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Executive Summary Foreign And Domestic Politics Won't Stop The Fed Investors woke up to the Ukraine risk this week. It is not yet resolved. Stay defensive. Market reactions to Ukraine suggest investors will favor defensive sectors and growth stocks in the short term, with the notable exception of the energy sector. External risks will not dissuade the Fed from hiking rates in the face of 6% core inflation. Later the Fed might adjust to foreign crises but the stock market faces more downside in the interim. Polarization is reviving ahead of the midterm elections, which will usher in gridlock. Gridlock is disinflationary, reinforcing a tactically defensive market positioning despite our cyclical House View. Bottom Line: Biden’s external risks are not yet subsiding. The Fed will hike rates even in the face of external supply shocks. Stay tactically defensive. Feature Our three key views for the year are: gridlock, executive power, and foreign policy. First, Congress will become gridlocked even prior to the midterm elections. Second, President Biden will have to shift to executive power to achieve policy objectives. Third, Biden’s focus will be forced to engage in foreign policy more than he would prefer due to rising external risks. The Ukraine crisis – covered extensively in our Geopolitical Strategy – is the most pressing external risk but it is not the only one that we think will trouble markets this year. We expect politically induced volatility to persist all year. The cyclical investment view should be driven by the underlying macroeconomic reality. But that macro reality will change if external risks materialize and cause greater supply disruptions or if they alter the US midterm election outlook. We maintain our tactically defensive positioning for now. Mr. Market Wakes Up To Ukraine Risk The reason for the crisis is the historic Russian military buildup on all sides of Ukraine, in the face of US defense cooperation with Ukraine, not the “hysterical” American propaganda over the risk of war. When and if Russian forces withdraw, the crisis will melt away. But for now, Russia’s reported withdrawal of some troops is contradicted by movements of other troops as well as the fact that the Russian navy has effectively blocked off the Black Sea. Investors must judge by capabilities, not intentions, and Russia still has the capability to stage a limited attack at present so investors should maintain a defensive or cautious approach. In this context investors are rightly bidding up the US dollar and bidding down US equities in absolute terms (albeit not relative to European equities). Bond yields have not responded much to the external risk due to the high rate of inflation, which is pushing yields up (Chart 1). If Russia re-invades, stocks and bond yields will fall at least temporarily and the dollar will rise higher. When Russia initially invaded Ukraine eight years ago, in February 2014, the US stock-to-bond ratio moved sideways for several months but cyclicals outperformed defensives. Energy stocks rallied, until the oil crash in summer 2014. Small caps underperformed large caps, yet value outperformed growth stocks (Chart 2). Small caps likely suffered from risk-off sentiment and expectations of a drag on global growth, while value benefited from gently rising interest rates at that time. Chart 1Ukraine Crisis Escalates Chart 2Market Response To Crimea Invasion, 2014 Comparing the situation today, the difference is that cyclicals are trailing defensives and small caps are trailing large caps even more than they were in 2014. Yet value stocks have performed far better against growth now than then, in accordance with higher inflation and bond yields (Chart 3). Further escalation of the Ukraine crisis should drive investors to favor defensives, large caps, and growth stocks on a tactical time frame, even though this decision runs against our BCA House View on a cyclical time frame. The past week’s market moves reinforce the 2014 experience in general, with the stock-to-bond ratio faltering and cyclicals falling back (Chart 4). Small caps and value have benefited but these charts suggest that a negative hit to global growth will hurt small caps, while value is overextended relative to growth in the short term. The market only really began to discount the risk of a new war in Europe this past week, specifically on Friday, February 11 and Monday, February 14. Chart 3Market Response 2022 Versus 2014 Chart 4US Equities Just Woke Up To Ukraine There is not yet a solid diplomatic solution as we go to press on Tuesday, February 15, but some positive signs are fueling a rebound in risk assets. Fade these improvements in risk appetite until Russia makes its decision on whether to use military force and, if so, until Europe makes its decision on whether to impose crippling sanctions.  Bottom Line: Tactically stay long growth stocks versus value, but prepare to switch back to overweighting value if the Ukraine crisis abates. The Energy Sector Response To Ukraine So Far Commodity prices and the energy sector are naturally benefitting from rising supply risks. But there is a risk that they will suffer later if a war breaks out and generates a supply shock and energy price shock that weigh on European and global growth. Russia will likely maintain energy production to help pay for its military adventures. The Saudis could increase production to prevent demand destruction. It is also possible that a US-Iran nuclear deal could release Iranian oil to the market. The global economy can handle gradually rising energy prices but maybe not a sharp supply shock. Oil prices are rising on signs of escalating tensions and energy sector equities are generally outperforming the broad market and other cyclical sectors. Domestically oriented small cap energy stocks are rising relative to large caps, suggesting that the market does not believe that global growth will suffer greatly from any conflict. Apparently investors do believe that US energy companies will benefit from shipping more fossil fuels abroad (Chart 5). Bottom Line: Cyclically stay long small cap energy stocks versus their large cap brethren. Chart 5US Energy Sector Just Woke Up To Ukraine Peak-To-Trough Drawdowns Amid Geopolitical Crises The peak-to-trough equity drawdown amid major geopolitical crises ranges from 11%-15%, depending on the magnitude and nature of the crisis (Chart 6). In this case, the US will not be directly involved in any war in Ukraine, but US NATO allies will be right next door and providing aid to Ukraine. For “limited incursion” scenarios we looked at over a dozen crises, from the Berlin Blockade of 1949 to the Russian invasion of Crimea in 2014. The peak-to-trough drawdown averages 10%. For an unlimited or “full-scale” invasion, we looked at the S&P500 reaction to major invasions at the dawn of World War II as well as significant wars in the twentieth century, down to the US invasion of Iraq and NATO’s intervention in Libya in 2011. The peak-to-trough equity drawdown averaged 13%. Chart 6Range Of US Equity Peak-To-Trough Drawdowns Amid Geopolitical Crisis Given that the S&P500 has fallen by 8% since its peak on January 3, 2022, investors should be prepared for more downside. Health care stocks and consumer staples are outperforming the broad market this year so far, though they are underperforming energy where the supply squeeze is happening (Chart 7). The magnitude of war and sanctions will determine whether energy ultimately falls in expectation of demand destruction. Bottom Line: It is too soon to buy the dip in the S&P 500. Stay long health stocks relative to the broad market. Chart 7Health Care And Consumer Staples Will The Fed Respond To External Risks? No. Over the past year, we have argued with investors who tried to differentiate the current bout of inflation from the inflation of the 1970s by arguing that there is no energy supply shock. We argued that an energy shock could transpire by pointing to external risks such as Russia and Iran. While the Biden administration will likely prove risk-averse, for fear that higher prices at the pump will weigh on the Democratic Party in the midterm elections, what about the Federal Reserve? During the Arab oil embargo of late 1973, and the Iranian revolution of 1979, the Federal Reserve continued to hike interest rates, responding to domestic inflation and rising bond yields. Foreign supply shocks threatened to push up inflation, so the Fed was not deterred from hiking rates (Chart 8). When the US itself engages in war, the Fed might react differently (Chart 9). Chart 8The Fed Responds to Oil Shocks by Hiking Rates But... Chart 9... US At War Could Trigger Looser Monetary Policy In 1990, the Fed cut the policy rate once after the US entered the Iraq war, then kept rates flat for a few months before cutting more at the end of the year. Bond yields were falling due to recession. In 2001, the Fed was already cutting rates due to the business cycle and the September 11 terrorist attacks reinforced that process. In 2003, the Fed cut rates after the beginning of the Iraq war and did not start hiking rates until mid-2004 when the initial phase of the war ended. The implication is that Fed Chair Alan Greenspan accommodated both the war and the 2004 presidential election. Most external risks will not prevent the Fed from hiking rates, especially during an inflation bout when the nature of the external risk may be an energy supply disruption that pushes up prices. However, while we do not doubt that the Fed could hike by 50bps in March, we doubt that the consensus of 175bps in hikes in 2022 will pan out. The combination of initial hikes, fiscal drag, and foreign growth shocks would temper the Fed’s enthusiasm. Bottom Line: Stocks face more downside risk in this environment.   Bipartisanship And The Return Of Gridlock Polarization and partisanship are recovering. The Philadelphia Fed “Partisan Conflict Index” is now only 0.6% below its 2020 peaks as the midterm election approaches (Chart 10). Interestingly, one of our key views from last year – bipartisan reform – is still taking place beneath the surface. Our 2022 view of gridlock has not yet fully set in. Congress is stealthily cooperating on fiscal spending, the US Postal Service, women’s issues, public servants’ stock trading, and an attempt to revise the Electoral Count Act. Congress is also passing a bipartisan bill to make the US more economically competitive with China and impose sanctions against Russia. Chart 10Foreign And Domestic Politics Won't Stop The Fed The only area where bipartisanship is not happening is Biden’s “Build Back Better” reconciliation bill, which even lacks sufficient support from moderate Democratic senators due to high inflation. Passage is still possible in a partisan, watered-down, and deficit-neutral form. These developments show that Republican lawmakers are demonstrating some pragmatic governing ability and will use their voting records to make a case in the midterms, while pinning the blame for inflation, crime, immigration, and any foreign crises on Democrats. As such they reinforce the market consensus that Republicans are likely to take back Congress this fall. Thus while last year’s bipartisanship is spilling into the current legislative session, gridlock is rapidly approaching. When investors look to the second half of the year and beyond, they should expect to see legislative cooperation dry up, especially if Republicans only take the House and not the Senate. Bottom Line: Gridlock will freeze fiscal policy, which is non-inflationary or disinflationary for 2022-24. As such the midterm election is not fully priced. Midterm dynamics will support an overweight or at least neutral stance toward defensives and growth stocks. Investment Takeaways Tactically stay long defensives, notably health care, and growth stocks. Cyclically remain invested in the bull market – and stay long energy small caps. The chief risks to these views would be a speedy diplomatic resolution to the Ukraine and Iran conflicts or a dramatic revival of the Democratic Party’s popular support ahead of the midterm election. Diplomacy would remove risks to global growth, whereas a Democratic comeback would boost inflation expectations.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets Footnotes  

Chart 1 Today, we are downgrading the overall Consumer Discretionary index to underweight by reducing our allocation in two key industry groups: Retailing and Consumer Durables & Apparel. We remain constructive on Consumer Services, i.e., the Travel Complex (Hotels & Cruises, Restaurants, and Airlines). Consumer spending is shifting from goods to services, for which there is still strong pent-up demand (Chart 1). While consumers still sit on $2.2 trillion in excess savings, their sentiment is in a downward trend. High inflation and negative real wage growth are cutting into middle-class Americans’ disposable income: For many high costs of food and gas crowd out discretionary spending.  Empirical analysis supports our reasoning. Performance of the S&P Retailing and the S&P Consumer Durables & Apparel industry groups has been strongly inversely correlated with consumer sentiment and inflation (Charts 2 and 3). With inflation high and intransigent, stimulus checks in a rear-view window, and consumers worried about their finances, these industries have been underperforming, and will continue doing so.  Chart 2 Chart 3 Even if inflation abates, thanks to unclogging of supply chain bottlenecks and tighter monetary policy, we will need to see an inflection in consumer sentiment and positive real wage growth to change our stance. Bottom Line: We downgrade the S&P Retailing and the S&P Consumer Durables & Apparel indexes to below benchmark. Those downgrades also push the overall S&P Consumer Discretionary into an underweight basket. Appendix Table 1 Table 2

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Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (February 15 at 10:00 AM EST, 15:00 PM GMT, 16:00 PM CET). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Best regards, Ryan Swift, US Bond Strategist