Developed Countries

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

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

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

Executive Summary We look at the Ukraine crisis in the broader context of shocks, what we can learn from them, and how we can incorporate them into our strategy for investment, and life in general. Our high-conviction view is that the Ukraine crisis will be net deflationary, because the economic and financial sanctions imposed on Russia will lead to a generalized demand destruction. Bond yields will be lower in the second half of the year. Underweight cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100. Stay structurally overweight the 30-year T-bond. The ultimate low in the 30-year T-bond yield is yet to come, and will be a long way below the current 2.1 percent. Fractal trading watchlist: We focus on banks, add alternative electricity, and review bitcoin. Every Shock Is Always Supplanted By A New Shock Bottom Line: The recent rise in bond yields and the associated outperformance of cyclical sectors such as banks, ‘value’, and value-heavy stock markets such as the FTSE 100 was just a short-lived countertrend move within a much bigger structural downtrend. This structural downtrend is now set to resume. Feature Suddenly, nobody is worried about Covid and everybody is worried about nuclear war. Or as Vladimir Putin warns, “such consequences that you have never experienced in your history.” The life lesson being that every shock is always supplanted by a new shock. Hence, in this report we look at the Ukraine crisis through a wider lens. We look at the broader context of shocks, what we can learn from them, and how we can incorporate them into our strategy for investment, and life in general. The Predictability Of Shocks Shocks are very predictable. This sounds like a contradiction, but we don’t mean the timing or nature of individual shocks. As specific events, Russia’s full-scale invasion of Ukraine and the global pandemic were ‘tail-events’ that did come as shocks. Yet the statistical distribution of such tail-events is very predictable. This predictability of shocks forms the bedrock of the world’s $5 trillion insurance industry, and should also form the bedrock of any long-term strategy for investment, or life in general. The predictability of shocks forms the bedrock of the world’s $5 trillion insurance industry, and should also form the bedrock of any long-term investment strategy. We define a shock as any event that causes the long-duration bond price in a major economy to rally or slump by at least 20 percent, albeit this is just one definition.1On this definition, the Ukraine crisis is not yet a far-reaching economic or financial shock, but it is certainly well-placed to become one. Applying this definition of a shock through the last 60 years, the statistical distribution of shocks over any long period is well-defined and very predictable. For example, over a ten-year period the number of shocks exhibits a Poisson distribution with parameter 3.33 (Chart I-1), while the time between shocks exhibits an Exponential distribution with parameter 3.33. Chart 1The Statistical Distribution Of Shocks Is Very Predictable Many economists and investment strategists present their long-term forecasts for the economy and financial markets, yet completely ignore this very predictable distribution of shocks – making their long-term forecasts worthless! The question to such economists and strategists is why are there no shocks over your forecasting horizon? Their typical answer is that it is not an economist’s job to predict ‘acts of god’ or ‘black swans.’ But if insurance companies can incorporate the very predictable distribution of acts of god and black swans, then why can’t economists and strategists? Over any ten-year period, the likelihood of suffering a shock is a near-certainty, at 95 percent; in any five-year period, it is an extremely high 80 percent; in a two-year period, it is a coin toss at 50 percent; and even in one year it is a significant 30 percent (Chart I-2). Chart I-2On A Multi-Year Horizon, Another Shock Is A Near-Certainty Witness that since just 2016 we have experienced Brexit, and the election of Donald Trump as US president. These were binary-outcome events where we could ‘visualise’ the tail-event in advance, but many dismissed it as implausible. Then we had a global pandemic, and now Russia’s full-scale invasion of Ukraine. Therefore, the crucial question is not whether we will experience shocks. We always will. The crucial question is, will the shock be net deflationary or net inflationary? Our high-conviction view is that the Ukraine crisis will be net deflationary. Meaning that even if it starts as inflationary, it will quickly morph into deflationary. The Danger From Higher Energy Prices: The Obvious And The Not So Obvious Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns – most recently, the 1999-2000 trebling of crude and the subsequent 2000-01 downturn, and the 2007-2008 trebling of crude and the subsequent 2008-09 global recession. Begging the question, should we be concerned that the Ukraine crisis has lifted the crude oil price to a near-trebling since October 2020, not to mention the massive spike in natural gas prices? Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns. Of course, we know that the root cause of both the 2000-01 downturn and the 2008-09 recession was not the oil price surge that preceded them. As their names make crystal clear, the 2001-01 downturn was the dot com bust and the 2008-09 recession was the global financial crisis. And yet, and yet… while the oil price surge was not the culprit, it was certainly the accessory to both murders. The obvious way that high energy prices hurt is that they are demand destructive to both energy and non-energy consumption. In this regard, the good news is that the economy is becoming much less energy-intensive – every unit of real output requires about 40 percent less energy than at the start of the millennium (Chart I-3). Nevertheless, even if the scope to hurt is lessening, higher energy prices are still demand destructive. Chart I-3The Economy Is Becoming Less Energy-Intensive The not so obvious way that high energy prices hurt is that they risk driving up the long-duration bond yield and thereby tipping more systemically important economic and financial fragilities over the brink. This was the where the greater pain came from in both 2000 and 2008 (Chart I-4 and Chart I-5). Chart I-4Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 1999 Chart I-5Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 2008 Fortunately, the recent decline in the 30-year T-bond yield suggests that the bond market is looking through the short-term inflationary impulse of higher energy prices (Chart I-6). Instead, it is focussing on the deflationary impulse that will come from the demand destruction that the higher prices will trigger. Chart I-6Today, The Bond Market Is Looking Through The Inflationary Impulse From Higher Energy Prices The economic and financial sanctions imposed on Russia will only lead to additional demand destruction. Sanctions restrict trade and economic and financial activity – therefore they hurt both the side that is sanctioned and the side that is sanctioning. This mutuality of pain caused the West to balk at both the timing and severity of its sanctions. But absent an unlikely backdown from Russia, the sanctions noose will tighten, choking growth everywhere.   If bond yields were to re-focus on inflation and move higher, it would add a further headwind to the economy and markets, forcing the 30-year T-bond yield back down again from a ‘line in the sand’ at around 2.4-2.5 percent. So, the long-duration bond yield will go down directly or via a short detour higher. Either way, bond yields will be lower in the second half of the year. Given the very tight connection between bond yields and stock market sector, style, and country allocation, it will become clear that the recent outperformance of cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100 was just a short-lived countertrend move in a much bigger structural downtrend (Chart I-7). This structural downtrend is set to resume. Chart I-7When Bond Yields Decline, Banks Underperform Underweight cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100. Yet, the over-arching message from the anatomy of shocks is that the ultimate structural low in the 30-year T-bond yield is yet to come, and will be a long way below the current 2.1 percent. Stay structurally overweight the 30-year T-bond.   Fractal Trading Watchlist This week’s analysis focusses on banks, adds alternative electricity, and reviews bitcoin. Supporting the fundamental arguments in the main body of this report, the recent outperformance of banks has reached the point of fractal fragility that has signalled several important turning-points through the past decade (Chart 1-8). Accordingly, this week’s recommended trade is to go short world banks versus world consumer services, setting the profit target and symmetrical stop-loss at 12 percent.  Chart I-8The Recent Outperformance Of Banks May Soon End Alternative Electricity Is Rebounding From An Oversold Position Bitcoin's Support Is Holding Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 20 percent. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5 Indicators To Watch - Interest Rate Expectations Chart II-6 Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations