Commodities & Energy Sector

Executive Summary Will The War Stall The Expected Downturn In Inflation This Year? Will The War Stall The Expected Downturn In Inflation This Year? Will The War Stall The Expected Downturn In Inflation This Year? The Russia/Ukraine conflict is impacting financial markets across numerous channels – uncertainty, risk aversion, growth expectations & inflation expectations – but all have a common link through soaring commodity prices, most notably for oil. For global bond investors, allocations to inflation-linked bonds are a necessary hedge to the war and the associated commodity shock, particularly with breakevens in most countries re-establishing the link to oil prices. We recommend investors maintain neutral allocations to inflation-linked bonds versus nominal government bonds across the developed world until there is greater clarity on future global oil production. Markets are discounting a peak in interest rates at the low end of the Bank of Canada’s neutral range, which is reasonable given high household debt levels in Canada. This creates an opportunity for bond investors to go long Canadian government bonds versus US Treasuries. Bottom Line: The supply premium on global oil prices will persist until there are signs of more global oil production or less chaos in the Ukraine – neither of which is imminent. Maintain neutral allocations to inflation-linked bonds versus nominal government debt across the developed markets. Feature Chart 1A Broad-Based Surge In Commodity Prices A Broad-Based Surge In Commodity Prices A Broad-Based Surge In Commodity Prices The Russia/Ukraine war has sent an inflationary shock though the world through a very traditional source – rising commodity prices. Energy prices are getting most of the attention, with oil prices back to levels last seen in 2008 and US gasoline prices now above $4 per gallon. The commodity rally is not just in energy, though. Industrial metals prices have also gone up substantially, with the spot prices for copper and aluminum hitting an all-time-high and 16-year-high, respectively (Chart 1). Agricultural commodities have seen even larger increases, with the price of wheat up 22% and the price of corn up 11% since the Russian invasion began on February 24th. Europe is acutely exposed to the war-driven spike in energy prices given its reliance on Russia for natural gas supplies. Natural gas prices in Europe have spiked a staggering 117% since the invasion started, exacerbating a sharp demand/supply imbalance dating back to the reopening of Europe’s economy from COVID lockdowns one year ago (Chart 2). To date, booming energy prices have fueled a huge rise in headline inflation rates in the euro area – producer prices were up 31% on a year-over-year basis in January – but with little trickle down to core inflation which was only up 2.3% in January. High energy prices are not only a problem for global growth and inflation, but also for the future policy moves by central banks. Inflation rates boosted over the past year by commodity supply squeezes and supply chain disruptions were set to decline this year, but the Ukraine shock has thrown that into question. If the benchmark Brent oil price were to hit $150/bbl, this would end the decelerating trend for energy price inflation momentum, on a year-over-year basis, that has been in place since mid-2021 (Chart 3). That means a higher floor for the energy component of inflation indices, and thus overall headline inflation rates, throughout the major economies in the coming months. Chart 2Europe's Reliance On Russian Natural Gas Is A Big Problem Europe's Reliance On Russian Natural Gas Is A Big Problem Europe's Reliance On Russian Natural Gas Is A Big Problem ​​​​​ Chart 3Will The War Stall The Expected Downturn In Inflation This Year? Will The War Stall The Expected Downturn In Inflation This Year? Will The War Stall The Expected Downturn In Inflation This Year? ​​​​​ Chart 4The Oil Price Spike Makes Life More Difficult for CBs The Oil Price Spike Makes Life More Difficult for CBs The Oil Price Spike Makes Life More Difficult for CBs How will bond markets respond to higher-than-expected inflation? Rate hike expectations have been highly correlated to the trend of headline inflation in the US, Europe, UK, Canada and Australia over the past year (Chart 4). Currently, overnight index swap (OIS) curves are still discounting between 5-6 rate hikes from the Fed, the Bank of England, the Bank of Canada and the Reserve Bank of Australia before the end of 2022. A single rate hike is still priced into the European OIS curve, even with the Ukraine shock. Global bond yields have been volatile, but surprisingly resilient despite the worries about war and commodity inflation. The 10-year Treasury yield has been trading in a range between 1.7% and 2% since the Russian offensive began, while the 10-year German Bund yield has hovered around 0%. Bond markets are pricing in a stagflation-type outcome of slowing growth and rising inflation, as multiple rate hikes are still discounted despite the geopolitical risks from the war. That reduces the value of using increased duration exposure to position for risk-off moves in a bond portfolio. At the same time, real bond yields are falling and breakeven rates are rising for global inflation-linked bonds – a part of the fixed income universe that looks to offer good protection against the uncertainties of war. Inflation-Linked Bonds – A Good Hedge Against War Risks Since the Russian invasion began, breakeven inflation rates on 10-year inflation-linked bonds have moved higher in the US (+13bps), Canada (+19bps), Australia (+15bps) and even Japan (+15bps). The moves have been even more significant on the European continent – 10-year breakevens have shot up in the UK (+23bps), Germany (+45bps), France (+31bps) and Italy (+36bps). Chart 5Inflation Breakevens Are Rising, Especially In Europe Inflation Breakevens Are Rising, Especially In Europe Inflation Breakevens Are Rising, Especially In Europe The absolute levels of breakevens in Europe are high in the context of recent history (Chart 5). However, breakevens also look a bit stretched in other countries like the US. Our preferred metric to evaluate the upside potential for inflation-linked bonds is our Comprehensive Breakeven Indicators (CBI). The CBI for each country is comprised of three components: the deviation of 10-year breakevens from our model-implied fair value, the spread between 10-year breakevens and longer-term survey-based inflation expectations (the “inflation risk premium”) and the gap between actual inflation and the central bank inflation target. Those three components are all standardized and added together with equal weights to come up with the CBI. A higher CBI reading suggests less potential for inflation breakevens to widen, and vice versa. Currently, the CBIs for the eight countries in our Model Bond Portfolio universe are close to or above zero, suggesting more limited scope for breakevens to widen further (Chart 6). Only in Canada is the CBI below zero, and only slightly so as high realized Canadian inflation is offset by breakevens trading below both fair value and survey-based measures of inflation (Chart 7). Chart 6Global Inflation Breakeven Valuations Are Not That Cheap A Crude Awakening For Bond Investors A Crude Awakening For Bond Investors In the US, the CBI is above zero mostly because of high realized US inflation. In Europe, the CBIs of the UK, Germany and Italy all are well above zero, while in France the CBI is close to zero. The UK has the highest CBI in our eight-country universe, with all three components contributing roughly equally (Chart 8). The Japanese CBI is also just above the zero line. Chart 7Some Mixed Signals On Inflation Breakeven Valuations Some Mixed Signals On Inflation Breakeven Valuations Some Mixed Signals On Inflation Breakeven Valuations ​​​​​​ Chart 8European Breakevens Have Adjusted Sharply To The Energy Shock European Breakevens Have Adjusted Sharply To The Energy Shock European Breakevens Have Adjusted Sharply To The Energy Shock ​​​​​​ We have been recommending a relative cautious allocation to global breakeven bonds in recent months. We saw the upside potential on breakevens as capped given the dearth of “cheap” signals on breakevens from our CBIs, especially with central banks moving towards monetary tightening in response to elevated inflation – moves intended to restore inflation-fighting credibility with bond markets. Yet the Ukraine commodity shock has boosted inflation breakevens even in countries with modest underlying (non-commodity) inflation like Japan and the euro area. We now see greater value in owning inflation-linked bonds in global bond portfolios as a hedge against the inflation risks stemming from the Ukraine and the worsening geopolitical tensions between the West and Russia. This is true even without the typical positive signal for breakevens from having CBIs below zero. We recommend that fixed income investors maintain a neutral allocation to inflation-linked bonds in dedicated government bond portfolios across the entire developed market “linker” universe. In our model bond portfolio, we had been allocating to linkers based off the signal from the CBIs, but in the current stagflationary war environment, we see country allocations as secondary to having neutral exposure to linkers in all countries. The new weightings to inflation-linked bonds are shown in the model bond portfolio tables on pages 12-14.1 Bottom Line: For global fixed income investors, allocations to inflation-linked bonds are a necessary hedge to the war and the associated commodity shock, particularly with breakevens in most countries re-establishing the link to oil prices. Canada Update: BoC Liftoff At Last The Bank of Canada (BoC) raised its policy interest rate by 25bps to 0.5% last week, commencing the start of the first rate hike cycle since 2018. The move was no surprise after BoC Governor Tiff Macklem signaled at the January monetary policy meeting that the start of a rate hiking cycle was imminent. The Canadian Overnight Index Swap (OIS) curve is discounting another 171bps of hikes in 2022, with a peak rate of 1.98% reached by March 2023 - near the low-end of the BoC’s range of neutral rate estimates between 1.75% and 2.75% (Chart 9). Chart 9Markets Discounting A Shallow BoC Rate Hiking Cycle, Even With High Inflation Markets Discounting A Shallow BoC Rate Hiking Cycle, Even With High Inflation Markets Discounting A Shallow BoC Rate Hiking Cycle, Even With High Inflation The BoC noted that the Canadian economy was recovering faster than expected from the effects of the Omicron variant and the associated restrictions on activity, coming off a robust 6.7% annualized real GDP growth rate in Q4/2021. The BoC now estimates that economic slack created by the pandemic shock has been fully absorbed, with the unemployment rate at 6.5%. Canadian headline inflation reached a 32-year high of 5.1% in January (Chart 10) – a level that Governor Macklem bluntly called “too high” in a speech the day following the rate hike. The BoC’s CPI-trim measure that excludes the most volatile components is also at an elevated reading of 4%, suggesting that the higher inflation is broad based. The BoC sees persistent high inflation as a risk to the stability of medium-term inflation expectations, thus justifying tighter monetary policy. According the latest BoC Survey of Consumer Expectations, Canadians expect inflation to be 4.1% over the next two years and 3.5% over the next five years, both of which are above the BoC’s 1-3% inflation target band. So with a robust economy, tight labor market, inflation well above the BoC target and elevated consumer inflation expectations showing no signs of settling, why is the OIS curve discounting such a relatively low peak in the BoC policy rate? The answer lies with Canada’s housing bubble and the associated high household debt levels. In a recent Special Report, our colleagues at The Bank Credit Analyst estimated that the neutral rate in Canada was no higher than 1.75%- the previous peak in rates during the 2017-2018 tightening cycle. A big reason for that was the high level of Canadian household debt, which now sits at 180% of disposable income. This compares to the equivalent measure in the US of 124%, showing that unlike their southern neighbors, Canadian households had little appetite for deleveraging after the 2008 financial crisis (Chart 11). Chart 10Good Reasons For A More Aggressive BoC Good Reasons For A More Aggressive BoC Good Reasons For A More Aggressive BoC ​​​​​​ Chart 11A Big Reason For A Less Aggressive BoC A Big Reason For A Less Aggressive BoC A Big Reason For A Less Aggressive BoC ​​​​​​ Chart 12Position For Narrower Canada-US Bond Spreads Position For Narrower Canada-US Bond Spreads Position For Narrower Canada-US Bond Spreads The Bank Credit Analyst report estimated that if the BoC hiked rates to 2.5% over the next two years – just below the high end of the BoC neutral range – the Canadian household debt service ratio would climb to a new high of 15.5% (bottom panel). This would greatly restrict Canadian consumer spending and likely trigger a sharp pullback in both housing demand and real estate prices. The conclusion: the neutral interest rate in Canada is likely closer to the peak seen during the previous 2018/19 hiking cycle around 1.75%. We have been recommending an underweight stance on Canadian government bonds in global fixed income portfolios dating back to the spring of 2021. However, with markets now discounting a peak in rates within plausible estimates of neutral, the window for additional underperformance of Canadian government bonds may be closing - but not equally versus all developed economies. We have found that a useful leading indicator of 10-year cross-country government bond yield spreads is the differential between our 24-month discounters. The discounters measure the cumulative amount of short-term interest rate increases over the next two years priced into OIS curves. Currently the “discounter gaps” are signaling room for Canadian spread widening versus the UK and Japan and, to a lesser extent, core Europe (Chart 12). However, the discounter gap is pointing to significant potential for narrowing of the Canada-US 10-year spread over the next year (top panel). This would occur even if the BoC follows the Fed with rate hikes in 2022, as the Fed is likely to deliver more increases in 2023/24 than the BoC. This week, we are introducing two new recommended positions to benefit from narrower Canada-US government bond spreads: We are reducing the size of our underweight position in our model bond portfolio in half, offset by a reduction in the allocation to US Treasuries (see the table on page 13). We are introducing a new trade in our Tactical Overlay, going long Canadian 10-year government bond futures versus selling 10-year US Treasury futures on a duration-matched basis (the specific details of the trade can be found in the table on page 15) We are maintaining our cyclical underweight recommendation on Canada, in a global bond portfolio context, given the potential for Canadian yield spreads to widen versus core Europe, Japan and the UK. That underweight recommendation will be more concentrated versus countries relative to the US. Bottom Line: Markets are discounting a peak in interest rates at the low end of the Bank of Canada’s neutral range, which is reasonable given high household debt levels in Canada. This creates an opportunity for bond investors to go long Canadian government bonds versus US Treasuries.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The allocations to inflation-linked bonds shown in the model bond portfolio reflect both the recommended country weights and the recommended weighting of linkers versus nominal bonds within each country.  For example, we are neutral US TIPS versus nominal bonds within the US Treasury component of the portfolio, but since we are also underweight the US as a country allocation, the TIPS allocation is below the custom benchmark index weight. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark A Crude Awakening For Bond Investors A Crude Awakening For Bond Investors The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) A Crude Awakening For Bond Investors A Crude Awakening For Bond Investors Tactical Overlay Trades

Executive Summary US Can Do Without Russia's Oil, EU, NATO … Not So Much US Will Ban Russian Oil Imports US Will Ban Russian Oil Imports The US will ban Russian oil imports shortly.  This is not as big a deal markets had feared over the weekend, when news of a possible ban of Russian oil and refined products into the US and Europe was telegraphed by US officials, powering prices to $140/bbl.1 The US imported a combined 400k b/d of Russian crude oil and refined products in December 2021, the EIA reports, which accounted for less than 5% of the 8.6mm b/d of imports. Europe is another story.  Roughly 60% of Russia's 11.3mm b/d of crude oil and refined-products output goes to OECD Europe, according to the IEA. Russia considers Western sanctions to be on an equal footing with a declaration of war.2  President Putin has threatened a nuclear response if the West interferes with invasion of Ukraine, which could elicit a similar response from the West.3  US shale producers will be highly incentivized to increase output given high prices.  Our view continues to include a production increase from core OPEC 2.0 – Saudi Arabia, UAE and Kuwait.  We also anticipate a return of 1mm b/d from Iran, following a nuclear deal with the US. Bottom Line: We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to oil and gas producers via the XOP ETF. Footnotes 1     Please see Crude price jumps on talk of US oil ban as Russia steps up shelling of civilian areas, published by the Financial Times on March 6, 2022. 2     Please see Putin says Western sanctions are akin to declaration of war, published on March 5, 2022. 3    Please see How likely is the use of nuclear weapons by Russia?, published by Chatham House on March 1, 2022.  The report notes, " If Russia were to attack Ukraine with nuclear weapons, NATO countries would most likely respond on the grounds that the impact of nuclear weapons crosses borders and affects the countries surrounding Ukraine. NATO could respond either by using conventional forces on Russian strategic assets, or respond in kind using nuclear weapons as it has several options available."

Executive Summary A Perfect Metals Storm A Perfect Metals Storm A Perfect Metals Storm The bitter truth at the heart of the Ukraine conflict is that the constraints the US and Europe are willing to impose on Russia are not enough to deter it from completing its conquest of the eastern and coastal parts of the country and installing a puppet government in Kiev. The conflict will reduce the available supplies of oil and gas, base metals and grains. Increasing commodity costs will add to existing inflation pressures and threaten to aggravate slowing growth trends in Europe. However, we expect that the net effect in the US will be more inflationary than deflationary, as flush consumers are well positioned to withstand upward price pressure. BCA has turned tactically neutral on equities as it does not appear that stock markets have yet come to terms with the glum reality of the military campaign. We foresee increased near-term market turbulence as investors experience periodic episodes of panic in response to developments on the ground. We are making several moves to dial down the risk in our ETF portfolio for the time being. We plan to unwind the moves before too long to align the portfolio with our bullish 12-month view but are relieved to have adopted a more defensive position while financial markets digest the implications of the geopolitical shock. Bottom Line: Financial market moves seem to be lagging the course of events in Ukraine. We recommend that investors position more defensively until markets catch up. Feature Chart 1Extreme Volatility Extreme Volatility Extreme Volatility Ukraine has dominated the news since Russia invaded it a week and a half ago. The fighting has already triggered huge single-day swings in global financial markets with Russian equities falling nearly 40% the day the invasion began and rising 26% the next day before failing to open all of last week (Chart 1, top panel), western European sovereign 10-year bond yields falling by over six standard deviations across the board last Tuesday before retracing much of the move the next day (Chart 1, second panel) and Brent crude moving more than three standard deviations on several days (Chart 1, third panel). The S&P 500’s reversal from losing 3.5% in overnight futures markets to closing up 3% during the New York session on the day of the invasion is modest by comparison, as is the 10-year Treasury yield’s 2-3-standard deviation moves (Chart 1, bottom panel), though they show that the US is not immune. The inevitability that US markets and the US economy will be affected by events seven time zones away has led us to devote this week’s report to Ukraine and its potential consequences. This report is not meant to be the definitive guide to the conflict. It simply synthesizes the views expressed within BCA under the leadership of our Geopolitical Strategy team and adds our own thoughts about market implications and how investors in US markets might prepare to manage their way through the crisis. What’s The Endgame? BCA does not expect Russia to halt its offensive until Kiev is captured and Ukraine’s government is toppled. We therefore view any rallies on hopes for a negotiated settlement to be premature and vulnerable to subsequent reversals. Despite their stirring courage, resolve and pluck, the Ukrainians are massively outgunned and the ultimate military outcome is not in doubt. The cities that are under siege will fall unless Russian forces relent. No one within BCA imagines that Russia will relent until it achieves its aim of establishing a buffer between NATO forces and its own territory. It appears as if the only logical option for Russia’s Vladimir Putin is to proceed until Kiev has fallen. Now that he has already triggered nearly all the economic retaliation that the US and a surprisingly united Europe is likely to muster, there is very little reason not to complete his objective. As dispiriting as it is for humankind, conditions on the ground are likely to get worse. BCA’s base-case scenario is that the military campaign will continue until the coast and all the major cities east of the Dnieper River have succumbed (Map 1). At that point, we expect that the de facto political outcome will leave Russia in control of the eastern half of the country and its southern coast while the remnants of Ukraine’s democratically elected officials establish a new federal government in the country’s west. Once the political borders are redrawn, the active conquest can end. Russia will remain a pariah state, and heated rhetoric between Washington and Moscow and various European capitals and Moscow will wax and wane, but no party will have an incentive to disturb the fragile and uneasy equilibrium. Map 1Tightening The Noose Ukraine’s Grim Tidings Ukraine’s Grim Tidings We are saddened by the Ukrainian peoples’ grim plight. We are dismayed by the way that events have laid bare multilateral institutions’ weaknesses. We lament the clinical tone with which we are discussing events that involve extreme human suffering. As we’ve said before, albeit in more comfortable contexts, our job is bullish or bearish, not good or bad and not right or wrong. The coldly objective bottom line is that the US and Europe are unwilling to interpose their own troops or risk escalating tensions with the possessor of the world’s second largest nuclear arsenal over the integrity of Ukraine’s borders. The constraints they are willing to impose on Russia’s actions are insufficient to preserve Kiev and the other cities within its crosshairs. Economic And Market Implications The most immediate economic consequence will be a reduction in the supply of crude oil, natural gas, several base metals and wheat and corn. Russia is the world’s third-largest oil producer; second-largest natural gas producer; a major source of aluminum, copper and nickel; and Russia and Ukraine together account for one-seventh of global wheat and corn production. Banks and shipping companies are increasingly unwilling to finance and transport Russian exports and Ukraine’s ability to cultivate and ship crops will likely be limited by ground-level hazards and Russian control of its ports. Crop and metals prices will rise at least temporarily while alternatives to established trade flows are developed and energy prices could spike if either side cuts off flows between Russia and Europe. Increased energy prices are properly viewed as a tax on economic activity for oil importing economies and the 1973-74 Arab oil embargo’s contribution to the November 1973 to March 1975 recession and the grinding 1973-74 equity bear market loom large in American minds. There are two key distinctions between then and now, however. First, the American economy is far less energy intensive than it was in the early seventies (Chart 2). Second, now that the US is the world’s largest oil producer, rising oil prices lead to increased employment (Chart 3), greater income and marginally better credit performance, given that the energy sector is the plurality issuer of high-yield bonds. Higher oil prices are no longer unadulteratedly negative for the US economy. Chart 3... And Higher Prices Now Mean More Jobs ... And Higher Prices Now Mean More Jobs ... And Higher Prices Now Mean More Jobs Chart 2Oil Ain't What It Used To Be ... Oil Ain't What It Used To Be ... Oil Ain't What It Used To Be ... There is a threat, however, that rising commodity prices could push up long-run inflation expectations, forcing the Fed to take a harder line on rate hikes than it otherwise might. Although the 10-year Treasury yield fell last week, inflation expectations rose (Chart 4). Fortunately, American households are unusually well positioned to confront higher inflation, thanks to their modest debt burden, enormous savings cushion and robust pandemic wealth gains powered by advances in financial markets and home prices. We therefore expect that events in Ukraine will prove to be more inflationary than deflationary in the US, though risk-off moves may make it look like the economy is slowing in a worrisome way in the near term. Chart 4Longer-Run Inflation Expectations Have Perked Up Longer-Run Inflation Expectations Have Perked Up Longer-Run Inflation Expectations Have Perked Up From Investment Strategy … Though we are still constructive on financial markets and the economy, we expect that markets will be subject to downdrafts as investors come to terms with the likely course of events in Ukraine. Although our base-case scenario does not include an expansion of the conflict beyond Ukraine’s borders, financial markets will experience additional turbulence as they price in the non-zero probability that it might. Against that backdrop, we are tactically reducing risk in our ETF portfolio and recommend that investors follow suit. … To Portfolio Construction To reduce our near-term exposure to what our Global Investment Strategy colleagues describe as “panic events,” we are temporarily closing out our equity overweight. We are also reducing our cyclicals-over-defensives, value and small-cap positions as a further way of trimming the sails. We are directly investing in two sub-industry groups that will help protect the portfolio against lower interest rates and higher metals prices. To get our overall equity exposure down by 500 basis points (bps), we are reducing our four remaining equal weight sector exposures (Table 1). Table 1Tactical Equity Adjustments In The ETF Portfolio Ukraine’s Grim Tidings Ukraine’s Grim Tidings To reduce our cyclicals-over-defensives exposure, we are closing out the respective 160- and 100-bps overweights in Industrials (XLI) and Financials (XLF) while reducing our Consumer Staples (XLP) underweight by 230 bps. Those moves have the effect of reducing our net equity exposure by 30 bps. We are dialing back our Value (RPV) overweight by 250 bps to defend against the potential drag on the Financials-heavy position from lower interest rates and a flatter yield curve. We are trimming our small-cap exposure (IJR) by 100 bps. These moves free up 350 bps of capital. The potential for further war-inspired disruptions leads us to drill down from sectors to sub-industry groups to tailor exposure to homebuilders and miners of metals and alternative fuels. Consumer Discretionaries are rate-sensitive but homebuilders are hyper sensitive, as their customers typically finance 80 to 90% of their purchase price. Every penny of the group’s revenue is earned in the US, which is less exposed to Ukraine disruptions than Europe, Japan (which imports all of its oil and gas) and emerging markets (vulnerable to a rising dollar). Demand is robust (Chart 5), supply will remain limited and the group’s low P/E multiple stands out in a world with few cheap stocks. We are selling 100 bps of our overall sector exposure (XLY) to fund the targeted purchase of ITB, the ETF offering the purest play on homebuilders. We follow the same targeted-exposure playbook in zeroing out our overall Materials position (XLB) to initiate a 150-bps position in XME, a pure-play metals and mining ETF which our Commodity and Energy Strategy team recommends to profit from tight base metals markets (Chart 6). As a tactical move, we are effectively swapping exposure to chemicals, which use natural gas as a feedstock, for base metals, precious metals and coal and uranium. XLB is vulnerable to higher natural gas prices while XME would benefit from them, as well as from base metals supply interruptions and flight-to-safety demand for gold and silver. Given our commodity colleagues’ expectation that alternative energy ambitions will keep base metals well bid for an extended period, XME may remain in the portfolio after markets fully digest Ukraine implications. Chart 5The Homebuilding Outlook ##br##Is Bright The Homebuilding Outlook Is Bright The Homebuilding Outlook Is Bright Chart 6Metals Inventories Were Tight Before Russian Resources Went Offline Metals Inventories Were Tight Before Russian Resources Went Offline Metals Inventories Were Tight Before Russian Resources Went Offline The foregoing equity moves reduce our net holdings by 380 bps; we trim each of our four remaining equal weight positions – in Communication Services (XLC), Health Care (XLV), Real Estate (XLRE) and Tech (XLK) – by 30 bps to shed the remaining 120 bps needed to reset equities to equal weight to ride out temporary market turbulence. We also reduce our hybrid preferred stock position (VRP), as there’s less need for variable-rate protection if yields are going to decline and the preferred space may become more volatile as retail investors react to unsettling headlines. The 250-bps hybrid drawdown will be allocated to traditional fixed income, along with 250 bps of the equity sales proceeds, to bulk up our Treasury positions (SHY, IEI and IEF) in the proportion required to maintain benchmark duration (Appendix Table, shown at the back of the report). The remaining 250 bps raised by equity sales will be parked in cash to await an opportunity to re-risk the portfolio in line with our bullish cyclical view. Our relative equity sector positioning as of today is shown in Chart 7 and our relative fixed income positioning is shown in Chart 8. Chart 7Narrowing Our Sector Tilts Ukraine’s Grim Tidings Ukraine’s Grim Tidings Chart 8Shrinking Our Treasury Underweight Ukraine’s Grim Tidings Ukraine’s Grim Tidings   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Cyclical ETF Portfolio Ukraine’s Grim Tidings Ukraine’s Grim Tidings

Executive Summary Nuclear Worries Take Center Stage Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse Vladimir Putin has now committed himself to orchestrating a regime change in Kyiv. Anything less would be seen as a defeat for him. Assuming he succeeds, and it is far from obvious that he will, the resulting insurgency will drain Russian resources. Along with continued sanctions, this will lead to a further deterioration in Russian living standards and growing domestic discontent. If Putin concludes that he has no future, the risk is that he will decide that no one else should have a future either. Although there is a huge margin of error around any estimate, subjectively, we would assign an uncomfortably high 10% chance of a civilization-ending global nuclear war over the next 12 months. These odds place some credence on Brandon Carter’s highly controversial Doomsday Argument. Even if World War III is ultimately averted, markets could experience a freak-out moment over the next few weeks, similar to what happened at the outset of the pandemic. Google searches for nuclear war are already spiking. Despite the risk of nuclear war, it makes sense to stay constructive on stocks over the next 12 months. If an ICBM is heading your way, the size and composition of your portfolio becomes irrelevant. Thus, from a purely financial perspective, you should largely ignore existential risk, even if you do care about it greatly from a personal perspective. Bottom Line: The risk of Armageddon has risen dramatically. Stay bullish on stocks over a 12-month horizon. All In on Sanctions In the criminal justice system, there is a reason why the punishment for armed robbery is lower than for murder. If the punishment were the same, an armed robber would have a perverse incentive to kill his victim in order to better conceal his crime. The same logic applies, or at least used to apply, to geopolitics: You do not impose maximum sanctions from the get-go because that removes your ability to influence your enemy with the threat of further sanctions. Following Russia’s invasion of Ukraine, the West chose to go all in on sanctions, levying every type imaginable with the exception of those entailing a big cost to the West (such as cutting off Russian energy exports). Most notably, many Russian banks have been blocked from the SWIFT messaging system while the Russian central bank’s foreign exchange reserves have been frozen. Even FIFA has barred Russia from international competition, just weeks before it was set to participate in the qualifying rounds of the 2022 World Cup. At this point, there is not much more that can be done on the sanctions front. This leaves military intervention as the only avenue available to further pressure Russia. A growing chorus of Western pundits, some of whom could not have picked out Ukraine on a map two weeks ago, have begun clamoring for regime change… this time, in Moscow. As one might imagine, this is not something that sits well with Putin. Last week, he declared that “No matter who tries to stand in our way or … create threats for our country and our people, they must know that Russia will respond immediately, and the consequences will be such as you have never seen in your entire history.” To ensure there was no uncertainty about what he was talking about, he proceeded to place Russia’s nuclear forces on “special regime of combat duty.” Yes, It’s Possible The Putin regime has used nuclear weapons of a sort in the past. The FSB likely orchestrated the poisoning of Alexander Litvinenko with polonium-210 in 2006, leaving traces of the radioactive substance scattered in dozens of places across London. As former US presidential advisor and Putin biographer Fiona Hill said in a recent interview with Politico, “Every time you think, “No, he wouldn’t, would he?” Well, yes, he would.” Admittedly, there is a big difference between dropping polonium into a cup of tea at the Millennium hotel in Mayfair and dropping a 10-megaton nuclear bomb on London or any other major Western city. Still, if Putin feels that he has no future, he may try to take everyone down with him. The collapse in the ruble, and what is sure to be a major plunge of living standards across Russia, could foment internal opposition to Putin. A quiet retirement is not an option for him. Based on the latest exchange rates, Russia’s GDP is smaller than Mexico’s and barely higher than that of Illinois (Chart 1). While denying gas to Europe is a very real threat, it has a limited shelf life. Europe will aggressively build out infrastructure to process LNG imports. Chart 1Russia's Economic Power Has Faded Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse In a few years, the one viable weapon that Russia will have at its disposal is its nuclear arsenal. As Dutch historian Jolle Demmers has said, “It is precisely the decline and contraction of Russian power, coupled with the possession of nuclear weapons and a tormented repressive president, that poses great risks.” Some of the world’s most prominent strategic thinkers flagged these risks before the invasion, but with little effect. The Mother of All Risks In simulated war games, it is generally difficult to get participants to cross the nuclear threshold, but once they do, a full-blown nuclear exchange usually ensues.1 The idea of “limited” nuclear war is a mirage.  How high are the odds of such a full-blown war? I must confess that my own feelings on the matter are heavily colored by my writings on existential risk. As I argued in Section XII of my special report, “Life, Death, and Finance in the Cosmic Multiverse,” we are probably greatly understating existential risk, especially when we look prospectively into the future. Although there is a huge margin of error around any estimate, subjectively, we would assign an uncomfortably high 10% chance of a civilization-ending global nuclear war over the next 12 months. These odds place some credence on Brandon Carter’s highly controversial Doomsday argument (See Box 1). A Paradox for Investors For investors, existential risk represents a paradoxical concept. If an ICBM is heading your way, the question of whether you are overweight or underweight stocks would be pretty far down on your list of priorities. And even if you were inclined to think about your portfolio, how would you alter it? In a full-blown global nuclear war, most stocks would go to zero while governments would probably be forced to default or inflate away their debt. Gold might retain some value – provided that you kept it in your physical possession – but even then, you would still have trouble exchanging it for anything of value if nothing of value were available to purchase. This means that from a purely financial perspective, you should largely ignore existential risk, even if you do care greatly about it from a personal perspective. What, then, can we say about the current market environment? I touched on many of the key issues in Monday’s Special Alert, in which we tactically downgraded global equities from overweight to neutral. I encourage readers to consult that report for our latest market views. In the remainder of today’s report, allow me to elaborate on a couple of key themes. A Freak-Out Moment Is Coming Chart 2Nuclear Worries Take Center Stage Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse The market today reminds me of early 2020. We wrote a report on February 21 of that year entitled “Markets Too Complacent About The Coronavirus,” in which we noted that a full-blown pandemic “could lead to 20 million deaths worldwide,” and that “This would likely trigger a global downturn as deep as the Great Recession of 2008/09, with the only consolation being that the recovery would be much more rapid than the one following the financial crisis.” Many saw that report as alarmist, just as they saw our subsequent decision to upgrade stocks in March as cavalier.  Even if you knew in February 2020 that the S&P 500 would reach an all-time high later that year, you should have still shorted equities aggressively on a tactical basis. I feel the same way about the present. Google searches for nuclear war are spiking (Chart 2). A freak-out moment is coming, which will present a good buying opportunity for investors. Just to be on the safe side, I picked up a couple of bottles of Potassium Iodide earlier this week. When I checked the pharmacy again yesterday, all the bottles were sold out. They are now being hawked on Amazon for ten times the regular price. From Cold War to Hot Economy? The spike in commodity prices – especially energy prices – will have a negative near-term impact on global growth, while also limiting the ability of central banks to slow the pace of planned rate hikes (Chart 3). In general, inflation expectations and oil prices move together (Chart 4).   Chart 3Central Banks: Caught Between A Rock And A Hard Place Central Banks: Caught Between A Rock And A Hard Place Central Banks: Caught Between A Rock And A Hard Place   Chart 4Inflation Expectations And Oil Prices Go Hand-In-Hand Inflation Expectations And Oil Prices Go Hand-In-Hand Inflation Expectations And Oil Prices Go Hand-In-Hand Assuming the geopolitical situation stabilizes in a few months, oil prices should come down. The forward curve for oil is heavily backwardated now: The spot price for Brent is $111/bbl while the December 2022 price is $93/bbl (Chart 5). BCA’s commodity strategists expect the price of Brent oil to fall to $88/bbl by year-end. The decline in energy prices should provide some relief to global growth and risk assets in the back half of the year, which is one reason we are more constructive on equities over a 12-month horizon than a 3-month horizon. Looking out beyond the next year or two, the new cold war will lead to higher, not lower, interest rates. Increased spending on defense and alternative energy sources will prop up aggregate demand, especially in Europe where the need to diversify away from Russian gas is greatest. As Chart 6 shows, capex in the euro area cratered following the euro debt crisis. Capital spending via the Recovery Fund and other sources will rise significantly over the next few years. Chart 5The Brent Curve Is Heavily Backwardated Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse Chart 6European Capex Is Poised To Increase European Capex Is Poised To Increase European Capex Is Poised To Increase In addition, the shift to a multipolar world will expedite the retreat from globalization. Rising globalization was an important force restraining inflation – and interest rates – over the past few decades. Lastly, the ever-present danger of war could prompt households to reduce savings. It does not make sense to save for a rainy day if that day never arrives. Lower savings implies a higher equilibrium rate of interest. As we discussed in our recent report entitled “A Two-Stage Fed Tightening Cycle,” after raising rates modesty this year, the Fed will resume hiking rates towards the end of 2023 or in 2024, as it becomes clear that the neutral rate in nominal terms is closer to 3%-to-4% rather than the 2% that the market assumes. The secular bull market in equities will likely end at that point. In summary, equity investors should be somewhat cautious over the next three months, more optimistic over a 12-month horizon, but more cautious again over a longer-term horizon of 2-to-5 years. Box 1The Doomsday Argument In A Nutshell Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1     For example, an article from the Center for Arms Control and Non-Proliferation discusses a Reagan administration war game called “Proud Prophet,” an exercise the Americans hatched to test the theory of limited nuclear strikes. The result of this exercise was that the “Soviet Union perceived even a low-yield nuclear strike as an attack, and responded with a massive missile salvo.” Global Investment Strategy View Matrix Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse Special Trade Recommendations Current MacroQuant Model Scores Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse

Executive Summary Chinese Onshore Stocks Are Less Impacted By External Factors Upgrading Chinese Onshore Stocks To Neutral Upgrading Chinese Onshore Stocks To Neutral We are upgrading Chinese onshore stocks from underweight to neutral relative to global stocks. At the same time, we are closing our tactical trade of long Chinese investable stocks/short global stocks. In the near term, Russia’s armed invasion of Ukraine will spark a further selloff in global risk assets. Volatility in Chinese onshore stock prices will remain high; A-share prices in absolute terms may also drop but should fall by less than their peers in European and emerging markets. On the other hand, Chinese offshore stocks are more vulnerable to geopolitical risks compared with their onshore counterparts. There are tentative signs that home prices may be stabilizing, although demand for housing remains in deep contraction. Chinese policymakers remain vigilant in preventing the property market from overheating and credit creation from overshooting. However, the ongoing Russia/Ukraine incursion has the potential to catalyze a larger stimulus package in China. If the escalating geopolitical crisis threatens the global economy, China’s authorities will likely strengthen policy supports at home to buttress the country’s domestic political, economic and financial conditions. Bottom Line: Chinese onshore stocks will weather the ongoing geopolitical storm better than their offshore and global peers. China’s economy is also less negatively impacted by the Russia/Ukraine hostilities. If the crisis deepens, China’s leadership will likely step up measures to support its economy and ensure stable domestic financial and political dynamics. Feature The conflict between Russia and Ukraine unnerved global financial markets in the past few weeks. Chinese offshore stocks were not insulated from the geopolitical event; the MSCI China Index declined by about 4% in February, in-line with the selloff in global stocks. Chart 1Chinese Onshore Financial Markets Held Up Relatively Well Last Month Chinese Onshore Financial Markets Held Up Relatively Well Last Month Chinese Onshore Financial Markets Held Up Relatively Well Last Month The current global geopolitical environment, however, has turned us a bit more positive on Chinese onshore stocks in relative terms. In the near term, the onshore market should hold up better than its offshore and European counterparts. China’s closed capital market prevents panic capital outflows and its large current account surplus as well as favorable real interest rate differentials help to maintain strength in the RMB (Chart 1). On a cyclical basis, China’s domestic economic fundamentals will continue to drive prices in the A-share market. China’s aggregate economy is less affected by the Russia/Ukraine conflict than Europe. Energy supplies from Russia to China will likely continue and may even accelerate, mitigating the risks of energy shock-induced inflation spikes. As such, we are upgrading Chinese onshore stocks from underweight to neutral in a global portfolio, both in tactical and cyclical time horizons. We remain cautious about the size of Chinese stimulus for the year and, therefore, are neutral in our cyclical view on Chinese onshore stocks relative to global equities. Despite some nascent signs of reflation and an easing of housing policy in a few Chinese cities, aggregate property demand remains weak and overall policy easing in the sector has been marginal. Nonetheless, the situation surrounding Ukraine and the global sanctions against Russia are highly fluid and may provide some ground for Chinese policymakers to ramp up stimulus at home. If the conflict intensifies and derails the European/global economy, Beijing will be more inclined to adopt measures to ensure the stability of its domestic economy, financial markets and political dynamics. Meanwhile, we are closing our long MSCI China/short MSCI global tactical trade. Chinese offshore stocks are more vulnerable to geopolitical tensions and risk-off sentiment among global investors. The Russia Incursion Has Limited Direct Impact On China’s Economy Chinese stocks were not immune last week to the global financial market’s gyrations triggered by Russia’s invasion of Ukraine. While Russia’s attack on its neighbor will create short-term disruptions on the prices of global commodities and China’s A-shares, the cyclical performance of Chinese onshore stocks is tied to the country’s domestic economic fundamentals. The military conflict between Russia and Ukraine should have a limited knock-on effect on China’s business cycle dynamics for the following reasons: Russia and Ukraine together account for less than 3% of Chinese total exports as of 2021, limiting the negative impact from reduced demand in the region on China’s current account balance.  Chart 2Ukraine: China’s Major Source Of Agricultural Commodity Supplies Upgrading Chinese Onshore Stocks To Neutral Upgrading Chinese Onshore Stocks To Neutral Russia’s incursion of Ukraine may have consequences on China’s food prices. Ukraine is a major agricultural commodity exporter to China, hence a prolonged military conflict may disrupt agricultural supplies and push up imported food prices in China (Chart 2). In this scenario, we expect that Beijing will provide subsidies to ease pressures on domestic food prices due to supply shocks, rather than tighten monetary policy to reduce demand. China is unlikely to experience shocks linked to possible energy disruptions. Russia is a core exporter of energy to China and supplies of crude oil, natural gas and coal have increased in recent years (Chart 3). We do not expect that Russia’s energy supply to China will be disrupted. Indeed, following the 2014 Russia’s invasion of Crimea, Russia’s crude oil exports to China increased by 40% (Chart 3, top panel). We anticipate that oil prices will fall from the current level in the second half of the year, limiting the upshot from higher oil prices on Chinese inflation. So far, the US and EU have announced tough sanctions on Russia’s non-energy sectors, but they have avoided halting Russia’s energy exports. ​​​​​​​In the unlikely scenario that energy flows from Russia to Europe are disrupted in any meaningful and long-lasting way, either through European sanctions or a Russian embargo, Russia would probably turn to China to absorb its energy exports. Given that Russia cannot easily replace Europe with any other alternative market, particularly natural gas, China would gain an upper hand in price negotiations with the Russians (Chart 4). Thus, a steady supply of cheap natural gas and other forms of energy would be a net positive for China’s economy. Chart 4Russia Cannot Easily Replace Europe With Any Alternative Consumer Other Than China Upgrading Chinese Onshore Stocks To Neutral Upgrading Chinese Onshore Stocks To Neutral Chart 3Russia's Ties With China On Energy Supplies Will Likely Strengthen Russia's Ties With China On Energy Supplies Will Likely Strengthen Russia's Ties With China On Energy Supplies Will Likely Strengthen Meanwhile, oil’s current price spike may widen the gap in profits between China’s upstream and downstream industrial enterprises (Chart 5). However, the effect from higher oil prices on Chinese downstream manufacturers should be temporary. Our Commodity and Energy Strategists believe that the Russian invasion will prompt increased production from core OPEC producers. These production increases would reduce prices from last week’s $105 per barrel level to $85 per barrel by the second half of 2022 and keep it at that level throughout 2023 (Chart 6). Chart 6Crude Oil Price Risk Premium Will Abate But Not Disappear Crude Oil Price Risk Premium Will Abate But Not Disappear Crude Oil Price Risk Premium Will Abate But Not Disappear Chart 5Rising Oil Prices May Temporarily Widen Profit Gaps Between China's Up- And Downstream Industries Rising Oil Prices May Temporarily Widen Profit Gaps Between China's Up- And Downstream Industries Rising Oil Prices May Temporarily Widen Profit Gaps Between China's Up- And Downstream Industries Bottom Line: Russia’s invasion of Ukraine should have a limited direct impact on China’s domestic economy, inflation and monetary policy. Tentative Signs Of Home Price Stabilization Although the property market is showing some signs of improvement, the aggregate demand for homes remains very sluggish. Recently released housing data in China show some slight progress, as fewer cities reported a month-on-month drop in new home prices in January (Chart 7). The monthly average new home prices among China’s 70 cities were broadly flat last month following four consecutive months of falling prices. Tier 1 and Tier 2 cities had the largest increases in home prices, whereas prices in other regions continued to contract through January, albeit to a lesser degree (Chart 7, bottom panel). The minor improvement in home prices reflects recently implemented measures to help shore up the flagging market. Last month, the PBoC cut the policy rate by 10 bps and reduced the one- and five-year loan prime rates by 10 bps and 5 bps, respectively. Moreover, last week several regional banks lowered the down payments on mortgages for homebuyers. Chart 8...Demand For Housing Remains In Deep Contraction ...Demand For Housing Remains In Deep Contraction ...Demand For Housing Remains In Deep Contraction Chart 7Although There Are Some Early Signs Of Stabilization In Home Prices... Although There Are Some Early Signs Of Stabilization In Home Prices... Although There Are Some Early Signs Of Stabilization In Home Prices... Nonetheless, the aggregate demand for housing remains weak. China’s 100 largest developers experienced a roughly 40% year-on-year plunge in total sales in January, indicating that recent easing measures failed to revive the downbeat sentiment among homebuyers (Chart 8). Bottom Line: Policymakers will remain vigilant in not inducing another surge in house prices and will continue to target steady home prices. As such, it is too early to upgrade our cyclical view on China’s property market, stimulus and economic recovery. Investment Conclusions We are upgrading Chinese onshore stocks to neutral relative to global equities (both tactically and in the next 6 to 12 months), while closing our tactical trade of long MSCI China/short MSCI global index. Chart 9Chinese Onshore Stock Prices Are Largely Driven By Domestic Rather Than External Factors... Chinese Onshore Stock Prices Are Largely Driven By Domestic Rather Than External Factors... Chinese Onshore Stock Prices Are Largely Driven By Domestic Rather Than External Factors... Given the limited impact of the Russia/Ukraine conflict on China’s domestic economy and the low correlation to the global equity index, Chinese onshore stock prices may also fall in absolute terms in the coming weeks, but not by as much as their offshore and European counterparts (Chart 9). Furthermore, while we maintain a cautious cyclical outlook for China’s stimulus, the ongoing geopolitical crisis has the potential to provide a catalyst for Chinese policymakers to stimulate the domestic economy more forcefully. If the clash evolves into a real risk to the European economy and global financial markets, odds are high that Chinese policymakers will step up stimulus measures to ensure domestic stability. In this scenario, Chinese onshore stocks will likely outperform global equities. In the past, Chinese authorities refrained from a credit overshoot when the business cycle slowed in an orderly manner, but they stimulated substantially following an exogenous shock. For example, China rolled out massive stimulus packages after the 2008 Global Financial and the 2011/12 European credit crises. Beijing did not directly respond to Russia’s 2014 annexation of Crimea with additional monetary support to China’s domestic economy. However, the Chinese authorities started to aggressively stimulate when a collapse in domestic demand coincided with a global manufacturing recession in 2015. Chart 10...Whereas Chinese Offshore Stocks Are More Vulnerable To Global Risk-Off Sentiment ...Whereas Chinese Offshore Stocks Are More Vulnerable To Global Risk-Off Sentiment ...Whereas Chinese Offshore Stocks Are More Vulnerable To Global Risk-Off Sentiment The PBoC’s outsized liquidity injection in the interbank system last Friday is also a sign that Beijing is willing to accelerate policy easing if the geopolitical backdrop meaningfully worsens.  Regarding Chinese investable stocks, we maintain our cyclical underweight stance relative to global equities. In the near term, risk-off sentiment among global investors will undermine the performance of Chinese offshore stocks in both absolute and relative terms (Chart 10). Over a longer time horizon (6 to 12 months), growth stocks will likely underperform value stocks when global stocks recover. Thus, the tech-heavy MSCI China Index is less attractive to investors compared with other emerging and developed market equities that are more value-centric. Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations

Executive Summary Wars Don’t Usually Affect Markets For Long Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested We expect the war in Ukraine to stay within its borders, and therefore to have little impact on global growth. Markets will be volatile, but we recommend allocators stay invested – with some moderate hedges in place. The Fed won’t tighten as fast as markets expect, and US long rates will not rise much further this year. So, within fixed-income, we raise government bonds to neutral. Flat rates remove a positive for the Financials equity sector, which we lower to neutral. The oil price will fall back to $85 by the second half, as Saudi and others increase supply. We reduce our recommendation for Canadian equities and the CAD. Recommendation Changes Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested Bottom Line: Stay invested in risk assets, but have some hedges. We shift from Financials to the defensive-growth IT sector, raise our weight in UK equities, and suggest long positions in cash, CHF and JPY.   Recommended Allocation Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested The war in Ukraine is likely to have only a limited impact on markets beyond the short term. As disturbing as the human tragedy is, Russia’s aims are limited to regime change in Kyiv. The European Union and US face restraints on how draconian sanctions against Russia can be, balking (so far at least) at blocking imports of Russian energy to the EU, given how much this would hurt the economy. The risk of the conflict spreading beyond Ukraine’s borders is low, limited perhaps to cyberattacks on Western targets. A Russian attack on a NATO member, such as Poland or one of the Baltic states, is extraordinarily unlikely – though Moldova and Georgia (not NATO members) might be more vulnerable at some point in the future. For more detailed analysis, please read the two reports on the Ukraine situation by our Geopolitical Service that we have made available to all BCA Research subscribers.1 Asset allocators need to look at these events dispassionately. Markets are likely to remain volatile over the coming months, as events in Ukraine unfold. But the lesson of most major conflicts is that they typically do not have a long-lasting impact on asset performance (Chart 1). There is little chance that the Ukraine war will significantly dent global growth. The only exception would be if the oil price were to rise much further to, say, $120 a barrel as some are forecasting. Certainly, in the past, a jump in the oil price has often been associated with recessions – even though the causality is unclear (Chart 2). But BCA’s Energy strategists expect to see an increase in oil supply by Saudi Arabia and Gulf states which will bring Brent crude back to $85 by the second half (from $98 now). Chart 1Wars Don't Usually Affect Markets For Long Wars Don't Usually Affect Markets For Long Wars Don't Usually Affect Markets For Long Chart 2But A Jump In Oil Prices Would But A Jump In Oil Prices Would But A Jump In Oil Prices Would Meanwhile, global growth remains robust, with all major economies expected to continue to grow well above trend this year, supported by robust consumption and capex (Chart 3). And sentiment towards equities has turned very pessimistic since the start of the year, with indicators such the US Association of Individual Investors’ weekly survey at its most bearish level since 2008 (Chart 4). These sort of sentiment levels have typically pointed to a rebound in risk assets. Chart 4Sentiment Is At Rock-Bottom Sentiment Is At Rock-Bottom Sentiment Is At Rock-Bottom Chart 3Economic Growth Still Above Trend Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested         Our advice now would be to stay invested, but with some moderate safe-haven hedges in place – largely as we have recommended since late last year. We continue to recommend an overweight in cash, but will look to allocate this to risk assets when it becomes clearer how the situation in Ukraine will pan out. The trajectory of markets over the rest of this year still largely comes down to what the Fed and other central banks will do. The hawkish turn by the Fed in December has been the driver of markets in the past two months, with the result that none of the major asset classes have produced positive returns year to-date – only inflation hedges such as commodities and gold (Chart 5). Chart 5Most Asset Classes Are Down Year-To-Date Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested The futures market is pricing the Fed to raise rates seven times over the next 12 months, the fastest rate of predicted tightening since the early 2000s (Chart 6). We think that is a little excessive. Inflation, as we have argued previously, is likely to fade over the coming quarters, as the supply response to strong consumer demand for manufactured goods brings down the price of cars, semiconductors, shipping and other major items. The Fed may well start in March with the intention of raising rates by 25bps every meeting, but the slowing of inflation we expect, and the tightening of financial conditions already under way (Chart 7), make it unlikely that it will continue at that pace. And remember that Fed policy will need to be even more hawkish than the market is currently pricing in for it to have an incrementally negative impact on risk assets. Chart 6Market Believes Fed Will Hike Fast Market Believes Fed Will Hike Fast Market Believes Fed Will Hike Fast Chart 7Financial Conditions Have Already Tightened Financial Conditions Have Already Tightened Financial Conditions Have Already Tightened There are certainly risks to this scenario. The forward yield curve is pointing to inversion one year ahead, something which normally presages recession over the following 1-3 years (Chart 8). Higher prices are starting to hurt consumer confidence, though there is a big disparity between the two main US indicators (Chart 9). Chart 8Will Yield Curve Invert Within A Year? Will Yield Curve Invert Within A Year? Will Yield Curve Invert Within A Year? Chart 9Inflation May Be Hurting Consumer Confidence Inflation May Be Hurting Consumer Confidence Inflation May Be Hurting Consumer Confidence What all this boils down to is how high a level of interest rates the economy is able to withstand. The futures markets imply that, in most countries, central banks will raise rates aggressively this year, but then be forced to stop or even cut rates after that because their actions cause an economic slowdown (Table 1). Our view is that the terminal rate is much higher than what is priced by markets and projected by central banks: In the US perhaps 3-4% in nominal terms.2 Even with seven Fed hikes over the next year, the policy rate would therefore remain well below neutral – an environment in which historically equities have outperformed bonds (Chart 10). Table 1Central Banks Will Hike Aggressively – But Then Stop Soon Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested Chart 10Even In A Year, Rates Will Be Well Below Neutral Even In A Year, Rates Will Be Well Below Neutral Even In A Year, Rates Will Be Well Below Neutral One final comment: On long-term returns. As a result of the recent moderate equity correction, strong earnings growth, and higher long-term rates, the outlook is somewhat rosier than when we published our most recent report on Return Assumptions in May 2021 – though admittedly forward long-term returns are still likely to be lower than over the past 20 years (Table 2). This is not, then, a time to turn defensive. Table 2Long-Term Return Outlook No Longer Looks So Gloomy Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested Fixed Income: In the short-term, government bonds look oversold (Chart 11). With inflation set to peak and the Fed likely to be less hawkish than the market has priced in, we do not see the 10-year US Treasury yield rising more than another 25 basis points or so above its current level this year. Accordingly, we are changing our duration call from underweight to neutral, and raise our recommendation for government bonds within the (still underweight) fixed-income bucket to neutral. For more cautious investors, a slight increase in government bond holdings might be warranted. Within credit, investment-grade bonds still offer little pickup, despite the moderate rise in spreads this year (from 92 to 121 in the US, for example), and so we lower this asset class to underweight. We continue to prefer high-yield bonds, which in the US now imply a jump in the default rate from 1.2% over the past 12 months to 4.5% over the coming year (Chart 12). As long as the economy grows in line with our expectations, that is very unlikely. Chart 11Government Bonds Look Oversold Government Bonds Look Oversold Government Bonds Look Oversold Chart 12Will Defaults Really Jump This Much? Will Defaults Really Jump This Much? Will Defaults Really Jump This Much?   Equities: With the economy continuing to grow above-trend, global earnings should remain robust. This will not be a classic year for equity returns, but we expect them to do better than bonds. We continue to prefer US over European equities. As was seen in the aftermath of the invasion of Ukraine, US stocks are more defensive, and European growth will continue to be under threat from higher energy prices (Chart 13). We also move our recommended portfolio a little in the defensive direction by going overweight UK equities (which have a particularly high weight in defensive growth sectors, such as a 13 point overweight in Consumer Staples); we fund this by lowering Canadian equities to underweight, given their close linkage with oil (Chart 14), and the vulnerability of the Canadian housing market to rising rates. We remain underweight EM, but Chinese stocks (which were very oversold in late 2021) have been a relative safe haven as China started to stimulate, and so we continue with our neutral position for now. Chart 13Higher Energy Prices Threaten Europe Higher Energy Prices Threaten Europe Higher Energy Prices Threaten Europe Chart 14Canadian Stocks Move With The Oil Price Canadian Stocks Move With The Oil Price Canadian Stocks Move With The Oil Price Chart 15Financials Not So Attractive If Rates Don't Rise Financials Not So Attractive If Rates Don't Rise Financials Not So Attractive If Rates Don't Rise Our view that long-term rates have limited upside this year makes us more cautious on Financials stocks, which are closely correlated with rates, and so we cut this sector to neutral (Chart 15). A period of slowing growth points towards a preference for defensive growth, and so we raise our recommended weight in the IT sector to overweight from neutral. It is tempting to think of this sector as being composed of ridiculously overvalued speculative internet names, but it is in fact dominated by established hardware and software titans with deep competitive moats (Table 3). While the sector is not exactly cheap, its risk premium over bonds is quite reasonable by historical standards (Chart 16).   Table 3Tech Sector Is Not Made Up Of Speculative Stocks Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested Chart 16Tech Is Not Unreasonably Priced Tech Is Not Unreasonably Priced Tech Is Not Unreasonably Priced Chart 17Relative Rates Suggest Some Upward Pressure On USD Relative Rates Suggest Some Upward Pressure On USD Relative Rates Suggest Some Upward Pressure On USD Currencies: A neutral position on the US dollar still makes sense. Short-term rates are likely to rise somewhat faster in the US, relative to expectations, than in Europe or Japan (Chart 17). Nevertheless, the USD is expensive, and long-dollar is a consensus trade – reasons why the dollar has risen by less than 1% year-to-date on a trade-weighted basis, despite all the higher rate expectations and geopolitical shocks. Investors looking for hedges against downside risk might look to the Japanese yen, which is particularly cheap, and the Swiss franc. By contrast, the Canadian dollar, like Canadian equities, is closely linked to the oil price and a fallback in the Brent price would be negative; we move underweight. We also raise the CNY to neutral, since it may become a safe haven currency in the current geopolitical situation, though the Chinese authorities won’t let it rise too much since that would slow the economy. Commodities: China’s stimulus remains somewhat halfhearted (Chart 18). Although the credit and fiscal impulse has bottomed, we expect to see it rebound only moderately, with just minor cuts in interest rates and the reserve ratio. This will stabilize Chinese growth, but not cause a boom as in 2020, 2016 or 2013. The rise in industrial commodities prices, therefore, is likely to be limited from here. For oil, as mentioned above, we expect to see Brent crude return to around $85 by the second half, as new supply comes onto the market. Gold has done well, as expected, in the face of a major geopolitical event. But it is expensive by historical standards, vulnerable to a rise in real (as opposed to nominal rates) as inflation eases (Chart 19), and faces cryptocurrencies as a rival. We keep our neutral, as a hedge against the tail-risk of much higher inflation, but would not chase the price at this level. Chart 18China's Stimulus Isn't Enough To Help Metals Prices China's Stimulus Isn't Enough To Help Metals Prices China's Stimulus Isn't Enough To Help Metals Prices Chart 19Rising Real Rates Are Negative For Gold Rising Real Rates Are Negative For Gold Rising Real Rates Are Negative For Gold Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Footnotes 1     Please see Geopolitical Strategy Special Reports, “Russia Takes Ukraine: What Next?” dated February 24, 2022, and "From Nixon-Mao To Putin-Xi," dated February 25, 2022. 2     Please see Global Investment Strategy, “The New Neutral” dated January 14, 2022.   Recommended Asset Allocation Model Portfolio (USD Terms)