Commodities & Energy Sector

Special Report

Executive Summary From Nixon-Mao To Putin-Xi The geopolitical “big picture” of Russia’s invasion of Ukraine is the deepening of the Russo-Chinese strategic partnership. While Russia’s economic and military constraints did not prohibit military action in Ukraine, they are still relevant. Most likely they will prevent a broader war with NATO or a total energy embargo of Europe. Still, volatility will persist in the near term as saber-rattling, aftershocks, and spillover incidents will occur this year.  Russo-Chinese relations are well grounded. Russia needs investment capital and resource sales, while China needs overland supply routes and supply security. Both seek to undermine the US in a new game of Great Power competition that will prevent global politics and globalization from normalizing. Tactically we remain defensive but buying opportunities are emerging. We maintain a cyclically constructive view. Favor equity markets of US allies and partners that are geopolitically secure. Trade Recommendation Inception Date Return Long Gold (Strategic) 2019-12-06 32.7% Bottom Line: Tactically investors should remain defensive but cyclically they should look favorably on cheap, geopolitically secure equity markets like those of Australia, Canada, and Mexico. Feature To understand the Russian invasion of Ukraine and the likely consequences, investors need to consider three factors: 1.  Why Russia’s constraints did not prohibit war and how constraints must always be measured against political will. 2.  Why Russia’s constraints will grow more relevant going forward, as the costs of occupation and sanctions take hold, the economy weakens, and sociopolitical pressures build. 3.  Why the struggle of the Great Powers will drive a Russo-Chinese alliance, whose competition with the US-led alliance will further destabilize global trade and investment. Russia’s Geopolitical Will Perhaps the gravest national security threat that Russia can face, according to Russian history, is a western military power based in the Ukraine. Time and again Russia has staged dramatic national efforts at great cost of blood and treasure to defeat western forces that try to encroach on this broad, flat road to Moscow. Putin has been in power for 22 years and his national strategy is well-defined: he aims to resurrect Russian primacy within the former Soviet Union, carve out a regional sphere of influence, and reduce American military threats in Russia’s periphery. He has long aimed to prevent Ukraine from becoming a western defense partner. Chart 1Russia Structured For Conflict While Moscow faced material limitations to military action in Ukraine, these were not prohibitive, as we have argued. Consider the following constraints and their mitigating factors: Costs of war: The first mistake lay in assuming that Russia was not willing to engage in war. Russia had already invaded Ukraine in 2014 and before that Georgia in 2008. The modern Russian economy is structured for conflict: it is heavily militarized (Chart 1). Military spending accounts for 4.3% of GDP, comparable to the United States, also known for waging gratuitous wars and preemptive invasions. Financial burdens: The second mistake was to think that Moscow would avoid conflict for fear of the collapse of the ruble or financial markets. Since Putin rose to power in 2000, the ruble has depreciated by 48% against the dollar and the benchmark stock index has fallen by 57% against EMs. Each new crackdown on domestic or foreign enemies has led to a new round of depreciation and yet Putin remains undeterred from his long-term strategy (Chart 2). Chart 2Putin Doesn't Eschew Conflict For Sake Of Ruble Or Stocks Economic health: Putin’s foreign policy is not constrained by the desire to make the Russian economy more open, complex, advanced, or productive. While China long practiced a foreign policy of lying low, so as to focus on generating wealth that could later be converted into strategic power (which it is doing now), Russia pursued a hawkish foreign policy for the past twenty years despite the blowback on the economy. Russia is still an undiversified petro-state and total factor productivity is approaching zero (Chart 3). Chart 3Putin Doesn't Eschew Conflict For Sake Of Productivity​​​​​​ Chart 4Putin Doesn’t Eschew Conflict For Fear Of Sanctions​​​​​​ Western sanctions: Western sanctions never provided a powerful argument against Russian intervention into Ukraine. Russia knew all along that if it invaded Ukraine, the West would impose a new round of sanctions, as it has done periodically since 2014. The 2014 oil crash had a much greater impact on Russia than the sanctions. Of course, Russia’s overall economic competitiveness is suffering, although it is capable of gaining market share in exporting raw materials, especially as it depreciates its currency (Chart 4). Chart 5Putin Doesn't Eschew Conflict For Sake Of Popular Opinion Public opinion: Surely the average Russian is not interested in Ukraine and hence Putin lacks popular support for a new war? True. But Putin has a strong record of using foreign military adventures as a means of propping up domestic support. Of course, opinion polls, which confirm this pattern, are manipulated and massaged (Chart 5). Nevertheless Russians like all people are highly likely to side with their own country in a military confrontation with foreign countries, at least in the short run. Over the long haul, the public will come to rue the war. Moscow believes that it can manage the domestic fallout when that time comes because it has done so since 2014. We doubt it but that is a question for a later time. Investors also need to consider Putin’s position if he did not stage ever-escalating confrontations with the West. Russia is an autocracy with a weak economy – it cannot win over the hearts and minds of its neighboring nations in a fair, voluntary competition with the West, the EU, and NATO. Russia’s neighbors are made up of formerly repressed Soviet ethnic minorities who now have a chance at national self-determination. But to secure their nationhood, they need economic and military support, and if they receive that support, then they inherently threaten Russia and help the US keep Russia strategically contained. Russia traditionally fights against this risk. Bottom Line: Investors and the media focused on the obstacles to Russian military intervention without analyzing whether there was sufficient political will to surmount the hurdles. Constraints Eroded None of the above suggests that Putin can do whatever he wants. Economic and military constraints are significant. However, constraints erode over time – and they may not be effective when needed. Europe did not promise to cancel all energy trade if Russia invaded: Exports make up 27% of Russian GDP, and 51% of exports go to advanced economies, especially European. Russia is less exposed to trade than the EU but more exposed than the US or even China (Chart 6). However, Russia trades in essential goods, natural resources, and the Europeans cannot afford to cut off their own energy supply. When Russia first invaded Ukraine in 2014, the Germans responded by building the Nord Stream pipeline, basically increasing energy cooperation. Russia concluded that Europeans, not bound to defend Ukraine by any treaty, would continue to import energy in the event of a conflict limited to Ukraine. Chart 6Putin Limits Conflict For Sake Of EU Energy Trade​​​​​​ Chart 7Putin Limits Conflict For Sake Of Chinese Trade​​​​​​ Russia substitutes China for Europe: As trade with the West declines, Russia is shifting toward the Far East, especially China (Chart 7). China is unlikely to reduce any trade and investment for the sake of Ukraine – it desperately needs the resources and the import-security that strong relations with Russia can provide. It cannot replace Europe – but Russia does not expect to lose the European energy trade entirely. (Over time, of course, the EU/China shift to renewables will undermine Russia’s economy and capabilities.) Ukraine is right next door: Aside from active military personnel, the US advantage over Iraq in 2002-03 was greater than the Russian advantage over Ukraine in 2022 (Chart 8). And yet the US got sucked into a quagmire and ultimately suffered political unrest at home. However, Ukraine is not Afghanistan or Iraq. Russia wagers that it can seize strategic territory, including Kiev, without paying the full price that the Soviets paid in Afghanistan and the US paid in Afghanistan and Iraq. This is a very risky gamble. But the point is that the bar to invading Ukraine was lower than that of other recent invasions – it is not on the opposite side of the world. ​​​​​​​Chart 8Putin Limits Conflict For Fear Of Military Overreach Chart 9Putin Limits Conflict For Fear Of Military Weakness NATO faces mutually assured destruction: NATO’s conventional military weight far surpasses Russia’s. For example, Russia, with its Eurasian Union, does not have enough air superiority to engage in offensive initiatives against Europe, even assuming that the United States is not involved. Even if we assume that China joins Russia in a full-fledged military alliance under the Shanghai Cooperation Organization (SCO), NATO’s military budget is more than twice as large (Chart 9). However, this military constraint is not operable in the case of Ukraine, which is not a NATO member. Indeed, Russia’s aggression toward Ukraine stems from its fear that Ukraine will become a real or de facto member of NATO. It is the fear of NATO that prompted Russia to attack rather than deterring it, precisely because Ukraine was not a member but wanted to join. Bottom Line: Russia’s constraints did not prohibit military action because several of them had eroded over time. NATO was so threatening as to provoke rather than deter military action. Going forward, Russia’s economic and military constraints will prevent it from expanding the war beyond Ukraine.  Isn’t Russia Overreaching? Yes, Russia is overreaching – the military balances highlighted in Charts 8 and 9 above should make that plain. The Ukrainian insurgency will be fierce and Russia will pay steep costs in occupation and economic sanctions. These will vitiate the economy and popular support for Putin’s regime over the long run. Chart 10The West Is Politically Divided And Vulnerable The West is also vulnerable, however, which has given rise to a fiscal and commodity cycle that helps to explain why Putin staged his risky invasion at this juncture in time: The US and West are politically divided. Western elites see themselves as surrounded by radical parties that threaten to throw them out and overturn the entire political establishment. Their tenuous grip on power is clear from the thin majorities they hold in their legislatures (Chart 10). Nowhere is this clearer than in the United States, where Democrats cannot spare a single seat in the Senate, five in the House of Representatives, in this fall’s midterm elections, yet are facing much bigger losses. Russia believes that its hawkish foreign policy can keep the democracies divided.​​​​​​​ Elites are turning to populist spending: Governments have adopted liberal fiscal policies in the wake of the global financial crisis and the pandemic. They are trying to grow their way out of populist unrest, debt, and various strategic challenges, from supply chains to cyber security to research and development (Chart 11). China is also part of this process, despite its mixed economic policies. The result is greater demand for commodities, which benefits Russia.    Elites are turning to climate change to justify public spending: Governments, particularly in Europe and China, are using fears of climate change to increase their political legitimacy and launch a new government “moonshot” that justifies more robust public investment and pump-priming. The long-term trend toward renewable energy is fundamentally threatening to Russia, although in the short term it makes Russian natural gas and metals all the more necessary. Germany especially envisions natural gas as the fossil-fuel bridge to a green future as it has turned against both nuclear power and coal (Chart 12). Russian aggression will provoke a rethink in some countries but Germany, as a manufacturing economy, is unlikely to abandon its goals for green industrial innovation. Chart 11Politically Vulnerable States Need Fiscal Stimulus​​​​​​ Chart 12The West Reluctant To Abandon Climate Goals​​​​​​ Proactive fiscal and climate policy motivate new capex and commodity cycle: The West’s attempt to revive big government and strategic spending will require vast resource inputs – resources that Russia can sell at higher prices. The new commodity cycle gives Russia maximum leverage over Europe, especially Germany, at this point in time (Chart 13). Later, as inflation and fiscal fatigue halt this cycle, Russia will lose leverage. Chart 13Commodity Cycle Gives Russia Advantage (For Now) Meanwhile Russia’s economic and hence strategic power will subside over time. Russia’s potential GDP growth has fallen since the Great Recession as productivity growth slows and the labor force shrinks (Chart 14). Chart 14Future Will Not Yield Strategic Opportunities For Russia​​​​​​ Chart 15Younger Russians Not Calling The Shots (But Will Someday) In short, the Kremlin has chosen the path of economic austerity and military aggression as a means of maintaining political legitimacy and achieving national security objectives. Western divisions, de-carbonization, the commodity cycle, and Russia’s bleak economic outlook indicated that 2022 was the opportunity to achieve a pressing national security objective, rather than some future date when Russia will be less capable relative to its opponents. In the worst-case scenario – not our base case – the invasion of Ukraine will trigger an escalation of European sanctions that will lead to Russia cutting off Europe’s energy and producing a global energy price shock. And yet that outcome would upset US and European politics in Russia’s favor, while Putin would maintain absolute control at home in a society that is already used to economic austerity and that benefits from high commodity prices. Note that Putin’s strategy will not last forever. Ukraine will mark another case of Russian strategic overreach that will generate a social and political backlash in coming years. While Putin has sufficient support among older, more Soviet-minded Russians for his Ukraine adventure, he lacks support among the younger and middle-aged cohorts who will have to live with the negative economic consequences (Chart 15). The entire former Soviet Union is vulnerable to social unrest and revolution in the coming decade and Russia is no exception. The Russo-Chinese Geopolitical Realignment Chart 16From Nixon-Mao To Putin-Xi From a broader, geopolitical point of view, Russia’s invasion of Ukraine drives another nail into the coffin of the post-Cold War system and hyper-globalization. Russia is further divorcing itself from the western economy, with even the linchpin European energy trade falling victim to renewables and diversification. The US and its allies are imposing export controls on critical technologies such as semiconductors against Russia to cripple any attempts at modernization. The US is already restricting China’s access to semiconductors and from now on is locked into a campaign to try to enforce these export controls via secondary sanctions, giving rise to proxy battles in countries that Russia and China use to circumvent the sanctions. Russia will be forced to link its austere, militarized, resource-driven economy to the Chinese economy. Hence a major new geopolitical realignment is taking place between the US, Russia, and China, on the order of previous realignments since World War II. When the Sino-Soviet communist bloc first arose it threatened to overwhelm the US in economic heft and dominate Eurasia. This communist threat drove the US to undertake vast expeditionary wars, such as in South Korea and Vietnam. These were too costly, so the US sought economic engagement with China in 1972, which isolated the Soviet Union and ultimately helped bring about its demise. Yet China’s economic boom predictably translated into a strategic rise that began to threaten US preeminence, especially since the Great Recession. Today Russia and China have no option other than to cooperate in the face of the US’s increasingly frantic attempts to preserve its global status – and China’s economic growth and technological potential makes this alliance formidable (Chart 16). In short, the last vestiges of the “Nixon-Mao” moment are fading and the “Putin-Xi” alignment is already well-established. Russia cannot accept vassalage to China but it can make many compromises for the sake of strategic security. Their economies are much more complimentary today than they were at the time of the Sino-Soviet split. And Russia’s austere economy will not collapse as long as it retains some energy trade with Europe throughout the pivot to China. In turn the US will attempt to exploit Russian and Chinese regional aggression as a basis for a revitalization of its alliances. But Europe will dampen US enthusiasm by preserving economic engagement with Russia and China. The EU is increasingly an independent geopolitical actor and a neutral one at that. This environment of multipolarity – or Great Power Struggle – will define the coming decades. It will ensure not only periodic shocks, like the Ukraine war, but also a steady undercurrent of growing government involvement in the global economy in pursuit of supply security, energy security, and national security. Competition for security is not stabilizing but destabilizing. Hyper-globalization has given way to hypo-globalization, as regional geopolitical blocs take the place of what once promised to be a highly efficient and thoroughly interconnected global economy. Investment Takeaways Tactically, Geopolitical Strategy believes it is too soon to go long emerging markets. Russia is at war, China is reverting to autocracy, and Brazil is still on the path to debt crisis. Multiples have compressed sharply but the bad news is not fully priced (Chart 17). The dollar is likely to be resilient as the Fed hikes rates and a major European war rages. Europe’s geopolitical and energy insecurity will weigh on investment appetite and corporate earnings. American equities are likely to outperform in the short run. Chart 17Investors Should Not Bet On Russian And European Equities In This Context​​​​​ Chart 18Investors Find Value, Minimize Risk In Geopolitically Secure Equity Markets​​​​​​ Cyclically, global equities outside the US, and pro-cyclical assets offer better value, as long as the war in Ukraine remains contained, a Europe-wide energy shock is averted, and China’s policy easing secures its economic recovery. While European equities will snap back, Europe still faces structural challenges and eastern European emerging markets face a permanent increase in geopolitical risk due to Russian geopolitical decline and aggression. Investors should seek markets that are both cheap and geopolitically secure – namely Australia, Canada, and Mexico (Chart 18). We are also bullish on India over the long run.    Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Special Report

Executive Summary EU-Russia Energy Trade To Persist Russia invaded Ukraine to prevent it from becoming a defense partner of the US and its allies. It is not likely to attack NATO members, which share a mutual defense treaty, so the war is limited in scope. Spillovers can occur but the US and Russia have 73 years of experience avoiding direct war. The US and EU will levy sweeping sanctions but they will not halt Russian energy exports, as that would cause a recession in Europe. European political leaders would likely fall from power in the coming years if there were a full-scale energy crisis. European nations will leverage Russian aggression to strengthen their popular support at home, while diversifying away from Russian energy over the long run. Europe will impose tough sanctions on Russia’s non-energy sectors, including finance and technology, to hobble the regime. China will consolidate power at home and strengthen ties with Russia but a war over Taiwan is a medium-to-long term risk.   Bottom Line: Investors should be cautious over the very near term but should prepare to buy the dip of a geopolitical incident that is generally limited to Ukraine and the Black Sea area. Supply responses from oil producers will remove the risk premium from oil prices and send the price of Brent crude to $85 per barrel by the end of the year. EU-Russia energy flows are the key risk to monitor. Feature Russia launched an invasion of Ukraine on February 24. The invasion was not limited to the far eastern corner of the country but involved attacks in the capital Kiev and in the far west and the coastline. Hence investors should proceed on the assumption that Russia will invade all of Ukraine even if it ends up limiting its invasion, as we expect (Map 1). Map 1Russian Invasion Of Ukraine 2022 It is critical for investors to understand the cause of the war in order to gauge its scope and adjust their risk appetite accordingly. Consider: Ukraine does not have mutual defense treaties that automatically trigger a broader war. Russia is attacking Ukraine to prevent it from becoming a defense partner of the US and its allies. Russia does not have the military capacity to attack the North Atlantic Treaty Organization (NATO) members, which have a mutual defense pact. Russia is attacking Ukraine because it does not have a mutual defense pact but was seeking one. Russia aims to neutralize Ukraine. If Moscow sacks Kiev and sets up a puppet state, then Ukraine will not seek western defense cooperation for the foreseeable future. If Russia conquers key territories to strengthen its control over Ukraine, then future Ukrainian governments will limit relations with the West for fear of Russian absorption. Russia is likely to seize coastal territory to ensure the long-term ability to blockade Ukraine. Russia will not withdraw troops until it has changed the government and seized key territories. Russia and NATO have no interest in war with each other. In the immediate fog of war, global financial markets will experience uncertainty about whether fighting will expand into a broader war between Russia and NATO. Such an expansion is unlikely because of mutually assured destruction (MAD) due to nuclear weapons. The US and Europe have already pledged that they will not send troops to fight in Ukraine. They will send troops and arms to support neighboring NATO states in central Europe, such as the Baltic states, Poland, Slovakia, Hungary, and others. This will serve as a deterrent to Russia to keep its operations limited. Spillover incidents can and will occur, such as with Malaysian Airlines Flight 17 in 2014, but the US and Russia have 73 years of experience avoiding direct war, including when Russia invaded Hungary in 1956, Czechoslovakia in 1968, and Afghanistan in 1979. The US and EU will levy sweeping sanctions but the EU will not halt Russian energy exports. When Russia first invaded Ukraine and seized territory in 2014, Germany responded by working with Russia to build the Nord Stream II pipeline so as to import energy directly from Russia and circumvent Ukraine. This historical fact over the past eight years reveals Germany’s true interests. Thus energy cooperation increased as a result of Russian aggression. Of course, Germany has suspended the certification of that pipeline in light of today’s invasion, but it was not yet operating, so energy flows are not impeded, and it still physically exists for future operation when Germany finds it politically expedient. Hungary, Italy, Finland, the Czech Republic and others will also need to keep up Russian energy flows. Chart 1EU-Russia Energy Trade To Persist Nevertheless, a cessation of energy flows is still the most important risk for investors to monitor, whether triggered by European boycott or Russian embargo. That would cause a recession in Europe. Recession would cause European political leaders to fall from power in the coming years, which explains why they will not pursue that objective in face of Russian aggression. Even the US is vulnerable to a global price shock (during a midterm election year) and hence will allow the EU to keep importing Russian energy, whatever its sanctions package may contain. True, Russia may cut off natural gas flows via Ukraine, which account for nearly 20% of Europe’s imports (Chart 1). Moreover, Europe may threaten or claim that they will sanction the energy sector. But most flows will likely continue. Europe will diversify away from Russian energy over the long run. Instead of cutting off their own vital energy supplies, European nations will leverage Russian aggression to strengthen their popular support at home, while initiating emergency state-led efforts to diversify away from Russian energy over the long run through renewables and imports from the US and its allies. This will be advantageous to European democracies that were already struggling to increase political legitimacy amid nascent populism – they will now have a crusade with which to rally their people and maintain fiscal support for their economy: energy security. Europe will sanction Russia’s non-energy sector. Europe will impose tough sanctions on Russia’s non-energy sectors, including finance and technology, to hobble the regime. Russia will eventually be cut off from the SWIFT banking communications network, since it already has a rudimentary alternative that it developed in recent years, but Germany will not agree to cut it off until the payment alternate to continue energy flows can be arranged, which is ultimately possible. China will take advantage of the moment but is probably not ready to invade Taiwan. China could seize the opportunity to consolidate power at home and it may increase pressure on Taiwan through rhetoric, sanctions, or cyber-attacks, but it is not likely to invade Taiwan. An amphibious invasion of the globally critical territory of Taiwan is far riskier for China than a land invasion of the non-critical territory of Ukraine is for Russia. Russia’s strategic calculations and timing are separate from China’s, despite their growing de facto alliance. But a war in the Taiwan Strait is at risk over the long run, as the situation is geopolitically unsustainable, for reasons similar to that of Ukraine. The situation in Ukraine is likely to get worse before it gets better, implying that investors should expect further volatility in risk assets in the near term. Structurally, the shift to a less geopolitically stable multipolar world will favor defense and cybersecurity stocks. “Great Power Struggle” is our top geopolitical investment theme over the long run and Russia’s invasion of Ukraine highlights its continuing relevance. Bottom Line: A buying opportunity for heavily discounted, pro-cyclical or high-beta assets is emerging rapidly, given our assessment, and we will monitor events over the coming weeks to identify when such a shift is prudent. A wholesale energy cutoff to Europe is the chief risk, as it would justify downgrading global equities relative to long-maturity bonds on a six-to-12 month horizon. Investment Takeaways Global Investment Strategy: With real rates coming down, owning gold remains an attractive hedge. As a fairly cheap and defensive currency, a long yen position is advisable. Assuming the conflict remains contained to Ukraine, equities and other risk assets should recover over the remainder of the year. The geopolitical premium in oil prices should also come down. Consistent with our Commodity & Energy Strategy views, our Global Investment Strategy service is closing its long Brent trade recommendation today for a gain of 24.0%. Commodities & Energy Strategy: While oil exports from Russia are not expected to diminish as a result of the invasion, it will prompt increased production from core OPEC producers – Saudi Arabia, the UAE, and Kuwait – to take the elevated risk premium out of Brent crude oil prices and allow refiners to rebuild inventories. The US and Iran may rejoin the 2015 nuclear deal, which would add about 1.0mm b/d of production to the market – Russia’s 2014 invasion of Crimea did not prevent the original nuclear deal. These production increases would take prices from the current $105 per barrel level to $85 per barrel by the second half of 2022 and keep it there throughout 2023, according to our base case view. This change marks an increase on our earlier expectation of an average $79.75 per barrel in 2023 in our previous forecast. European Investment Strategy: European equities are likely to continue to underperform in the near-term. Even if Russia and Europe avoid a full embargo of Russian energy shipments to the West, the disruption caused by a rupture of natural gas flows via Ukraine will keep European gas prices at elevated levels. Additionally, investors will continue to handicap the needed risk premia to compensate for the low but real threat of an energy crisis, which would prove particularly debilitating for Hungary, Poland, Germany, Czechia and Italy (Chart 2). Moreover, European equities sport a strong value and cyclical profile with significant overweight positions in financial and industrial equities. Industrials will suffer from higher input costs. European financials will suffer from a decline in yields as hawks in the European Central Bank are already softening their rhetoric on the need to tighten policy. However, due to the likely temporary nature of the dislocation, we do not recommend selling Europe outright and instead will stick with our current hedges, such as selling EUR/JPY and EUR/CHF. The evolution of the military situation on the ground will warrant a re-valuation of this hedging strategy next week. The euro will soon become a buy. Chart 2EU Economy Highly Vulnerable To Any Large Energy Cutoff Foreign Exchange Strategy: The Ukraine crisis will lead to a period of strength for the US dollar (DXY). Countries requiring foreign capital will be most at risk from an escalation in tensions. We still suspect the DXY will peak near 98-100, but volatility will swamp fundamental biases. Geopolitical Strategy: On a strategic basis, stick with our long trades in gold, arms manufacturers, UK equities relative to EU equities, and the Japanese yen. On a tactical basis, stick with long defensive sectors, large caps, Japanese equities relative to German, and Mexican equities relative to emerging markets. We will revisit these trades next week, after the European energy question becomes clearer, to determine whether to book profits on our bearish tactical trades.   – The BCA Research Team  

Executive Summary Copper Demand Follows GDP European copper demand will increase on the back of still-accommodative monetary policy, coupled with a loosening of COVID-19-related gathering and mobility restrictions as the virus becomes endemic. Copper demand will be supported by the EU's need to diversify natural gas supplies in favor of increased LNG import capacity over the next 10 years, which will require incremental infrastructure investment. Increasing policy stimulus in China and government measures to increase lending to metals-intensive sectors – e.g., construction and grid infrastructure – will boost global copper demand. In the US, the Biden administration is backing a $550 billion bill to fund its renewable-energy buildout, which will result in higher demand for metals and steel over the next decade. Global copper supply growth will be restrained by local politics going forward, particularly in the Americas. Bottom Line: Copper prices have been grinding higher even as China maintains its zero-tolerance COVID-19 public health policy, and markets wait out the Russia-Ukraine standoff.  We are maintaining our forecast for COMEX copper to trade to $5.00/lb this year and $6.00/lb next year.  We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to miners and traders via the XME and PICK ETFs. Feature Ever since it hit its record high in May 2021, copper prices have been range-bound, despite tight market fundamentals and record low inventories in 3Q21, which, as it happens, have not significantly rebuilt since then (Chart 1, panel 1). This can be explained by weak global macro conditions since prices peaked, which have not been especially conducive to higher copper prices, particularly in Europe and China. Activity in these two markets accounting for ~ 60% and 11% of global refined copper demand, respectively, has had a stop-start aspect that has hindered full recovery to now. Chart 1Global Copper Inventories Remain Tight Chart 2Copper Demand Follows GDP As GDP in these regions rises, demand for copper will rise, as Chart 2 shows. Per our modelling, refined copper demand in China, the EU and the world are highly cointegrated with Nominal GDP estimates provided by the IMF. The coefficient associated with nominal GDP in all three instances is positive. Further, running Granger Causality tests indicate that past and present values of nominal GDP explain present refined copper demand values for all three entities. These results indicate that economic growth and refined copper demand have a positive long-run relationship. China’s zero-COVID tolerance policy and the property-market crisis there have restricted economic growth, activity and hence demand for the metal used heavily in construction and manufacturing. In Europe, lockdowns due to the Omicron variant restricted activity causing supply chain disruptions, which contributed to inflation. Now, Europe is relying on immunity among large shares of its population to keep economies open, as COVID-19 becomes endemic. Germany is loosening restrictions at a slower rate than its neighbors, as COVID still has not reached endemicity (Chart 3). Europe’s top manufacturer reportedly is expected to ease restrictions and increase economic activity by March-end. Chart 3New EU COVID-19 Cases Collapse Natural Gas Remains Critical To Europe Apart from COVID, elevated natural gas prices have and will continue to affect economic activity in Europe. These prices will only get more volatile as fears of a Russian invasion of Ukraine increase. In the short term, we do not expect Russia to cut off all gas supplies to the EU in case of an invasion.1 However, supplies going through Ukraine likely would be cut. Coupled with the region’s precariously low natgas inventory levels, this could fuel a gas price spike (Chart 4). Higher gas prices could lead to demand destruction, if, as occurred this winter, higher power-generating costs arising from higher natgas costs makes electricity too expensive to keep industrial processes like aluminum smelters up and running. In addition, another regional bidding war could incentivize more re-routing of LNG to Europe instead of Asia. This would reduce European prices, but could force Asian markets to raise their bids. Chart 4EU's Natgas Inventories Remain Critical Assuming gas prices do not remain significantly higher for the rest of the year, Europe will start seeing economic activity improve, and as our European Investment Strategy notes, PMIs will bottom out by the second quarter of this year. High immunity levels are allowing European nations to relax restrictions as it becomes apparent that COVID in the continent – at least in Western Europe – appears to be reaching endemicity. Importantly for base metals generally, and copper in particular, lower natgas prices will allow smelters and refining units to remain in service as electricity prices stabilize or even fall in the EU. During the pandemic, households – primarily in DM economies – built up significant levels of excess savings, particularly in Europe. The IMF reported that households in Europe have amassed nearly 1 trillion euros more in savings vs. normal levels over the last two years than if the pandemic had never occurred.2 While the entirety of excess savings will not be released as spending, even a portion of it will spur economic activity, once supply-chain issues are ironed out when the global economy reopens. China's Copper Demand Will Revive China’s property sector crisis last year was a major drag on economic growth. The Chinese government’s efforts to stabilize this sector seem to be paying off. China’s National Bureau of Statistics reported that for January housing prices in China’s first-tier cities reversed a month-on-month decline from December. The number of cities that saw home prices fall in January also was lower compared to December. Continued improvements in the property sector in China will be bullish for copper. Once macro hurdles related to COVID and high gas prices dissipate, and China’s property market stabilizes, economic activity will increase and copper demand will rebound (Chart 5). However, a timeline for this is difficult to handicap, given China's insistence – at least for now – on maintaining a zero-covid public-health policy. The zero-covid policy has resulted in sharply lower infection rates than the rest of the world, but, because it has not been accompanied by wide distribution of mRNA vaccines, immunity in the population is low. As global macro factors become conducive for copper, investors’ focus will switch to tight fundamentals in the copper market (Chart 6). Unlike the first half of 2021, copper’s high prices will be more sustained, given COVID’s current trajectory towards endemicity globally, and relatively higher immunity rates. Chart 5China's Demand Will Rebound Chart 6Coppers Tight Fundamentals Will Come Into Focus Again In addition, markets will have to factor in additional demand from the US that heretofore did not exist: The Biden administration is backing a $550 billion bill to fund renewable-energy development. More such funding can be expected in coming years as the US leans into decarbonization, and competes with the likes of the EU and China for limited base metals supplies. Supply Side Difficulties Mount Local governance is becoming increasingly critical to the supply side of base metals, no moreso than in the Americas – chiefly in Chile, Peru and, of late, the US., where the Biden administration recently shut down a Minnesota mining proposal in a major win for environmental groups.3 A number of these critical commodity-producing states in the Americas have elected – or are leaning toward – left-of-center candidates, some of whom are proposing fundamental changes in the laws and regulations governing resource extraction. Gabriel Boric, Chile’s new president, takes office in March. He has largely focused his campaign on the environment, human rights, and closer ties with other Latin American countries. Boric promotes a “turquoise” foreign policy, which includes “green” policies to combat climate change, and “blue” ones to protect oceans. He is likely to commit Chile, which accounts for ~ 30% of global copper mining, to participation in the Escazú Agreement, is being positioned to span the region.4 Of greatest import to the global metals and mining markets, Boric will push for a constitutional re-write affecting taxes on copper mining, decarbonization, Chile's water crisis and the nationalization of lithium mining. Chile's new constitution is expected to be put up for a vote by the end of 2022. In Peru, which accounts for ~ 10% of global copper output, President Pedro Castillo announced at the UN General Assembly that Peru would declare a "climate emergency," and promised to reach net-zero in Peru by 2050. Civil unrest in Peru directed at mining operations is becoming more widespread, as citizens become increasingly frustrated with pollution and poverty.5 Colombia is not a major metals producer, but it is a resource-based economy leaning left. In May it will hold its general elections to Congress and Presidency. The future president will have pressure on the ratification of the Escazú Agreement, fight against illegal mining, and work on the Amazon deforestation. Presently, a left-of-center candidate, Gustavo Petro, leads the polling, according to the latest December survey by the National Consulting Center.6 Petro is promising to stop approving oil exploration contracts to restructure Colombia's economy away from hydrocarbons, and plans to accelerate the transition towards renewable energy.7 In addition, Petro is trying to gather ideological allies across Latin America and the world to fight against climate change. He hopes Chile’s president-elect Gabriel Boric will be joining this alliance.8 Caution: Downside Risks Remain Apart from the Russia-Ukraine crisis discussed above, there are more headwinds to the bullish copper view. China’s zero-covid policy will lead to reduced activity in the world’s largest producer and consumer of refined copper. This will disrupt global supply chains and, along with high energy prices, spur global inflation, prolonging slow economic growth and activity. Central bank tightening globally – led by the Federal Reserve – will increase borrowing costs, reduce manufacturing, and act as a downside risk to copper, particularly if the Fed miscalculates and lifts rates too high too soon and sparks a USD rally. Finally, while DM economies have high vaccination rates, EM states do not have the same level of immunity (Chart 7). Europe exhibits this dichotomy in immunization rates between advanced and developing countries well. While most of Western Europe appears to be nearing endemicity and reopening, Omicron is spreading quickly into Eastern Europe, where immunity is low. As long as a majority of the global population is not vaccinated, COVID-19 mutations into more virulent and transmissive variants remain a major risk. Chart 7COVID-19 Remains A Risk Investment Implications Copper prices have been grinding higher even as China maintains its zero-tolerance COVID-19 public-health policy, and markets wait out the Russia-Ukraine standoff (Chart 8). As large economies continue to emerge from COVID-19-related disruptions demand for base metals can be expected to increase, particularly for copper. We are maintaining our forecast for COMEX copper to trade to $5.00/lb this year and $6.00/lb next year. We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to miners and traders via the XME and PICK ETFs. Chart 8Copper Continues To Grid Higher   Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish The US will expand its leading position as the EU-27's and UK's top liquified natural gas (LNG) supplier this year, in our view, although Qatar will provide stiff competition (Chart 9). In January, the EIA reported half of the Europe's LNG originated in the US. For all of 2021, 26% of Europe's LNG came from the US, while 24% came from Qatar and 20% came from Russia. We expect the Russia-Ukraine military standoff, which has the potential to become a kinetic engagement, will prompt Europe to diversify its natural gas supplies away from Russia to reduce its exposure to military and geopolitical pressure on its energy supplies. This also would apply, in our estimation, to pipeline supplies of natural gas from Russia, which shipped 10.7 Bcf/d to Europe in 2021 (vs. 11.8 Bcf and 14.8 Bcf/d in 2020 and 2019, respectively. Norway supplied 10.4 Bcf/d in 2019 and 2020, rising to 11.1 Bcf/d in 2021. We also would expect additional North Sea supplies to be developed to supply Europe in the wake of the current Russia-Ukraine tensions. Base Metals: Bullish Russia’s recognition of the two breakaway states of Donetsk and Luhansk People’s Republics (DPR and LPR), elicited US sanctions targeting Russian sovereign debt and its banking sector. The possibility of sanctions on Russian nickel and aluminum exports sent both metals to multi-year highs in LME trading. Russia constitutes around 6% and 9% of global primary aluminum and nickel ore supply, respectively. Precariously low inventory levels for both nickel and aluminum are inducing high price volatility. Year-over-year, global January LME aluminum and nickel stocks are 45% and 64% lower respectively. Precious Metals: Bullish Geopolitical uncertainty due to the Russia-Ukraine crisis and Western sanctions levied on Russia has pushed gold prices to levels not seen since its last bull run last year. While gold has risen, Bitcoin – once considered to be a safe-haven asset – has fallen on this uncertainty. Over the last two years, Bitcoin has been moving more in tandem with equity markets than with other safe-haven assets, as cryptocurrency has become more popular and central banks began large asset purchase programs in response to the pandemic (Chart 10). From beginning 2018 to end-2019 the coefficient measuring daily Bitcoin prices’ correlation with the S&P 500 index was ~0.31. From beginning 2020 to present day, this value has increased to ~ 0.86. Chart 9 Chart 10     Footnotes 1     Please see our report from February 3, 2022 entitled Long-Term EU Gas Volatility Will Increase.  It is available as ces.bcaresearch.com. 2     Please see Europe’s Consumers are Sitting on 1 Trillion Euros in Pandemic Savings published by the International Monetary Fund on February 10, 2022. 3    Please see our report from on November 25, 2021 entitled Add Local Politics To Copper Supply Risks, and Biden administration kills Antofagasta's Minnesota copper project published by reuters.com on January 26, 2022. 4    Please see Chile Turns Left: The Foreign Policy Agenda of President Gabriel Boric, published by Australian Institute of Mining Affairs on January 28, 2022. 5    Please see China's MMG faces Peru whack-a-mole as mining protests splinter, published by reuters.com on February 16, 2022. 6    Please see Six Challenges Facing Colombia in 2022, published by Global Americas on January 6, 2022. 7     Please see Gustavo Petro, who leads polls in Colombia, seeks to create an anti-oil front published by Bloomberg on January 14, 2022. 8    Please see Colombia Presidential Favorite Gustavo Petro Wants to Form a Global Anti-Oil Bloc, published by Time on January 14, 2022. Investment Views and Themes Strategic Recommendations Trades Closed in 2021

Executive Summary US Treasury yields have surged in response to high US inflation and Fed tightening expectations. However, the move looks overdone in the near-term. Too many Fed hikes are now discounted for 2022, US realized inflation should soon peak, inflation expectations have stabilized, financial conditions have started to tighten, and positioning in the Treasury market is now quite short. These factors will act to stabilize Treasury yields over the next few months, even with the cyclical backdrop remaining bond bearish. Markets Think The Fed Will Hike More Sooner And Less Later – The Opposite Is More Likely Recommendation Inception Level Inception Date Long Dec 2022/Short Dec 2024 3-Month SOFR Future 0.25 Feb 22/22 New Trade: Go long the December 2022 US SOFR interest rate futures contract versus shorting the December 2024 SOFR contract. The former discounts too many Fed hikes for this year and the latter discounts too few hikes over the next three years. Bottom Line: US Treasury yields now discount the maximum likely hawkish scenario for Fed rate hikes in 2022, with risks all pointing in the direction of the Fed delivering less than expected. Upgrade US duration exposure to neutral from below-benchmark on a tactical basis. Feature Chart 1A Near-Term Overshoot For UST Yields During the BCA Research US Bond Strategy quarterly webcast last week, we announced a shift in our recommended US duration stance, moving from below-benchmark to neutral. This move was more tactical (i.e. shorter-term) in nature, as we still strongly believe that bond markets are underestimating the eventual peak for US bond yields over the next couple of years. In the near term, however, we see several good reasons to expect the recent big run-up in US bond yields to pause, warranting a more neutral tactical duration exposure (Chart 1). We discuss those reasons – and the implications for both US duration strategy - in this report published jointly by BCA Research’s US Bond Strategy and Global Fixed Income Strategy services. Reason #1: Too Many Fed Rate Hikes Are Now Discounted For 2022 The US overnight index swap (OIS) curve currently discounts 146bps of Fed rate hikes by the end of 2022. This is a big change from the start of the year when only 77bps of hikes were priced (Chart 2). The OIS curve repricing now puts the path of the funds rate for this year well above the last set of FOMC interest rate projections published at the December 2021 Fed meeting. In other words, the market has already moved to discount a big upward shift in the FOMC “dots” for 2022, and even for 2023, at next month’s FOMC meeting. Chart 2Markets Think The Fed Will Hike More Sooner And Less Later - The Opposite Is More Likely We think a more likely outcome for 2022 is that the Fed lifts rates four or five times, not six or even seven times as some Wall Street investment banks are forecasting. We set out the reasons why we think the Fed will go less than expected in the rest of this report. At a minimum, there is virtually no chance that the Fed will provide guidance to markets that is more hawkish than current market pricing, which would push bond yields even higher in the near term. Reason #2: US Inflation Will Soon Peak The relentless string of upside surprises on US inflation has been the main reason the bond market has moved so rapidly on pricing in more Fed rate hikes. The story is about to change, however, as US inflation should peak sometime in the next few months and begin to rapidly decelerate toward levels much closer to, but still well above, the Fed’s 2% inflation target. Already, the intense global inflation pressures from commodities and traded goods prices over the past year has started to lose potency. The annual growth rate of the CRB Raw Industrials index has eased from a peak of 45% in June to 18%, in line with slowing growth momentum of global manufacturing activity (Chart 3, top panel). The softening of input price pressures is evident in business survey measures like the ISM Manufacturing Prices Paid index, which typically leads US headline CPI inflation by six months and has fallen by 16 points since the peak in June (middle panel). Chart 3Global Inflation Pressures Easing The global supply chain disruptions that have caused inventory shortages in products ranging from new cars to semiconductors also appear to be easing. Supplier delivery times are shortening according to the ISM Manufacturing and Non-Manufacturing surveys (bottom panel). Combined with other indications of the loosening of supply chain logjams, like lower shipping costs, the influence of supply disruptions on inflation should diminish, on the margin. Energy prices should also soon contribute to disinflationary momentum (Chart 4). BCA Research’s Commodity & Energy Strategy service is forecasting the Brent oil price to reach $76/bbl at the end of 2022 and $80/bbl at the end of the 2023. That represents a significant decline from the current $95/bbl price that reflects a large risk premium for the potential oil market supply disruptions in response to a Russian invasion of Ukraine. A war-driven spike in oil prices does risk extending the current period of high US (and global) inflation. However, it should be noted that the annual growth in oil prices has been decelerating even as oil prices have been rising recently, showing the power of base effect comparisons that should lead to a lower contribution to overall inflation from energy prices over the next 6-12 months. ​​​​​​Chart 4Oil Prices Will Soon Turn Disinflationary Chart 5A Changing Mix Of US Consumer Spending Will Lower Overall Inflation   Looking beyond the commodity space, a shifting mix of US consumer spending should also help push overall US inflation lower. US core CPI inflation hit a 34-year high of 6.0% in January, fueled by 11.7% growth in core goods inflation (Chart 5). We anticipate that overall core inflation will slow to levels more consistent with the trends seen in more domestically focused sectors like core services and shelter, where inflation is running around 4%. US consumers have started to shift their spending patterns away from goods, which was running well above its pre-pandemic trend, back toward services, which was running below its pre-pandemic trend (Chart 6). This will help narrow the gap between goods and services inflation, particularly as easing supply chain disruptions help dampen goods inflation. Chart 6Goods Inflation Should Soon Peak​​​​​ Chart 7There Are Still Pockets Of Available US Labor Market Supply​​​​​​ Chart 8US Wage Growth Should Soon Begin To Moderate There is also the potential for some of the pressures stemming from the tight US labor market to become a bit less inflationary in the coming months. While the overall US unemployment rate of 4% is well within the range of full employment NAIRU estimates produced by the FOMC, there are notable differences across employment categories suggesting that there are still sizeable pockets of labor supply. For example, the unemployment rate for managerial and professional workers is a tiny 2.3%, while the unemployment rate for services workers was a more elevated 6.7% (Chart 7, top panel). There are also noteworthy differences in US labor market trends when sorted by wage growth. Employment in industries with lower wages – predominantly in services – has not returned to the pre-pandemic peak, unlike employment in higher wage cohorts (middle panel).1 As the US economy puts the Omicron variant in the rearview mirror, service industries most impacted by pandemic restrictions should see an increase in labor supply as workers return to the labor force. This will help close the one percentage point gap between the labor force participation rate for prime-aged workers (aged 25-54) and its pre-pandemic peak (bottom panel). This will also help to mitigate the current upturn in service sector wage growth, which reached 5.2% at the end of 2021 according to the US Employment Cost Index (Chart 8). When US inflation finally peaks in the next few months – most notably for goods prices and service sector wages – the Fed will be under less pressure to hike rates as aggressively as discounted in current bond market pricing. Reason #3: US Inflation Expectations Have Stabilized Chart 9TIPS Breakevens Are Not Telling The Fed To Be More Aggressive The Fed always pays a lot of attention to inflation expectations, particularly market-based measures like TIPS breakevens, to assess if its monetary policy stance is appropriate. The current message from breakevens is that the Fed does not have to turn even more hawkish than expected to bring inflation back down to levels consistent with the Fed’s 2% target. The 10-year TIPS breakeven is currently 2.4%, down from a peak of 2.8% and within the 2.3-2.5% range that we deem consistent with the Fed’s inflation target. Inflation expectations are even more subdued on a forward basis, with the 5-year TIPS breakeven, 5-years forward now down to 1.95% (Chart 9). Shorter term TIPS breakevens remain elevated, with the 2-year breakeven at 3.7%. We continue to favor positioning for a narrower 2-year TIPS breakeven spread – realized inflation will soon peak and the New York Fed’s Consumer Expectations survey shows that household inflation expectations for the next three years have already fallen significantly (bottom panel). Lower inflation expectations, both market-based and survey-based, suggest that the Fed can be cautious on the pace of rate hikes after liftoff next month. Reason #4: US Financial Conditions Are Tightening Alongside Cooling US Growth Momentum We have long described the link between financial markets and the Fed’s policy stance as “The Fed Policy Loop.” In this framework, the markets act as a regulator on Fed hawkishness (Chart 10). If the Fed comes across as overly hawkish, risk assets will sell off (lower equity prices, wider corporate credit spreads), the US dollar will appreciate, the US Treasury curve will flatten and market volatility measures like the VIX index will increase. All of those trends act to tighten US financial conditions, threatening a growth slowdown that will force the Fed to back off from its previous hawkish bias. Chart 10The Fed Policy Loop Financial conditions have indeed tightened as markets have priced in more Fed rate hikes in 2022 (Chart 11). Since the start of the year, the S&P 500 is down 9% year-to-date, US investment grade corporate spreads have widened 26bps, the 2-year/10-year US Treasury curve has flattened by 34bps and the VIX index has increased 11 pts. In absolute terms, US financial conditions remain highly stimulative and the risk asset selloff so far poses little threat to US economic growth. However, if the Fed were to deliver all of the rate hikes in 2022 that are currently discounted in the US OIS curve, the market selloff would deepen as investors began to worry about a Fed-engineered economic slowdown. This would lead to a more significant tightening of financial conditions, representing an even bigger risk to US growth. The Fed cannot risk appearing too hawkish too soon, with US growth momentum already showing signs of slowing (Chart 12). The Conference Board US leading economic indicator has stopped accelerating and may be peaking, US business confidence is softening and consumer confidence is very depressed according to the University of Michigan survey. Importantly, high inflation is cited as the main reason for weak consumer confidence, as wage increases have not matched price increases. If realized inflation falls, as we expect, this could actually provide a boost to consumer confidence as households would feel an improvement in real incomes and spending power – a development that could eventually lead to more Fed rate hikes in 2023 if consumer spending improves, especially if inflation stays above the Fed’s 2% target. Chart 11Fed Hawkishness Has Already Tightened Financial Conditions​​​​​​ Chart 12Not The Best Time For The Fed To Be More Aggressive​​​​​ For now, however, the risk of a preemptive tightening of financial conditions will ensure that the Fed delivers fewer rate hikes than the market expects this year. Reason #5: Treasury Market Positioning Is Now Very Short Chart 13Reliable Bond Indicators Calling For A Pause In The UST Selloff The final reason to increase US duration exposure now is that Treasury market positioning has become quite short and has become a headwind to higher bond yields and lower bond prices. The JP Morgan fixed income client duration survey shows that bond investors are running duration exposures well below benchmark (Chart 13). Speculators are also running significant short positions in longer-maturity US Treasury futures. This suggests limited selling power in the event of more bond bearish news and increased scope for short-covering in the event of risk-off event – like a shooting war in Ukraine – or surprisingly negative US economic data. On that front, the Citigroup US data surprise index, which is typically highly correlated to the momentum of US Treasury yields, has dipped a bit recently but remains at neutral levels (top panel). A similar measure of neutrality is sent by some of our preferred cyclical bond indicators like the ratio of the CRB raw industrials index to the price of gold – the 10-year yield is now in line with that ratio, which appears to be peaking (middle panel). Investment Conclusions Given the five reasons outlined in this report – too many Fed hikes are now discounted for 2022, US realized inflation should soon peak, inflation expectations have stabilized, financial conditions have started to tighten, and positioning in the Treasury market is now quite short – we decided last week to upgrade our recommended US portfolio duration to neutral from below-benchmark. However, this move is only for a tactical investment horizon. We still see the cyclical backdrop as bond bearish, as Treasury yields do not yet reflect how high US interest rates will rise in the upcoming tightening cycle. The 5-year Treasury yield, 5-years forward is currently at 2.0%. This lies at the low end of the range of estimates of the longer-run neutral fed funds rate (Chart 14) from the New York Fed’s survey of bond market participants (2%) and the median FOMC longer-run interest rate projection from the Fed dots (2.5%). We see the Fed having to lift rates faster than markets expect in 2023 and 2024. US inflation this year is expected to settle at a level above the Fed’s 2% target before picking up again next year alongside renewed tightening of labor market conditions once the remaining supply of excess labor is fully absorbed. Chart 14The Cyclical UST Bear Market Is Not Over Yet Chart 15Go Long The Dec/22 SOFR Contract Vs. The Dec/24 Contract As a way to position for the Fed doing fewer rate hikes than expected in 2022, but more hikes than expected in 2023/24, we are entering a new trade this week – going long the December 2022 3-month SOFR US interest rate futures contract versus a short position in the December 2024 3-month SOFR contract.  The implied interest rate spread on those two contracts has tightened to 25bps (Chart 15). We expect that trend to reverse, however, with the spread increasing as markets eventually move to price out rate hikes in 2022 and price in much more Fed tightening in 2023 and 2024. We will discuss the implications of the shift in our US duration stance for our views on non-US bond markets in next week’s Global Fixed Income Strategy report. Our initial conclusion is that our country allocation recommendations for government bonds will remain unchanged – underweighting the US, UK, and Canada; overweighting core Europe, peripheral Europe, Japan and Australia – but we will also increase duration exposure within most (if not all) countries. As in the US, we also see markets pricing in too many rate hikes in the UK and Canada for 2022 but too few rate hikes over the next two years. On the other hand, markets are pricing in too many rate cumulative hikes over the next 2-3 years in Europe, Australia and Japan (Table 1). Table 1Markets Have Pulled Forward Rate Hikes Everywhere   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The definitions for the wage cohorts can be found in the footnote of Chart 7. Cyclical Recommendations (6-18 Months) Tactical Overlay Trades

Special Report

Executive Summary Earnings Growth Outpacing Multiple Expansion The US Energy sector is in a good place right now: Rising demand and faltering supply from OPEC 2.0 translate into a price of oil anchored at around $80 to $85/bbl. This price is twice the breakeven production cost for the majority of US producers. High prices have also created an opening for US Energy producers to restart Capex to increase production. Further, the Energy sector tends to outperform in an environment of high inflation and rising rates. As a real asset, oil is also a good inflation hedge, a quality that extends to Energy-related equities.  The favorable macro backdrop is also complimented by bombed-out valuation. Meanwhile, technicals are overbought signaling that a near-term pause is needed for prices to reset. Bottom Line: We reiterate our cyclical overweight in the Energy sector, despite the rising probability or a near-term pullback. Within Energy, we recommend a cyclical overweight of the upstream and equipment & services segments, underweight midstream, and equal weight downstream and integrated stocks.  Feature Dear client, In lieu of the February 28th publication, we will be sending you a Special Report on Wednesday, February 23rd written by our US Political Strategy service colleagues. Our regular weekly publication will resume Monday, March 7th. Kind Regards, Irene Tunkel Chief Strategist, US Equity Strategy Part I Recap Last week, in Part I of this Special Report, we described the structure of the Energy sector, its value chain, key industry drivers, and supply/demand/oil price dynamics. The Energy value chain consists of four distinct segments, with each segment corresponding to a section of the oil production value chain. The GICS classifies them as Oil & Gas Exploration and Production (Upstream or E&P), Oil & Gas Equipment and Services (E&S), Storage and Transportation (Midstream or S&T), and Refining and Marketing (Downstream or R&M). Integrated Oil & Gas straddles the entire supply chain (Integrated). Demand exceeds supply: We concluded that crude oil demand is expected to return to trend, driven by strong economic growth and the receding pandemic. In the meantime, production remains suppressed because of curtailments by OPEC 2.0 members, investment restraint from US producers, and multiple supply disruptions. Sizzling tensions with Iran, Russia, and a possible new market share war with the Saudis exacerbate supply problems and lead to heightened volatility in crude oil prices. The US Energy producers are ramping up supply: To meet the increasing oil demand, US shale oil producers are now perfectly positioned to pick up the slack in supply. To ramp up production, the US oil companies will have to invest in new and existing wells, starting a new Capex cycle, after “seven lean years” of Capex (Chart 1). There are early signs that the US Energy sector is in the early innings of new Capex and production. This week, we rely on our investment process, i.e., analysis of the macroeconomic backdrop, fundamentals, valuations, and technicals to shape our view on each segment of the Energy value chain. We are currently overweight the Energy sector and are ahead of the benchmark by 35%. Chart 1The Energy Industry Is In The Early Innings Of New Capex Cycle Macroeconomic Backdrop Can Withstand Rising Rates And High Inflation The Energy sector tends to outperform in the environment of high inflation and rising rates (Chart 2). As a real asset, oil is also a good inflation hedge, a quality that extends to Energy-related equities. Appreciating Dollar Is A Temporary Phenomenon There is a tight inverse relationship between the USD and energy prices due to the simple fact that commodity prices are quoted in dollars. Over the past seven years, the nominal WTI oil price has been over 70% inversely correlated with the strength of the USD trade-weighted index (TWI), with a beta of oil to USD of -1.6. That is, a 1% change in the TWI would be expected to translate into a $1.60/barrel change in the price of WTI (Chart 3). Chart 2The Energy Sector Is Resilient To Rising Rates Chart 3Price Of Oil And USD Are Inversely Correlated According to the BCA Research FX Strategy team, the recent dollar strengthening is a temporary phenomenon, catalyzed by the rising interest-rate differential with the rest of the world. However, historically, equity portfolio flows have been more important than other factors in explaining dollar moves. Rising rates undermine the performance of US equities and are likely to lead to a reversal in cross-border equity flows, damaging the key pillar of support for the dollar. Hence, risks to the dollar are on the downside. Fundamentals And Valuations The Energy Sector Is Enjoying Strong Sales EIA reports that “global oil consumption outpaced oil production for the six consecutive quarters, ending with the fourth quarter of 2021 (4Q21), which has led to persistent withdrawals from global oil inventories and significant increases in crude oil prices”.1 As a result of higher production, and WTI prices increasing from $52 to $85 over 2021, energy company sales have soared (Chart 4). Looking ahead, we expect sales growth to remain robust, albeit lower than in 2021: Not only are comparables more challenging, but economic growth is also decelerating. What can bring the strong sales growth to a halt? The answer is that it may be either higher prices or higher volumes: Surging prices destroy demand while surging volumes suppress oil prices, which, eventually, weigh on Capex and production. At the moment, both production levels and price are in a sweet spot: All segments of the value chain are benefiting from high but not excessive prices and volumes. Chart 4Energy Sales Surged In 2021 Chart 5Sector Profitability Is Tied To The Price Of Oil Profit Recovery Continues The overall profitability of the Energy sector is also tightly linked to the price of oil (Chart 5). The BCA Research house view is WTI centered around $80-85, with substantial volatility triggered by geopolitical tensions. With oil prices likely peaking, barring any negative geopolitical developments, earnings growth normalization off the high levels is expected (Chart 6). However, even if they are slowing, Energy sector earnings are expected to grow by 26% over the next 12 months, exceeding S&P 500 earnings by 17%. Further, over the next five years, energy earnings growth is expected to re-accelerate towards the 26% range. Chart 6Energy Sector's Earnings Growth To Exceed The Market's Chart 7Margins To Continue To Expand Importantly, sector operating margins are expected to expand towards 10% (Chart 7), which is quite a feat considering the broad-based margin contraction of the other S&P 500 sectors and industries. Our verdict? Earnings growth expectations look darn good! Despite Recent Outperformance, Valuations Are Still Attractive The BCA valuation indicator, which is a composite of P/B, P/S, and DY relative to the S&P 500, standardized relative to its own history, shows that the sector is still undervalued (Chart 8), despite a recent run of performance – earnings growth still outpaces multiple expansion (Chart 9). The energy sector is currently trading with a nearly 40% discount to the S&P 500 (Table 1) on a forward earnings basis (12.4x vs 20.3x). Chart 8Still Undervalued… Chart 9Earnings Growth Outpacing Multiple Expansion Table 1Valuation Summary Cheap But Overbought! Curiously, despite modest valuations, from a technical standpoint the sector appears overbought (Chart 10). Worse yet, our Energy Sentiment Composite is outright in the bullish zone (Chart 11) with a reading last achieved in 2009. This is certainly concerning, as euphoria is inevitably followed by panic and disappointment. However, we need to keep in mind that the technical indicators are short term in scope by design, and their main use is to help refine the position entry and exit timing. Chart 10...But Overbought! Chart 11Sentiment Is Extended Why such a pronounced dichotomy with valuations? Technical indicators are based on returns, which have been rather outstanding for the sector, while valuations take into account earnings growth, which explains and justifies the surging returns. Too Much Cash Our analysis would be amiss if we did not bring energy companies’ free cash flow (FCF) into the discussion. With a curtailed supply of energy and rising prices, these companies have been awash in cash (Chart 12) – their FCF has increased by nearly 80% year over year, and profits have surged. What will companies do with this windfall? Well, first and foremost, during the seven lean years of extreme Capex discipline, these companies have gotten their commitment to returning cash to shareholders embedded in the corporate psyche, which is something that is unlikely to change fast. Energy continues to be the highest-yielding sector in the S&P 500 (Chart 13). However, having learned the lesson the hard way, many companies are adopting variable dividends to avoid potential disappointment if the oil price collapses. In addition to disbursing cash, the energy companies are paying off debt and are investing in expanding production. Chart 12Windfall Of Cash Chart 13Energy Is The Highest Yielding Sector Investment Outlook By Segments Of The Energy Value Chain The macroeconomic backdrop for Energy appears benign, with rates rising, inflation elevated, and the dollar likely contained. The sector also appears attractive from both a profitability and a valuation standpoint. However, a near-term pullback is likely as the sentiment around the sector is overly bullish – but that is likely to be short-lived. While we like the sector overall, we aim to provide granular industry group recommendations. To do so, we will zoom in on each segment of the value chain. Oil And Gas Exploration & Production (Upstream) Strong demand recovery and OPEC 2.0 oil production shortages bode well for the US E&P companies, which are cautiously starting to restart capital investment and ramp up production. We expect the E&P, especially shale oil production, companies to be one of the best performing energy subsectors, with WTI anchored around a consensus of $80-85/bbl. The upstream segment is highly dependent on the price of oil, which is currently in a sweet spot: High but not high enough to cause demand destruction (Chart 14). With oil prices peaking, E&P sales growth is decelerating (Chart 15). However, upstream also benefits from the sustainable cost reductions achieved through improved experience in well siting, drilling, and completion techniques. Chart 14Upstream Earnings Depend On The Price Oil Chart 15Sales Growth Is Normalizing As a result of growing, albeit decelerating, sales and effective cost management, E&P is one of the most profitable segments of the energy complex: Operating margins are currently at 22% and are expected to expand to 27% (Chart 16). From a valuation standpoint, the industry is trading at 10 times forward earnings, which represents an 50% discount to the S&P 500. The BCA valuation indicator for the industry group is also in the undervalued territory (Chart 17). Chart 16Margins To Continue To Expand Chart 17E&P Is Still Cheap Overweight Oil and Gas Exploration & Production industry Equipment And Services Is A High Octane Play On The New Capex Cycle Upstream Capex is revenue for E&S companies. After “seven lean years” of the Capex cycle, the fortunes of E&S companies are finally turning, with a rising price of oil finally enticing upstream companies to expand production by reopening existing and drilling new wells (Chart 18). According to CFRA, upstream Capex is expected to increase by 25% in 2022, and 7% in 2023. With the new energy Capex cycle in sight, Oil Services is the only energy segment for which sales growth is expected to accelerate over the coming year (Chart 19). In fact, sales will continue to grow at a healthy clip until the cycle matures – a time period measured in years. Chart 18Capex Has Restarted Chart 19Sales Growth Is Rebounding Sharply   The profitability of the sector is also normalizing after a pandemic slump, and margins are expected to stay flat (Chart 20) despite industry labor costs rising sharply to 8% year over year (Chart 21). Earnings are expected to rise by a third in 2022, albeit off very low levels. Chart 20Profit Margins Will Stabilize Chart 21Rising Wages Are Cutting Into Profitability In terms of valuations, the E&S industry is one of the cheapest in the sector, with the BCA Valuations Indicator standing at -1.5 standard deviations below a long-term average. We are positive on the Energy Equipment and Services space, which we consider a high octane play on the upcoming production increases and the new energy cycle. Overweight Energy Equipment and Services Storage And Transportation Will Benefit From Rising Production Volumes The midstream segment is one of the most profitable in the energy supply chain. This industry has high fixed costs, and its profitability is a function of production volume, not oil price. (Chart 22). From that standpoint, the industry is in a good place: US production volume, especially of shale oil, is poised to increase, filling the pipelines and driving sales growth. However, there are also challenges: Pipelines installed in older shales start to see original contractual commitments expiring, resulting in lower cash flows as the pipelines try to re-commit suppliers within a market that has an abundance of pipeline capacity. On the cost side, the S&T segment is seeing an increase in labor costs, with average hourly earnings (AHE) rising close to 10%. Chart 22Production Volume Is A Driver Of Midstream Segment's Profitability With challenges on the sales side and rising costs, it is not surprising that the market expects earnings in the S&T industry to stay flat over the next year or so (Chart 23). Operating profit margins will contract over the next year from the 19% the industry is enjoying now to roughly 14% (Chart 24). Chart 23Midstream Earnings Are To Stay Flat Chart 24Industry Is Highly Profitable But Margins Are Contracting In addition, it is important to note that pipelines run through public land. The recent tightening of EPA regulations and an administration hostile to fossil fuel may halt or slow down pipeline build-out. This may be a short-term negative as some companies may have to forego some of their investments. Over the long run, this may limit pipeline availability and lead to higher energy transportation and storage costs. Underweight Energy Storage and Transportation Industry Energy Refining And Marketing– Favorable Backdrop But No Oomph Similar to the midstream segment, refiners are a high fixed cost operation, and their business is only loosely dependent on the price of oil. Profitability of downstream companies is a function of capacity utilization of the refining facilities, and the crack spread or price differential between the price of crude and refined oil. Thanks to rising demand for oil, and rising volumes, capacity utilization stands at nearly 90% and is approaching pre-pandemic levels (Chart 25, bottom panel). Crack spreads are also high in absolute terms thanks to low inventories (Chart 25, top panel). Chart 25High Capacity Utilization and Wide Crack Spreads Are A Boon For Downstream… Chart 26...But Razor-Thin Margins Make The Industry Vulnerable With the upstream segment ramping up production, refining volumes should increase, further improving capacity utilization. And while margins are razor-thin, they are projected to increase over the next year (Chart 26). The key concern about the industry is that, with margins this narrow, there is little or no buffer to absorb changes in crack spreads or capacity utilization should oil prices rise or volumes decline. And yet, downstream, while cheap, is more expensive than Oil Services, midstream, or Integrated Oil. Equal-weight Energy Refining and Marketing industry Integrated Oil & Gas Is A Safe Bet Integrated Oil is an industry that is diversified across all the segments of the value chain. The characteristics that allowed Integrated Companies to maintain their stock prices better during the downturn – less financial leverage, less reinvestment volatility, stronger dividend support, and counter-cyclical improvement of downstream operations – will work against these stocks during an oil price recovery. As such, while Integrated stocks should benefit from higher prices and production volumes, this is a lower beta proposition: It is better to own Integrated Oil on the way down, but riskier and higher beta E&P or Oil Services stocks during the up leg of the energy cycle. Equal-Weight Integrated Oil & Gas Investment Implications The US Energy sector is in a good place right now: Rising demand and faltering supply from OPEC 2.0, translates into a price of oil anchored around $80 to $85/bbl. This price is twice the breakeven production cost for the majority of the US producers. Rising oil prices had resulted in windfall profits and surging free cash flow, which the Energy companies are dutifully returning to shareholders. High prices have also created an opening for US Energy producers to restart their Capex to increase production. This positive stance of upstream companies is benefiting the entire supply chain. Energy Equipment and Services providers are enjoying accelerated sales growth as E&P increases Capex. Transportation and storage companies are benefiting from higher volumes. And last, the downstream segment benefits from high-capacity utilization of its refineries and wide crack spreads thanks to low refined oil inventories. We are cyclically positive on the Energy sector, the fundamentals of which are solid, and for which valuations are modest. However, overextended technicals indicate that a near-term correction after a strong run is highly likely. We won’t sell to avoid the pullback but will use it as an opportunity to add to the existing positions. Within the Energy Sector, we are constructive on the upstream and E&S segments, both of which benefit from the high price of oil. We are less keen on the midstream segment, which, despite the benefits of increased production volume, is handicapped by rising labor costs, and expiring transportation contracts. And lastly, we are equal-weight the downstream segment, which, despite rising volumes and wide crack spreads, has razor-thin margins. Integrated Oil is the most diversified segment, which is more resilient during the down leg of the energy cycle, but too tame during the upcycle. Bottom Line We recommend a cyclical overweight to the Energy sector as it is in the early innings of the new energy cycle, thanks to surging demand and constrained production capacity out of the US. It is also the highest yielding sector in the S&P 500. However, a near-term pullback after a strong run is likely – we will leverage it to add to our existing overweight. We also recommend a cyclical overweight of the upstream and Oil Equipment & Services segment, underweight midstream, and equal weight downstream.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com       Footnotes 1     https://www.eia.gov/outlooks/steo/   Recommended Allocation

Executive Summary A Swedish Warning Stocks are oversold but downside risks persist. The Fed is on the verge of beginning a tightening cycle, which creates a process often linked to deeper and longer equity corrections around the world. Global economic activity is decelerating, as growth transitions away from splurging on consumer goods to a return to trend in the service sector. Equities are more levered to industrial than services activity, which creates a risk window. Ukraine remains another near-term hurdle. Equity risk premia are not elevated enough to compensate for these threats. Despite near-term risks, the equity bull market will recover and Europe stocks will ultimately outperform. Bottom Line: Investors need to continue to hold portfolio hedges as the near-term outlook remains treacherous for equities. Nonetheless, a wholesale portfolio liquidation is unwarranted as we face a mid-cycle slowdown, not a recession. Feature Last week’s pattern of relaxation and renewed tensions in Ukraine is an acute reminder that markets remain fragile in the near-term. Investors must still contend with an imminent monetary tightening cycle in the US. Additionally, a few cracks are emerging on the global growth picture as a transition from spending on goods to services takes place. Under this light, we worry that risk premia remain too low, and that equities are still vulnerable to further near-term pullbacks. The situation is particularly complex for Europe, which is most exposed to the Ukrainian problems and to the global manufacturing cycle. We thus continue to recommend investors exposed to Europe hold protections. Oversold Enough? Many commentators argue that following the January equity sell-off, the mood of investors soured enough to warrant buying equities anew and closing our eyes. Most famously, the AAII Bull/Bear ratio is once again flirting with its 2018 and 2020 lows, two periods that, in hindsight, proved to be selling climaxes (Chart 1). The picture is complex. BCA’s Equity Capitulation Index is indeed becoming oversold (Chart 2). However, its reading is murky. It can either decline further, which would imply greater weaknesses in stocks, or rebound. Our first instinct is to look at the indicator’s behavior at the onset of Fed tightening cycles, which constitute close historical analogues: Chart 2... But Maybe Not Enough Chart 1Stocks Are Oversold...   In late 2015, when the last Fed tightening cycle began, the Capitulation Index plunged to much lower levels as stocks collapsed. In the background, the global economy was weakened by EM countries hammered by China’s slowdown and balance of payments crises. Around the hiking cycle that begun in June 2004, the Capitulation Index never plunged considerably, but the S&P 500 fell more than 8% between March and August 2004, in a volatile pattern. Back then, both US and global growth was very robust. In 1999, once the Fed resumed hiking rates after the 75bps of cuts following the LTCM debacle, the Capitulation Index and equities were very resilient. This strength persisted until the Nasdaq peaked in March 2000. The S&P 500 formed a complex top between March and August before starting a relentless collapse that September. Following the onset of the 1994-1995 tightening cycle, the Capitulation Index collapsed to much more oversold readings than current ones and equities entered a range-bound volatile episode that lasted until Q1 1995, as the Fed stopped hiking rates. The economy was replete with inflation fears and a mid-cycle slowdown was descending upon the US. The hiking cycle that started in 1988 did not witness significant downside in the Capitulation Index and stocks, but it took place soon after the 1987 crash when equities had become exceptionally oversold. Black Monday itself happened as inflation fear rose as a result of a weak dollar and as the Fed hiked rates through 1987. In 1984, the rate hike cycle was accompanied by a collapse in the Capitulation Index. The tightening in financial conditions caused by the Fed was exacerbated by the surge in the dollar that hurt US profitability and increased EM borrowing costs tremendously. After the 1981 hiking cycle, the Capitulation Index plunged as the US economy entered the second leg of the early 1980s double-dip recession. The latter was an economic crisis prompted by Federal Chairman Paul Volcker’s willingness to put an end to the inflation mentality of the 1970s. These historical experiences highlight one thing: Economic conditions were key to periods when the beginning of a tightening cycle caused a deeper correction in stocks than the one witnessed until now. Economic Clouds Today, the big question shaping the investment world is inflation. BCA expects inflation to peak over the coming months, whether in the US or in Europe. However, this process will take more time. CPI will not crest until after the Fed has begun to hike rates. In the meantime, there are plenty of factors that could easily fan inflation worries and, consequently, a continued upward repricing of the Fed’s interest rate path in the next few weeks. As Arthur Budaghyan highlighted in the most recent Emerging Market Strategy Report, US labor costs are rapidly rising, with the Atlanta Fed Median Wage growth measure up 5.1% annually and the Employment Cost Index (ECI) expanding at a 4.5% annual rate. Of particular worry, this surge in wages does not reflect underlying productivity and unit labor costs, which are up 3.2% annually (Chart 3), their highest rate since 2001, when the Fed funds rate was 4% and 10-year Treasurys yielded 5.4%.  Chart 3US Wage-Price Spiral? Elevated unit labor costs are a powerful inducement for inflation and, thus, are likely to continue to fan inflation fears among market participants. Of particular concern today, the rise in unit labor costs is not counterbalanced by a decline in US import prices and foreign deflationary pressures. Inflation fears remain a major risk for the market. As our BCA Monetary Indicator highlights, the liquidity backdrop is not supportive of equities anymore (Chart 4). Moreover, the technical picture is deteriorating, while speculation remains elevated. With investors fretting about the threat of inflation, the danger is that they start to anticipate a greater deterioration in monetary conditions. The problem is not unique to the US. At the global level, 75% of central banks are tightening policy and those that have not yet done so are gearing up to remove monetary accommodation. Adding to inflation fears are signs of a slowdown in the global goods sector. This slowdown reflects a natural transition from the spending binge on goods that took place during the pandemic, which is ebbing, to service spending, which is accelerating (Chart 5). This pattern is particularly evident for US consumers, the largest spenders in the world. Chart 5Transitioning From Goods To Services Chart 4Deteriorating Liquidity Conditions   One of the world’s most sensitive economies to the global industrial cycle is already feeling the pinch from this adjustment: Sweden. Swedish economic numbers have been weakening and Swedish assets are particularly soft (Chart 6), which heralds poorly for the global manufacturing sector. This deceleration in goods spending and industrial activity is a problem for equities because stock market profits are more geared toward the evolution of the industrial cycle than the service sector (Chart 7). Chart 6A Swedish Warning Chart 7Manufacturing, Not Services, Drives Profits Investment Conclusions In this context, it is prudent to maintain hedges to protect stock holdings. It is commonly argued that stocks are expensive, but if one considers the low level of bond yields, these valuations can be justified. Chart 8 challenges this notion. Yes, the earnings yield is still very elevated relative to 30-year Treasury bond yields; however, it is at its lowest in 42 years against core inflation. Why would core inflation be relevant? In a context in which investors are worried about the impact of inflation on both profit margins (higher labor costs) and the direction of policy, they are unlikely to remain unmoved by inflation fears, especially as the perception of higher policy rates may lift rates higher. Moreover, with many investors anxious that the Fed is falling far behind the curve, the marginal market players could easily become the individuals concerned that a catch up by the Fed will lead the economy into a recession. Considering the risks linked to Ukraine, the potentially negative impact on profitability of slowing goods spending, the growing policy uncertainty globally and in the US, and the inversion of many segments of the yield curve, prudence remains appropriate (Chart 9). Chart 8Value Is In The Eye Of The Beholder Chart 9Rising Policy Uncertainty Chart 10The Importance Of Manufacturing To Europe The problem for European equities is their elevated beta and pro-cyclicality. A pullback in US stocks will automatically drag down European stocks. Moreover, the region’s heavy reliance on manufacturing activity is reflected in the sectoral tilt of European benchmarks. As a result, the performance of European stocks is particularly sensitive to the evolution of the global industrial cycle (Chart 10). Add the fact that European economies are much more exposed to potential energy market disruptions emanating from Ukraine and the recent rebound in Europe’s relative equity performance becomes tenuous at best. Why would these dynamics be temporary and only warrant hedges, not a cyclical underweight in stocks and Europe? First, the inflation fear will recede in the second half of 2022. Our Global Supply Disruption Index has peaked and suggests that inflation surprises will soon ebb. Moreover, a measure of suppliers’ constraints based on the ISM Supplier Delivery Times, Backlog of Orders, Prices Paid, and Inventories is also rolling over (Chart 11). Second, a deepening of the stock market correction will tighten financial conditions and push credit spreads higher. This is a deflationary process that will cause inflation fears to recede and, thus, the pricing of expected Fed rate hikes to lessen. Third, the slowdown in the goods sector is concentrated among consumer goods. Capex will firm up. Capex intentions are elevated in Europe and the US, and global capital goods orders remain robust, despite having decelerated from their extraordinary rebound following the Q1 2020 shutdowns (Chart 12). Moreover, the political and corporate demand to build greater redundancy in global supply chains following the disruptions caused by the Sino-US trade war and COVID-19 will also boost corporate investments for a few more years. This means that many industrial sectors will recover globally and propel industrial equities higher. Chart 11Apex Bottlenecks? Chart 12Capex Will Stay Strong Fourth, Matt Gertken, BCA’s geopolitical strategist, continues to see a limited Ukrainian conflict as the most likely outcome of the current tensions.  As a result, any dislocation to global stocks and European assets caused by a conflict will be transitory. Finally, the business cycle has further to run. In 1994/95 and in 2015/16, the Fed tightening cycle materialized around the time of a mid-cycle slowdown. The economy recovered and profit firmed up anew, which allowed stocks to rebound. The Fed Funds rate is rising but remains below the neutral rate. Interest rates in Europe also have ample scope to rise before monetary policy becomes tight. Simultaneously, the recovering service sector will continue to support employment and, thus, final demand. Equity bear markets rarely materialize outside of recessions (Chart 13).   Chart 13Bear Markets Demand A Recession Bottom Line: Global equities are oversold, but the combination of rising inflation, Fed tightening, Ukrainian risks, and a transition from a goods-driven recovery to a service sector-led economy means that stocks risk becoming even more oversold in the near term. European equities are not immune to these threats. While rising rates are a lesser problem for Europe than the US, the developments in Ukraine and a manufacturing transition represent greater hurdles. Ultimately, the difficulties faced by stocks reflect a mid-cycle slowdown taking place alongside a period of policy tightening. It will be, therefore, temporary. Consequently, investors should not abandon stocks, but rather continue to hold protections.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades

Executive Summary Oil-Price Risk Skewed Upward The $10-$15/bbl risk premium in Brent prices will dissipate over the next month. Russia's best outcome is to follow the off-ramp offered by the US. President Biden's call to KSA's King Salman last week will result in higher oil output from the Kingdom, the UAE and Kuwait, in return for deeper US defense commitments. The Biden administration and Iran are in a hurry to get a deal done: The US wants lower oil prices, and Iran needs the revenue. Our Brent forecasts for 2022 and 2023 are revised slightly to $81.50 and $79.75/bbl, respectively, reflecting supply-demand adjustments. Price risks are tilted to the upside: A miss on any of the above assumptions will keep prices above $90/bbl, and push them higher. Bottom Line: Oil demand will remain robust this year and next.  To keep prices from surging from current levels into demand-destruction territory, additional supply is needed.  Most of this will come from KSA, the UAE and the US shale-oil producers.  We expect prices to fall from current prompt levels this year and next.  This will support sovereign budgets and oil producers' free cashflow goals.  We remain long the XOP ETF. Feature The $10-$15/bbl risk premium in Brent crude oil prices will dissipate, as the following supply-side events are ticked off: 1)   Russia gets on the off-ramp offered by the US last week to de-escalate the threat of another invasion of Ukraine by withdrawing its troops from the border;1 2)   OPEC 2.0's core producers – the Kingdom of Saudi Arabia (KSA), the United Arab Emirates (UAE), and Kuwait – increase supply in return for deeper US security commitments; 3)   Iran restores its remaining 1.0 – 1.2mm b/d of production to the market, following the restoration of its nuclear deal with Western powers; and 4)   US shale-oil producers step up production in response to higher WTI prices. Politics, Then Economics The first three assumptions above are political in nature, requiring a bargain be struck among contending interests to resolve. We do not believe Russia's endgame is to jeopardize its future oil and gas exports to the West, particularly to the EU (Chart 1). The US is warning that another invasion of Ukraine will put the use of the Nord Stream 2 pipeline to deliver gas to Germany at risk.2 It also is worthwhile noting NATO is aligned with the US on this stance. Russia derived 40-50% of its budget revenues from oil and gas production, and ~ 67% of its export revenue from oil and gas over the decade ended in 2020.3 Of course, only President Putin can determine whether oil and gas sales can be diversified enough – e.g., via higher shipments to China – to offset whatever penalties the West imposes. But, in a game-theoretic sense, the stakes are very high, and taking the US off-ramp is rational. Chart 1Russia's Critical Exports: Oil + Gas We expect the second assumption to play out in the near term, following US President Joe Biden's call to KSA's King Salman last week. The outreach stressed the US commitment to defend KSA and, presumably, its close allies in the Gulf (the UAE and Kuwait).4 KSA already has increased its production to 10.15mm b/d under the OPEC 2.0 agreement to restore 400k b/d beginning in August 2021. We estimate the coalition had fallen behind on this effort by ~ 1mm b/d, as only KSA, the UAE and Kuwait presently have the capacity to lift production and sustain it (Table 1). KSA's reference production level agreed at OPEC 2.0's July 2021 meeting will rise to 11.5mm b/d in June, up 500k b/d from its current level (Table 2). This means KSA could flex into another 850k b/d between now and the end of May; and another 500k b/d after that. The UAE's and Kuwait's reference production levels will rise 330k and 150k b/d in June to 3.5mm b/d and 3.0mm b/d, respectively. Markets will need these incremental volumes as demand continues to recover and non-core OPEC 2.0 production continues to fall (Chart 2). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Table 2Baseline Increases For Core OPEC 2.0 Our third assumption reflects our reading of the signaling by Iran over the past few weeks, which indicate growing confidence a deal with the US to restore the Joint Comprehensive Plan of Action (JCPOA) is in the offing.5 The politics here converge with the economics: the Biden Administration wants to increase oil supply ahead of mid-term elections in the US to keep gasoline prices under control; Iran needs to increase its revenues. Both sides get an immediate need satisfied. However, the risks to KSA and its Gulf allies will increase as Iran's revenues grow, because it will be able to fund proxy-war operations against the Gulf states. This is why deepening the US defense commitment to the region is critical to KSA and its allies. The last assumption reflects our view US E+P companies are being incentivized to lift production by high prompt and deferred prices. We continue to expect these companies – particularly those in the US shales, where the majority of the production increase will occur – to husband their capital resources closely, and to continue to prioritize shareholder interests. As capital availability declines – primarily due to reduced investor interest in investing in hydrocarbon production – these firms will have to focus on reducing operating costs and increasing productivity over the next decade to fund growth. Relative to 2021, we expect US oil production to increase 0.85mm b/d this year and by 0.53mm b/d in 2023 relative to this year, as producers respond to higher prices (Chart 3). Chart 2Increased Core OPEC 2.0 Production Becoming Critical Chart 3US Oil Production Will See Another Up Leg Supply-Demand Balances Are Tight Global oil demand growth this year is reduced slightly in our balances – going to 4.5mm b/d from 4.8mm b/d, mostly reflecting our assessment of slowing growth as central banks remove monetary accommodation. We lifted next year's growth estimate slightly, to 1.7mm b/d. These estimates still leave our growth expectations above the major data providers, the highest of which is OPEC's 4.2mm b/d estimate. We continue to expect DM demand to level off this year and next, and EM demand to retake its position as the global demand growth engine (Chart 4). The supply side remains tight, with average global crude oil and liquid fuels production estimated at 101.5mm b/d for 2022 and 102.8mm b/d for next year. With demand expected to average 101.5mm b/d this year and 103.2mm b/d next year, markets will remain balanced but tight (Chart 5). This means inventories will continue to be strained, leaving little in the way of a cushion to absorb unexpected supply losses (Chart 6).  Chart 4EM Demand Retakes Growth-Engine Role Chart 5Markets Remain Balanced But Tight... Chart 6...Keeping Pressure On Inventories Markets Remain Balanced But Tight Our supply-demand analysis indicates markets will remain balanced but tight, with inventories under pressure until supply increases. This will predispose markets to higher price volatility, as low inventories force prices to ration supply. This will increase the backwardation in the Brent and WTI curves, which will bolster the convenience yield in both of these markets (Chart 7).6 We expect implied volatility to remain elevated, as a result (Chart 8). Chart 7Backwardation Will Keep Convenience Yield Elevated Chart 8High Volatility Will Persist Because of these low inventory values, Brent prices for 2022 are higher than our previous estimate. By 2023, the effects of increased supply from KSA, UAE, Kuwait – albeit a marginal increase – and the US kick in to reduce prices. As supply increases, the risk premium currently embedded in Brent prices will decline, pushing them to our forecasted levels for 2022 and 2023 of $81.50/bbl and $79.75/bbl, respectively. For 1H22, we expect Brent prices to average $87.20/bbl, and in 2H22 we're forecasting a price of $75.80/bbl on the back of increased production. Next year, higher output will keep prices close to $80/bbl, with 1H23 Brent averaging $79.85 and 2H23 averaging $79.70/bbl. Word Of Caution Our analysis is predicated on strong assumptions regarding the incentives of oil producers taking a rational view of the need for stability and supply in markets. The bottom panel of Chart 9 provides an indication of how tenuous markets are if our assumptions are mistaken, and core OPEC 2.0 does not increase production, Iranian barrels are not returned to the market, or the US shale supply response is less vigorous than we expect. The highest price trajectory occurs when all of our assumptions prove wrong, which takes Brent prices above $140/bbl by the end of 2023. It goes without saying this is non-trivial. But we'll say it anyway: This is non-trivial. We can reasonably expect feedback loops in such a case – e.g., US and Canadian production kicks into high gear, and once-idled North Sea are brought back into service. However, this takes time, and will cause demand destruction on a global scale. Chart 9Scenarios For Oil Prices   Investment Implications Oil markets will remain tight and volatile until additional supplies are forthcoming. We are expecting core OPEC 2.0 to lift output by 3.2mm b/d this year, and for the US Lower 48 production to average 9.8mm b/d. The US production increase will be led by higher shale-oil output, which we expect to average 7.4mm b/d this year and 7.8mm b/d in 2023. Given the tight markets we expect, we remain long the XOP ETF, and commodity index exposure in the form of the S&P GSCI and the COMT ETF, an optimized version of the S&P GSCI.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish Marketed volumes of US natural gas are expected to hit a record high of just under 107 Bcf/d next year as prices stabilize close to $4/MMBtu, in the EIA's latest estimate. This is up from just over 104 Bcf/d of marketed production this year, which itself was a 3 Bcf/d increase over 2021 levels. Almost all of this will come from the Lower 48 (97%). We expect US LNG exports to increase on the back of rising production and further investment in export terminals. Most of this will be shipped to Europe, in our estimation, as EU states seek to diversify LNG sources in the wake of the Russia-Ukraine standoff currently underway. LNG imports accounted for roughly one-fifth of all natural gas supplied to the UK and EU-27 in 2020, according to the EIA, which notes, "Growing volumes of flexible LNG supplies, primarily from the United States, contributed to the notable increases in LNG imports to Europe from 2019 to 2021." Wide price differentials can be expected to support the flow of LNG to Europe from the US (Chart 10). Base Metals: Bullish Iron ore prices took a hit after China’s National Development and Reform Commission (NDRC) stated its intentions to stabilize iron ore markets, crack down on speculation and false price disclosures after prices in 2022 rallied sharply last week.  Authorities believe price strength is coming from speculation and hoarding, which is adding to inflationary pressures.  However, fundamental factors have been, and likely will keep iron ore prices buoyed.  Based on past steel inventory levels and seasonal patterns, steel production will increase and more than double current inventory levels by end-March. Monetary policy easing, and the push by China’s steel industry to become carbon-neutral over the next five years are additional fundamental factors supporting iron ore prices. Precious Metals: Bullish The January print for US CPI jumped 7.5% year-on-year, beating estimates as headline inflation rose to a 40-year high.  Markets are expecting around five interest increases this year (Chart 11).  BCA’s US Bond Strategy expects rate hikes will be around 100 – 125 bps this year.  Gold prices initially fell on the possibility of increasing rate hikes and a hawkish Fed, but in the second half of last week settled at subsequently higher prices on each day.  Apart from increased inflation demand, this was likely due to markets’ fear of the possibility of an ultra-hawkish Fed, which could tighten US financial conditions and see a rotation out of US equity markets into safe-haven assets or into other markets ex-US, both of which will be bullish for gold. Chart 10 Chart 11         Footnotes 1     Please see Background Press Call by a Senior Administration Official on the President’s Call with Russian President Vladimir Putin, released by the US White House on February 12, 2022. 2     Please see Long-Term EU Gas Volatility Will Increase, which we published on February 3, 2022 for further discussion.  The EU is a huge market for Russia supplies Germany with 65% of its gas.  Approximately 78% of total natural gas exports (pipeline + LNG) from Russia went to the EU in 2020. 3    Please see Russia’s Unsustainable Business Model: Going All In on Oil and Gas, published on January 19, 2021 by the Hague Centre for Strategic Studies (HCSS). 4    Please see Readout of President Joseph R. Biden, Jr.’s Call with King Salman bin Abdulaziz Al-Saud of Saudi Arabia, released on February 7, 2022. The readout noted, " issues of mutual concern, including Iranian-enabled attacks by the Houthis against civilian targets in Saudi Arabia." Energy security also was discussed, which we read as code for a deal to increase production in return for a deepening of US defense commitments. This line is followed closely by Gulf media – e.g., It took Biden a year to realize Saudi Arabia’s vital regional role, published by arabnews.com on February 13, 2022, which notes: "If Putin decides to invade Ukraine, the Saudis are the only ones who could help relieve the unsteady oil markets by pumping more crude, being the largest crude exporter in the OPEC oil production group. The White House emphasized that both leaders further reiterated the commitment of the US and Saudi Arabia in ensuring the stability of global energy supplies. 5    Please see Iran 'is in a hurry' to revive nuclear deal if its interests secured -foreign minister, published by reuters.com on February 14, 2022. 6    Please see our November 4, 2021 report entitled Despite Weaker Prices Crude Oil Backwardation Will Persist for additional discussion of convenience yields and volatility.   Investment Views and Themes Strategic Recommendations Trades Closed in 2021