY terms, imports contracted 1.7% annually. This is a nominal number. Both global goods and commodity inflation are elevated, and thus, import volumes are weakening sharply. Furthermore, a recent Reuters article indicated that Chinese crude oil imports have already contracted 14% annually. Chart 2China's COVID Problem Chart 3Slowing Chinese Domestic Demand Chart 4Declining Shipping Costs, But For How Long? China’s COVID policy also risks adding new supply chain bottlenecks. Freight within the country is grinding to a halt and ships are queuing up outside the port of Shanghai. As lockdowns multiply around China, risks to global supply chains will increase, hence, the recent decline in shipping rates out of China may soon be undone (Chart 4). This represents a major risk for the global economy, as it would tighten constraints to global economic activity. It also threatens European profitability, as PPI inflation would outpace CPI inflation for longer than anticipated (Chart 4, bottom panel). The US also shows signs of weakness. While a US recession is unlikely, a meaningful deceleration is probable. US consumers are feeling the pinch from surging food and energy prices. Consequently, real wages are contracting 1.8% annually and consumer confidence has plunged (Chart 5). Thankfully, US households have accumulated $185 billion in excess savings since the pandemic began and their net worth has increased by $33 trillion, which should prevent a complete meltdown. Nevertheless, a further deterioration in retail sales is still very likely. Businesses are also increasingly worried. The March NFIB survey shows that Small Business Optimism is falling quickly and that few companies believe it is a good time to expand (Chart 5, bottom panel). Adding to these stresses, the most cyclical sector of the US economy is weakening rapidly. The recent rise in US mortgage rates to 5% is causing a collapse in mortgage applications for house purchases and is behind the 30% tumble suffered by homebuilder stocks (Chart 6). Chart 5US Confidence Is Falling Chart 6Tarnished US Housing Outlook Europe is in a situation worse than the US and is at risk of a recession in the first half of 2022, or, at least, a very severe growth slowdown. As we highlighted six weeks ago, the energy shock in Europe is larger than it is in the US; moreover, Europe does not enjoy the counterweight of a large commodity sector. Recent data confirm that a slowdown is imminent. The ZEW Expectations survey, the German Ifo, and the European Commission’s Consumer Confidence data are all collapsing, which is consistent with a severe shock (Chart 7). To add insult to injury, bond yields continue to rise; therefore, the only relief valve for the region is a weak currency. Global monetary policy is unlikely to come to the rescue of investors anytime soon. The Fed began lifting rates in March and, if the actions of the Bank of Canada and the Reserve Bank of New Zealand are any indication, the FOMC will increase rates by 50bps in May. The OIS curve expects a Fed Funds rate at 2.2% by year-end, which seems appropriate. With a backdrop of weakening growth, a flat yield curve and an additional increase in real rates will feed risk aversion, especially against the cyclical sectors of the market (Chart 8). Chart 7Severe Slowdown In Europe... Or Worse Chart 8Slowing Growth Meets Higher Real Rates The liquidity tightening is not a phenomenon unique to the US. 63% of global central banks have removed monetary accommodation over the past three months (Chart 9). Moreover, our BCA Monetary Index continues to deteriorate. While we cannot characterize global monetary policy as being anywhere close to tight right now, cyclical equities remain vulnerable to the liquidity slowdown. Bottom Line: The global economy is likely to deteriorate in the coming months. The impact of COVID-19 on Chinese growth will only increase, while Europe flirts with a recession in the first half of the year. Meanwhile, US growth faces swelling headwinds. Expect a meaningful deterioration in global economic surprises (Chart 10). In this context, tighter policy will feed risk aversion, which will create a particularly strong headwind for cyclical stocks. Chart 9A Global Tightening Chart 10Economic Surprises Will Fall European Cyclicals Remain Vulnerable This backdrop is not equity-friendly and points to meagre returns over the next three to six months. Nonetheless, European stocks will not generate negative returns over this time frame because European benchmarks already discount a significant portion of the negative news, as illustrated by the surge in their earnings yield (Chart 11). Importantly, inflation in Europe should peak over the summer as the commodity impulse is decelerating (Chart 11, bottom panel). Therefore, fears of stagflation will recede, which will help aggregate European shares (Chart 12). Chart 11European Stocks Already Discount A Lot Chart 12Ebbing Stagflation Fears Will Help European Equities The consequence of the additional slowdown in global growth is likely to be reflected in the relative performance of European cyclical sectors. Already, Swedish economic growth and asset prices have deteriorated (Chart 13). This poor performance does not bode well for cyclical assets, considering the heightened sensitivity of Swedish assets to the global industrial cycle. More signals point to downside for the cyclical/defensive split. While the short-term momentum of the performance of cyclicals relative to defensives is becoming oversold, its 40-week rate of change has yet to reach a paroxysm (Chart 14). Additionally, cyclicals have not experienced the kind of valuation discount associated with a full discounting of the economic and monetary headwinds described in the previous section (Chart 14, bottom panel). Chart 13Heed Sweden's Message Chart 14Cyclicals Are Not Cheap Enough The commodity sector is also at risk of a pullback. China’s economic slowdown is likely to hurt commodity demand. While this will not end the secular commodity bull market underpinned by a lack of supply capacity, it could easily cause a significant correction in commodity prices. If, as we anticipate, inflation slows this summer, the inflation-hedging demand for commodities will also pause. These dynamics would hurt mining stocks, which have avoided a serious pullback, as well as the energy sector. Thus, a correction in commodities would cause additional weaknesses for the cyclicals-to-defensives ratio (Chart 15). Yields create a supplemental risk. Historically, rising US yields and inflation expectations correlate with an outperformance of cyclical shares. However, in 2022, cyclicals have bifurcated from yields and CPI swaps (Chart 16), because higher yields currently do not signal reflation but stagflation. If yields rise further, it will hurt growth prospects and damage cyclicals. If they fall, it will likely reflect increasing growth fears, which is also negative for cyclicals. Moreover, falling yields will hurt the profit margins of financials, which are a large component of cyclicals. Therefore, cyclicals seem stuck in a lose-lose situation with respect to yields. Chart 15The Commodity Link Chart 16Yields and Cyclicals: A Lose-Lose Proposition The strength in the dollar creates the last major hurdle for cyclicals. A strong dollar both tightens global financials conditions and indicates weak growth ahead. Consequently, it often heralds a period of softness in the cyclicals-to-defensives ratio (Chart 17). How should investors position themselves? We have a long-held preference for telecommunication services stocks over consumer discretionary equities and for healthcare relative to tech shares. These trades have respectively generated hefty gains of 32% and 13% since June 2021, but they are becoming long in the tooth (Chart 18). Chart 17A Strong Dollar Hurts Cyclicals Chart 18Hedges Have Performed Strongly Related Report  European Investment StrategyThe Great Rotation As an alternative, we recommend investors stay nimble and use our Excess Returns Rotation Approach expanded in a Special Report two months ago. Below, you will find the new trades suggested by this process. Bottom Line: Cyclicals remain vulnerable. They have not reached the kind of valuation discount necessary to compensate investors for weaker growth and tighter monetary policy. To hedge against these risks, we recommended selling consumer discretionary relative to telecom stocks and tech shares relative to healthcare. However, investors should not add to those trades to mitigate against further weaknesses in cyclical stocks. Instead, investors should focus on relative rotational patterns (see next section).   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Excess Returns Rotation Maps: An Update1 European Investment Styles The most noteworthy move comes from small-cap stocks, going from the “Lagging” quadrant to the “Leading” one rapidly (Chart 19). This is consistent with our view that European small-cap equities’ outperformance has further to run. The attractiveness of value stocks is thinning relative to growth stocks (Table 1). Chart 19Relative Rotation Graph: European Investment Styles Table 1European Investment Styles Positioning   Trade Recommendations (12-Month Horizon): Volatility stocks relative to momentum (unchanged) Small-cap stocks relative to momentum (new) European Sectors Chart 20 illustrates the wild ride in European equity markets in the wake of the Ukraine/Russia conflict. Most sectors experienced violent swings, moving rapidly across several quadrants. Only consumer discretionary, tech, and utilities stocks have remained in the same quadrant, the former two in “Lagging” and the latter in “Leading.” Interestingly, the European energy sector has moved into the “Weakening” quadrant (Table 2). We are taking profit on our Long Energy / Short Financials recommendation. It delivered 14% returns since mid-February and is getting long in the tooth. Chart 20Relative Rotation Graph: European Sectors Table 2European Sectors Positioning   Trade Recommendations (12-Month Horizon): Materials over energy (unchanged) Energy over financials (unchanged) Tech over communication services (unchanged) Utilities over healthcare (new) Communication services over healthcare (new) Consumer discretionary over healthcare (new) European National Markets Sectoral biases dictate the rotational patterns exhibited by European national bourses (Chart 21). The cyclicality of the German, French, and Italian markets caused them to lag behind their European counterparts. Meanwhile, the Dutch market remains solidly in the Lagging quadrant, mirroring tech equities. Only Spain and Sweden have shown signs of improvement over the past twelve weeks and should outperform the European benchmark over the short term (Table 3). Chart 21Relative Rotation Graph: European National Markets Table 3European National Markets Positioning   Trade Recommendations (12-Month Horizon): UK stocks over Dutch ones (new) UK stocks over French ones (new) Italian stocks over Swedish ones (new) UK stocks over Swedish ones (new) French Elections: Preparing For The Second Round The first round of the French presidential elections did not surprise. As in 2017, incumbent President Emmanuel Macron will face Marine Le Pen in the second round. Beyond this expected outcome, two important takeaways will be crucial in the second round: The collapse of traditional right-wing (Les Républicains) and left-wing (Parti Socialiste) parties. Far-left candidate Jean-Luc Mélenchon surprised to the upside with 22% of votes, right behind Marine Le Pen. The key implication is that the vote transfer has become more favorable to Macron (Diagram 1). In 2017, Marine Le Pen created the surprise and bested center-right candidate François Fillon by the narrowest of margins. As a result, Le Pen’s attempt to appeal to Fillon’s voters was a real threat. Today, the third largest pool of voters belongs to far-left candidate Mélenchon, who has already called upon his voters “not to give a single vote to Marine Le Pen.” Diagram 1Extrapolating France’s First-Round Election To The Second Round How does it translate into voting intentions for the second round? Assuming a full transfer of votes from the defeated candidates based on the support they made public, Macron will crush Marine Le Pen as he did in 2017. However, this is unlikely, since many voters feel stuck between a rock and a hard place, and may decide not to vote. Related Report  European Investment StrategyFrance: Macron And Macro Assuming Macron obtains only half of the voting intentions from other parties, while Marine Le Pen retains the full support from other far-right candidates’ voters, acquires half of the center-right votes, and secures a quarter of Mélenchon’s votes, the outcome will be much narrower at 53.4% vs. 46.6% in favor of Macron. This is in line with national polls. Two weeks ago, we presented the investment implications of a second Macron mandate.  Since then, we have received many questions about the market consequences should Marine Le Pen enjoy a surprise victory. While this is not our base-case, we cannot rule out the possibility of a negative shock to the markets. Chart 22A Le Pen Surprise Victory Would Hurt The Euro The only certainty within this very uncertain outcome is that Marine Le Pen would be constrained by a strong opposition in the Assemblée Nationale. Although she has changed her stance on “Frexit,” her presidency would undoubtfully carry an increased geopolitical risk within the European Union (EU) and hurt European unity and integration efforts. Thus, the resulting French isolationism would be synonymous with a weaker euro (Chart 22). French assets would be de-rated because her presidency would reverse previous reform efforts, which would hurt trend GDP growth, productivity, and the role of France within the EU. These trends are not only negative for stocks, but they would also put long-term upward pressure on OATs yields as French public finances would deteriorate meaningfully under a populist Le Pen presidency. In this context, underweighting both French equities and government bonds would be warranted.   Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com   Footnotes Tactical Recommendations Cyclical Recommendations Structural Recommendations