Economy

Highlights 2022 has had a rough start for equity investors: the S&P 500 is now down 8% from its peak, and NASDAQ is officially in correction territory.  The question on everyone’s mind is how long this correction will last, and whether it is the right time to start buying beaten-up Tech stocks. Looking “under the hood” of the NASDAQ, we observe that with the technology space being top-heavy and dominated by the likes of Microsoft and Apple, index returns mask the heavy losses of some of the smaller, and less profitable, constituents, with many down 40-50% from their peaks.  Analysis of the market breadth shows that three-quarters of NASDAQ names are trading below their one-week highs, which, according to our analysis, indicates that Tech is (almost) ripe for a bounce back. However, the sector is currently under duress from rising rates and imminent monetary tightening.  Historically, Tech’s worst performance was two to three months prior to the first rate hike – the current pullback is a “textbook” behavior.  It will take another couple of months after the rate hike for a sustainable rebound. In addition to headwinds from rising rates, there is also an ongoing slowdown in demand for tech products and services, which translates into a deceleration of earnings and sales growth. On the valuations front, Technology is trading with a significant premium to the market, while its expected earnings growth is on par with that of the S&P 500. We recommend investors to be patient: While Tech appears oversold, and recent volatility is a function of market panic, the stars have not yet aligned for the sector.  We are tactically bearish but structurally bullish. Feature 2022 has had a rough start for equity investors: Since the beginning of January, the S&P 500 has pulled back 8%.  Market consensus is that this violent rotation is a repricing of risk, triggered by the Fed’s new hawkish stance aimed at taming the runaway inflation that has surged to a nearly 40-year high. The market expects the first rate hike as soon as March, followed by three more into the year-end. It is also grappling with the timing and degree of quantitative tightening (QT), which will follow on the heels of tapering. Energy and Financials are the only sectors in the green so far this year, with Real Estate, Healthcare, and Tech being hit the hardest (Chart 1). Internet Retail is down almost 20% from its local peak in mid-2021 and Interactive Media, home of Facebook, is down 11%. NASDAQ is officially in correction territory (Chart 2). Rising rates have hit growth and interest-rate-sensitive areas of the market the hardest. While these negative returns indicate a sharp pullback, they don’t do justice to how painful this correction has been, as much of it was happening under the radar. The S&P 500 and many of its tech-related sectors and industries are top-heavy, being home to FAANG+M, which has proven to be more immune to rising rates.  It is the smaller growth companies that have fallen much more than the top-line number indicates, with many down 40-50% from their peaks. However, now with more than 58% of stocks in the NASDAQ trading below their 30-week moving average, the natural question is: “Are we there yet?” or how much longer will this sell-off last? There are early signs of bottom-fishing among the stocks and industries hit hardest. Yet most days, both the S&P 500 and the NASDAQ start in the green, only to finish splattering to a new low (Chart 3). Chart 3Mega-cap Tech Has Fallen But Less Than Small-cap Brethren In this report, we will aim to gauge when the sell-off in tech names will have run its course by focusing on the S&P 500 Technology sector.    Also in today’s publication, we will reverse our usual course of analysis: We will start from the technicals as they are most helpful for timing entry points, and we will follow with macro and fundamentals.   Tech Sector Is Top Heavy The S&P 500 Technology sector is top-heavy, with each industry group dominated by one of the tech giants, such as Microsoft in Software and Services, Apple in Hardware and Equipment, and Nvidia in Semiconductors. We call this trio “MAN.” The MAN accounts for 50% of the S&P 500 Technology sector market capitalization (Chart 4). As a result, both sector performance and valuation are heavily affected by index composition.  To unpack what is going on within the Tech sector, we plotted the dispersion of last month’s performance within the sector through a market cap bucket, with the first bucket containing the MANs. The last couple of buckets, 10 and 11, contain some of the smallest stocks in the index. Unsurprisingly, the largest stocks in the sector have not fallen that much. The correction has most affected stocks in buckets 7 through 11, with a market cap of between $8 to $33 billion, and these are the names that may be most tempting for “bottom-fishing.” Technicals It Is A Blood Bath Out There A useful indicator of market breadth, allowing us a look under the hood”, is the percentage of stocks making new lows – which currently stands at nearly 75% (Chart 5). This is a high reading which has happened only 11% of the months since 2000.  However, once this metric rises above 85%, it indicates that the market is oversold.  When that happens, the Tech sector outperforms the S&P 500 by around 7% over the next six months, and returns are positive every month (Chart 6).  Based on this indicator, the NASDAQ in general, and Tech in particular, are close to the oversold conditions and are ready for a bounce.  Chart 5Pullback In Tech Stocks Is Broad-based However, the BCA Technical Indicator for the sector (Chart 7) is still in neutral territory. It is driven primarily by momentum components: It gauges the trend in equities and determines if the market is at an extreme in terms of momentum or investor psychology.  This indicator is highly affected by the performance of the largest index constituents. All in all, we conclude that from a technical standpoint, the Tech sector is getting closer to a rebound. Chart 7The Technical Indicator Is In The Neutral Territory Macroeconomic Backdrop New Rate Hiking Cycle Will Take Time Getting Used To Ok, Tech is oversold. Yet there is still the not-so-small matter of a new, tighter monetary regime. How does Tech fare in the environment of rising rates? Clearly, not so good so far. However, the question is, how long will it take for the higher rates to be priced in, and for Tech to rebound. To answer this question, we have run another empirical study, anchoring the performance of the Tech sector to the beginning of each hiking cycle since 1996 (Charts 8 and 9).   According to our analysis, Tech’s worst performance is two to three months prior to the first rate hike – the current pullback in Tech is a perfect illustration. While we may expect a rebound rally “when the second shoe drops” and the Fed announces the first hike, it appears that a sustainable rally may still be a couple of months away. Based on this analysis, we conclude that it will pay off to be patient and wait until the summer. It Is The Economy, Stupid! Apart from the headwind from rising rates, there is also an ongoing slowdown in demand for Tech Business Investment (Chart 10). Moreover, the Tech New Orders Index peaked at a high level at the end of 2021 and has recently turned (Chart 11). So has Private Tech Investment (Chart 12).  This indicates that demand is waning following the surge that accompanied the most recent push to digital transformation—which was accelerated by the onset of the pandemic.   Chart 10Slowdown In Tech Business Investment Chart 11Tech New Orders Have Peaked Chart 12Private Tech Investment Is Also Slowing The macroeconomic backdrop is unfavorable for the Tech Sector Fundamentals Sales And Earnings Growth Are Slowing While the Tech sector enjoyed a fantastic sales recovery in 2021, with sales growth exceeding pre-pandemic levels, this year may be different. Waning demand for tech products and services translates into a sales growth slowdown (Chart 13).   Chart 13The Tech Sector Sales Growth Is Slowing... Chart 14... So Is Earnings Growth With sales growth slowing, earnings growth is bound to follow (Chart 14), which is no different from the broad market. Technology sector earnings growth for the next 12 months is converging with that of the S&P 500: 10% vs. 9% respectively (Chart 15). Margins are expected to compress in 2022, albeit from the high levels (Chart 16). Chart 15Tech And The S&P 500 Expected Earnings Growth Has Converged Chart 16Margins Are Expected To Compress Of course, the Q4-2021 earnings results could bring a respite.  So far blended the year-on-year earnings growth rate is 15.8%: However, only 5 companies out of 71 have reported, beating expectations by 4.6%.  Will these results save the day? Possibly – expectations are a low bar to clear.  Time will tell.  But to prop up the sector, results from the MAN have got to be stellar. Valuations: Better But Not Good Enough While Tech earnings are expected to grow in line with the S&P 500, the sector is trading with a 28% premium to the market at 27x vs. 21x forward PE (Table 1). Relative PE NTM currently stands at 1.7 standard deviations above the five-year average. Although this may seem high, the froth has come off as, only two months ago, Tech was trading at 2.4 standard deviations. This is a significant change, but the sector is not yet cheap enough for bargain hunting. Adjusting for the growth rate differential between Tech and the S&P 500, we divide PE NTM over EPS Growth NTM, to arrive at PEG: Even so, Tech is still more expensive trading at 2.7 for a percentage of future growth, compared to 2.3 for the S&P 500. However, Tech is a growth sector, and perhaps by looking at only one-year-ahead earnings growth, we are being myopic. Let’s take a look at longer-term growth expectations. Curiously, over the next five years, Tech earnings are expected to grow at about an 18% annualized rate, while the S&P 500 is expected to grow at 21% (Chart 17). As a result, the PE/Long-Term Earnings Growth Rate for Tech is 1.5 vs. 1.0 for the S&P 500. Table 1Tech Valuation Premium Is Still Too High Chart 17Long-term Earnings Growth Does Not Justify Valuation Premium Either Of course, we need to keep in mind that since this sector is so top-heavy, the forward PE of the MAN affects overall sector valuations. As you can see in the table below (Table 2), MAN is trading with a premium to the sector. However, within the sector, companies with sky-high valuations are easier to find among smaller constituents (Chart 18). Valuations are elevated, while fundamentals are deteriorating  Table 2The Largest Tech Companies Are Trading With A Premium To The Sector Investment Implications While it is tempting to add to Technology on the back of this pullback, we recommend caution. Tech is oversold and recent volatility is a function of market panic, yet the stars have not yet aligned for the sector. Historically, Tech has delivered negative returns several months prior to rate hikes and underperformed the broad market. Economic normalization also brings a slowdown in demand for tech goods and services, which translates into less exciting sales and earnings growth, and margin compression. Although some froth has come off, valuations for the sector remain elevated, and the premium over the S&P 500 is not justified. The scorecard summarizes each of these points, and it is clear that, on balance, the sector has quite a few challenges ahead (Table 3). Table 3Technology Sector Scorecard On a more optimistic note, this sell-off has been fast and furious, and the worst is most likely behind. We are underweight the Technology sector. Within the sector, we are underweight Semiconductors, and Hardware and Equipment. We are still overweight Software and Services for portfolio diversification purposes. The Software sector will be one of our next “deep dives.” Stay tuned. Are we there yet?  No, we still have a few months to go. Structural Positioning While we reiterate our tactical underweighting of the Tech sector, we are bullish on it over the longer investment horizon. This sector is at the heart of US technological innovation, such as cloud computing, artificial intelligence, cybersecurity, chip design that powers EV and AV, and many others.  The sector is home to some of the best American companies, which have powered US equities throughout the past decade, and will continue to do so for decades ahead. Bottom Line Despite a sell-off of NASDAQ and the Technology sector, we are not yet recommending increasing cyclical allocation to Tech: While technicals appear attractive, tighter monetary policy, the slowdown in demand for tech goods and services, pressures on profitability, and elevated valuations remain headwinds. We reiterate our underweight to the Technology sector on a tactical basis.  We are structurally bullish.    Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation

Highlights Banks, households, and businesses are still swimming in cash: Asset purchases and zero rates are ending, but banks, households and businesses have more cash than they know what to do with. It will not be easy for the Fed to mop up enough accommodation to slow the economy in a material way this year. The flood of liquidity may be a headwind for interest rates in 2022, … : The biggest banks have positioned themselves to benefit from rising rates and may limit the backup in yields as they deploy their unused capital hoard into it.  … and protect equities from suffering meaningful de-rating: All the money has to go somewhere, and equities may be the default winner if bonds and cash are poised to deliver negative real returns. The rosy near-term outlook implied by the biggest banks’ observations suggests that the bull market in risk assets isn’t over yet: Households have ramped up spending but have barely begun to tap into their excess savings and businesses are confident and well-heeled. Above-trend economic growth should bolster corporate earnings, credit performance and financial asset prices, keeping the bull market going through the end of the year. What The Banks See The SIFI banks (BAC, C, JPM and WFC) and USB kicked off fourth quarter earnings across three days bracketing the Martin Luther King long weekend. Their performance wasn’t bad – the SIFIs squarely beat analysts’ consensus estimates and USB came up about 3% short – but investors apparently wanted more from a group that had burst out of the gate to start 2022. Banks were market darlings in the year’s first nine sessions as investors sought out stocks that could outperform in a rising rate environment, and the SIFIs and USB beat the S&P 500 by 12 percentage points (Chart 1). Over the three sessions that they reported earnings, they gave back more than a third of their relative outperformance, though they still have a 7-point year-to-date advantage. Chart 1Rate Play Our focus, however, is not on the banks themselves or their stocks’ relative performance. We’re after what the principal financial intermediaries are seeing from their privileged vantage point into activity across the economy. We examine the banks’ earnings releases and listen to their earnings calls for insight into the broad macro backdrop as revealed by borrower performance, lender willingness, the state of the financial system and the actions and intentions of households and businesses. Considering the banks’ calls from that perspective, several growth-friendly themes emerged. Households remain flush with cash, even at the lower end of the wealth distribution, heralding robust 2022 consumption. Deposits from households and businesses continue to pile up, supporting credit performance and likely pushing out the date when net charge-off rates will rise to more normalized levels. The deposit flows are increasing the banks’ capacity to lend, and they are champing at the bit to deploy their cash into new loans. Investment banking pipelines are full and rampant liquidity should see to it that new debt and equity offerings meet with a warm reception once they come to market, as long as the current bout of market turbulence doesn’t lead to a lasting rollback in animal spirits. All in all, the banks’ observations affirmed our constructive take on the economy through at least the end of the year. Households are already spending in a way that validates our time-release view of fiscal transfers and their incomes have apparently risen enough that they have not yet begun to deplete the savings they built up from Congress’ pandemic largess. Businesses remain flush and are looking to replenish depleted inventories to reduce their vulnerability to supply chain disruptions. M&A activity is still hot and underwriting calendars are full. Yields are poised to rise as the Fed dials down monetary accommodation, but it’s possible the banks’ eagerness to put their idle cash to work will help limit how high they can go. Households Have Been Spending (Chart 2), But They Still Have Loads Of Dry Powder (Chart 3) … [F]or the holiday period of November and December, [debit and credit] spending was up 26% over 2019. … And so far this year that strength continues. [S]pending of all types through January 17 … [was] up over 11% versus the start of ’21, which is well up over ’20 and ’19, and that bodes well for the rest of the year and quarter. (Moynihan, BAC CEO) Chart 2You Can't Keep An Avid Consumer Down Chart 32 Trillion Of Excess Savings ... [C]ombined credit and debit [card] spend was up 27% versus the fourth quarter of 2019, with each quarter in 2021 showing sequential growth compared to 2019. Within that, travel and entertainment spend was up 13% versus 4Q19, though we have seen some softening in recent weeks contemporaneously with the Omicron wave. (Barnum, JPM CFO) Consumer credit card spend also continued to be strong, up 28% from the fourth quarter of 2020 and up 27% from the fourth quarter of 2019. All spending categories were up in the fourth quarter compared to a year ago, with the largest increases in travel, fuel, entertainment and dining. (Scharf, WFC CEO) [W]hile there is some softening [from Omicron] in restaurant, travel and entertainment in recent weeks, overall spending remained strong in the first week of January with credit card up 26% and debit card up 29% versus the same week in 2020. (Scharf, WFC) [W]e are seeing increases in [card] spend volume … across the board, [with] branded card spend volumes up 24% and retail services spend volumes up 16%[.] People are using our cards, which is a good thing. (Mason, C CFO) [C]onsumer[s] [are] in really good shape, … spending … 25% more than they spent pre-COVID, 25% more. And that number drives all the order books for everybody else. (Dimon, JPM CEO) We believe there’s lots of potential spending capacity left as average deposit balances (Chart 4) continue to move up … despite … heavy spending[.] We had [only] one cohort of deposits that dipped [in any] month [in] the last part of the year: … customers who had balances of $2,000 or less pre-pandemic [saw their balances] dip by 1% [in November]. Other than that, every cohort from June [through] December [had their balances] grow every month. And what’s striking is that the balances for people who had less than $2,000 average balances before the pandemic [now have] five times [their pre-pandemic] balances. [C]ustomers who had $10,000 in their accounts before the pandemic are now sitting with two times [that] in their accounts. (Moynihan, BAC) Chart 4... Are Sitting In Checking Accounts, Waiting To Be Spent  … Helping Credit Performance (Chart 5) And Keeping A Lid On Card Balances (Chart 6) Chart 6Cash-Rich Consumers Don't Need To Carry Credit Card Balances The asset quality of our customers remains very healthy and net charge-offs this quarter fell to a historical low of … 15 basis points of average loans. … Our credit card loss rate was 1.42%, … less than half of the pre-pandemic rate, [and] it improved in every quarter during the year. (Borthwick, BAC CFO) [O]ur 30, … 60 or 90 days past [due consumer loans] are staying at … low levels. … [C]ustomer [checking account] balances, elevated in some cases five times [above] … pre-pandemic levels … probably account for a lot of the consumer credit quality improvement. We’re anticipating at some point it will go back towards more normal historical levels. We just think it’s going to bump around here for a little while. (Borthwick, BAC) [W]e’re exiting the fourth quarter with a card net charge-off rate of … something like 1.2% -- -- Which you’ll never see again (Barnum and Dimon, JPM) [C]redit card [charge-offs] has been a number that we’ve never seen in our lives. Middle market has been lower than ever. … Mortgages have been lower than ever. They’re all low. Eventually, they’re going to normalize. (Dimon, JPM) In terms of [card] losses, … [we are seeing] very low loss levels. [W]hen I look at the delinquency trend, there’s really nothing to focus on there. [Delinquencies] remain quite low and we don’t see any signs or areas of concern. (Mason, C) Payment rates do remain stubbornly high, [negatively] impacting our loan growth … in [our] cards businesses. (Mason, C) Consumer credit performance remains strong with higher collateral values for homes and autos and consumer cash reserves remain[ing] above pre-pandemic levels. (Santomassimo, WFC CFO) Credit quality remains strong. Over the next few quarters, we expect the net charge-off ratio to remain lower than historical levels, but normalize over time as the effects of the pandemic continue to subside. (Dolan, USB CFO) Business Borrowing May Be Turning A Corner (Chart 7) Chart 7Are Middle-Market Corporate Borrowers Really Back? [Sequential] growth was broad-based across all commercial lending segments. We saw improvement in new loans as well as improvement in utilization from existing clients. … In the all-important small business segment, lending activity is running consistently above pre-pandemic levels. (Moynihan, BAC) We are seeing an uptick in revolver utilization rates, … and it remains sort of skewed to the smaller clients. But we are starting to see an uptick … even in the bigger clients. … [O]ne driver of that is CEOs and management teams have been burned by low inventory levels as a result of the supply chain problems, wanting to run higher inventories and that is maybe driving higher utilization. … At the same time, we’re hearing quite a bit of confidence in the C suites, and all else equal that should be positive for C[ommercial]&I[ndustrial] loan growth. The levels there are modest still in a world where capital markets have been exceptionally receptive to … [bond] issuance … and so people [have been] well-funded [by the] capital markets. (Barnum, JPM) Commercial loan balances started to increase late in the third quarter and have now grown for four consecutive months with growth accelerating in December. … Increases in middle-market banking were driven by growth from our larger clients, a modest uptick in revolver utilization and strong seasonal borrowing. Growth in asset-based lending and leasing was driven by new client wins as well as increased levels from higher prices and some increase in inventory levels. (Santomassimo, WFC) We are encouraged by the loan growth momentum and we have a positive outlook for 2022, given improving client sentiment and business conditions, and continued strength in certain focused commercial portfolios, such as asset-backed securitization lending and supply chain financing. (Cecere, USB CEO) [W]e’re now starting to see a nice shift with respect to the commercial and the C&I portfolios. … At the end of the fourth quarter, we saw nice expansion of utilization rates, … like 60 basis points on average from the third quarter, but in December it was up almost 2.5%. … [P]eople are rebuilding their inventories on the commercial side. I think … they still have some [supply chain] concerns, so I think they’re being cautious about making sure they have inventory to be able to run their business. And I think they’re starting to make business investment ahead of the consumer spend and the economic growth they see in 2022. (Dolan, USB) [The] number one fourth-quarter trend that looks positive going into 2022 is the increase in utilization rates, which we haven’t seen for a number of quarters. (Cecere, USB) Banks Have Tons Of Dry Powder (Chart 8) And Want To Put It To Work (Chart 9) When The Time Is Right Chart 8Water, Water Everywhere And Not A Drop To Drink Chart 9Banks Are Eager To Lend Given continued deposit growth and low rates, our asset sensitivity to rising rates remains significant. (Borthwick, BAC) [W]e still have significant dry powder to put to work with either client demand [loans] or in an increasing rate environment [securities], which we expect. (Mason, C) [W]e have huge firepower to grow, to expand, to make loans, to extend duration. I’ve never seen a bank with [our level of] liquidity: $1.7 trillion in cash and marketable securities and $1 trillion in loans. There’s $500 or 600 billion of those cash and marketable securities that could be deployed in higher-yielding assets or loans when and if the time comes. (Dimon, JPM) [Our] expectation is that when long-term rates rise, which we’re starting to see now, we’re going to be able to take advantage of the rising rate environment. … We [deployed some cash into securities] in the fourth quarter but employed hedging strategies to keep the duration of those purchases relatively short … to maintain as much asset sensitivity going into 2022 as we possibly could. (Dolan, USB) [W]e want maximum flexibility as long-term rates start to rise. (Dolan, USB) Investment Implications​​​​​​​ Chart 10Comeback Or Head Fake? The biggest banks told a consistent story about the US economy on their earnings calls. Activity is rising, as evidenced by avid consumption that gathered momentum across 2021, a pickup in business and consumer appetite for borrowing that quickened toward the end of the year (Chart 10), and expressions of confidence from businesses that are directing capital to replenishing inventories and buying equipment. Credit performance is tremendously strong with record-low net charge-off rates and low delinquency rates underpinned by bloated business and consumer deposit balances. Abundant cash reserves provide further fuel for consumption and should keep GDP growth well above its trend level. The growth and credit tailwinds suggest that a recession is not lurking around the corner and therefore offer a green light for investors to overweight equities within multi-asset portfolios. As detailed in the last two reports on rate hikes’ impact, we do not view the recent equity turbulence, triggered by a surge in Treasury yields, as the start of an inflection point for financial markets. We are inclined to see the decline as more of a buying opportunity than a herald of a new shift in the business cycle. The Fed has the means to slow the economy if it sets its mind to it but given the amount of cash that is overwhelming banks, businesses, households and investors, draining enough accommodation to do so by the end of 2022 is an awfully tall order.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com

Dear client, In lieu of our weekly bulletin next week, I will be hosting a webcast on Friday, January 28 at 11:00 am EST, to discuss recent dollar trends. I hope you all tune in. Kind regards, Chester Ntonifor Highlights While not often discussed, it is well known that the dollar is expensive. It is true that valuations tend to matter less until they trigger a tipping point. Such inflections usually coincide with huge external imbalances, especially generated by an overvalued exchange rate. The US dollar could be stepping into such a paradigm - the DXY is 1.5 standard deviations above fair value, at the same time as the goods trade deficit is hitting record lows, and real interest rates are deeply negative. More importantly, there has been limited precedence to such a dollar configuration. Historically, it has required much higher real interest rates, or an improving balance of payments backdrop, to justify such lofty valuations. Our trading model shows that selling a currency when it is expensive and buying it when it is cheap generates excess returns over time. Within our valuation ranking, the cheapest currencies are JPY, SEK and NOK. On a terms-of-trade basis, the AUD stands out as a winner. Feature Chart 1High Dollar Valuation And Ultra-Low Real Rates Is Unprecedented Valuations usually get little respect when it comes to medium-term currency movements. This has been especially the case over the last few years, where the macroeconomic environment has been by far the biggest driver of the US dollar. The bull market in the dollar from 2011 to 2020 coincided with higher real interest rates in the US, relative to the rest of the developed world. In fact, since 2008, no developed market central bank has been able to hike rates by more than 200bps, except for the US Federal Reserve. Our report last week focused on why aggressive interest rate increases by the Federal Reserve could be bullish for the US dollar in the short term, but eventually set the stage for depreciation. In this report, we argue that valuations will also become a more important factor for currency strategy over the next 1-2 years (Chart 1). The Dollar And The External Balance The framework to understand currencies and the external balance is straightforward - a rising trade deficit (imports > exports) requires a lower exchange rate to boost competitiveness in the manufacturing sector, or less spending to reduce the trade deficit. Reduced domestic spending is unlikely in most developed economies, given ample pent-up demand and loose fiscal policy. Therefore, the natural adjustment mechanism for countries running wide trade deficits will have to be the exchange rate. Within a broad spectrum of developed and emerging market currencies, the US dollar stands out as overvalued on a real effective exchange rate basis (Chart 2A and 2B). It is true that valuations tend to matter less until they trigger a tipping point. Such inflections usually occur with a shift in animal spirits, coinciding with huge external imbalances. In the US, these imbalances are already starting to trigger a shift. The US trade deficit is deteriorating, with the goods deficit hitting a record low of -$98bn in November. Over the last few years, it has become increasingly difficult to fund this widening trade deficit via foreign purchases of US Treasuries (Chart 3). Meanwhile, as we highlighted last week, substantial equity inflows over the last few years have started to roll over. In a nutshell, the basic balance in the US (the sum of the current account and foreign direct investment) is deteriorating at an accelerated pace (Chart 4). The US current account deficit for Q3 came in at -$214.8 billion, the widest in over a decade. This has reversed a lot of the improvement in the basic balance since the Global Financial Crisis. The dollar tends to decline on a multi-year basis when the basic balance peaks and starts deteriorating. Chart 4Deteriorating Balance Of Payments Dynamics US Balance Of Payments Chart 3It Is Becoming Increasingly Difficult To Fund The Widening Deficit Fiscal policy is likely to become tighter in the next couple of years, easing the domestic spending constraint for the exchange rate. That said, fiscal policy will remain loose compared to pre-pandemic levels and relative to underlying employment conditions. This has historically led to a deterioration in the external balance and pulled the real effective exchange rate of the dollar down (Chart 5). Chart 5The Dollar And The Budget Deficit Real Interest Rates And The Dollar It is remarkable that at a time when real rates are the most negative in the US, the dollar is as overvalued as it has been in decades on a simple PPP model. This is a perfect mirror image of the dollar configuration at the start of the bull market in 2010, where the dollar was cheap and real rates were more supportive (Chart 1). According to economic theory, a currency should adjust to equalize returns across countries. This is a no-arbitrage condition. In the early 80s, an overvalued dollar was supported by very positive real rates. The subsequent dollar declines thereafter also coincided with falling real interest rates. In fact, over the last decade, it has been an anomaly that the dollar is so strong despite relative real interest rates being so negative (Chart 6). Our view remains that the terminal interest rate for the US should be higher than what is currently discounted in the 10-year Treasury yield. According to the overnight index swap curve, the Fed will not hike interest rates past 1.75%. This is much lower than past cycles and will keep real interest rates low. This does not justify an expensive greenback. Our shorter-term interest rate model also shows the DXY as slightly expensive, even though short-term interest rates have moved in favor of the dollar over the past year (Chart 7). Chart 6The Level Of Relative Real Yields Also Matters Chart 7Our Timing Model Suggests ##br##A Pullback Other Considerations While real effective exchange rates and purchasing power parity models are among our favorite valuation gauges, they are not foolproof. Countries with structurally higher inflation (and so a higher real effective exchange rate), could also have higher productivity. According to the Balassa-Samuelson Hypothesis, competitiveness in the tradeable goods sector will boost wages across all sectors of the economy, leading to higher prices. This argument particularly resonates with proponents that suggest the US is a fast-growing economy, and so will tend to run a current account deficit, like Australia during the commodity boom of the early 2000s. Meanwhile, the US earns more on its overseas assets than it spends on its liabilities, suggesting that the funding gap will eventually close. Unfortunately, the overvaluation of the dollar has not been due to higher relative productivity in the US, especially when compared to other economies. Across a broad spectrum of developed and emerging market economies, the dollar is expensive according to our productivity models. The Chinese RMB (which is much overvalued on a PPP basis) is closer to fair value when productivity is taken into consideration (Chart 8). Meanwhile, the sizeable US deficit is not completely offset by its positive investment balance (Chart 9). This is occurring at a time when many faster growing countries (such as China for example) are generating current account surpluses (Chart 10A and 10B). In a nutshell, whether one looks at relative price levels, relative productivity trends, or relative real returns on government assets, the dollar is expensive. Chart 9The Positive Income Balance Has Not Helped The Us Investment Position Conclusion Last summer, we introduced a trading model for FX valuation enthusiasts. We used both our in-house purchasing power parity models (PPP) and our intermediate-term timing models as valuation tools. Since the 2000s, both valuation models have outperformed a buy-and-hold currency strategy with much lower volatility (Chart 11). Currency valuation tends to matter over the longer term, while the macro environment tends to dominate short-term currency trading. Given that the dollar has been overvalued for the last three to five years, the above analysis suggests we might be entering this “longer-term” tipping point where valuations will start to matter more going forward. Within our valuation ranking, the cheapest currencies are JPY, SEK and NOK. On a terms-of-trade and productivity basis, the AUD stands out as a winner. This is being reflected in a record-high basic balance surplus (Chart 12). In our trade tables, we went long AUD at 70 cents, and will upgrade this to a high conviction bet on signs that currency volatility is ebbing. Chart 11A Trading Rule Solely Based On Valuation Chart 12AUD And Balance Of Payments Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Forecast Summary

Highlights Our top five “black swan” risks for 2022: Social unrest in China; Russian invasion of all of Ukraine; unilateral Israeli strikes on Iran; a cyber attack that goes kinetic; and a failure of OPEC 2.0. Too early to buy the dip on Russian assets: President Biden says Putin will probably “move in” and re-invade Ukraine, Russian embassy staff have been evacuating Ukraine, the US and UK have been providing more arms to Ukraine, and the US is warning of a semiconductor embargo against Russia. Talks resume in Geneva on Friday. Tactically investors should take some risk off the table, especially if linked to Russia and Europe.  Stay short the Russian ruble and EM Europe; stay short the Chinese renminbi and Taiwanese dollar; stay long cyber security stocks; and be prepared for oil volatility. Convert tactical long equity trades to relative trades: long large caps versus small caps, long defensives versus cyclicals, and long Japanese industrials versus German industrials. Feature Chart 1Recession Probability And Yield Curve The 2/10-year yield curve is flattening and now stands at 79 bps, while the implied probability of a recession over the next 12 months troughed at 5.9% in April 2021, and as of December 2021 stood at 7.7% (Chart 1). Apparently stagflation and recession are too high of a probability to constitute a “black swan” risk for this year. Black swans are not only high impact but also low probability. In this year’s annual “Five Black Swan” report, the last of our 2022 outlook series, we concentrate on impactful but unlikely events. These black swans emerge directly from the existing themes and trends in our research – they are not plucked at random. The key regions are highlighted in Map 1. Black Swan #1: Major Social Unrest Erupts In China China’s financial problems are front and center risks for investors this year. They qualify as a “Gray Rhino” rather than “Black Swan” risk.1 It is entirely probable that China’s financial and property sector distress will negatively impact Chinese and global financial markets in 2022. What investors are not expecting is an eruption of social unrest in China that fouls up the twentieth national party congress this fall and calls into question the Communist Party’s official narrative that it is handling the pandemic and the underlying economic transition smoothly. Social unrest is a major risk around the world in the face of the new bout of inflation. Most of the democracies have already changed governments since the pandemic began, recapitalizing their political systems, but major emerging markets – Russia, India, Turkey, Brazil – have not done so. They have seen steep losses of popular support for both political leaders and ruling parties. There is little opinion polling from China and people who are surveyed cannot speak openly. It is possible that the government’s support has risen given its minimization of deaths from the pandemic. But it is also possible that it has not. Beijing’s policies over the past few years have had a negative impact on the country’s business elite and foreign relations. There are disgruntled factions within China, though the current administration has a tight grip over the main organs of power. Since President Xi is trying to clinch his personal rule this fall, sending China down a path of autocracy that proved disastrous under Chairman Mao Zedong, it is possible he will face surprise resistance. China’s economic growth is decelerating, clocking in at a 4.0% quarter-on-quarter growth rate at the end of last year. While authorities are easing policy to secure the recovery, there is a danger of insufficient support. Private sentiment will remain gloomy, as reflected by weak money velocity and a low propensity to spend among both businesses and households (Chart 2). The government will continue to be repressive in the lead up to the political reshuffle. At least for the first half of the year the economy will remain troubled. Structurally China is ripe for social unrest. It suffers from high income inequality and low social mobility, comparable to the US and Brazil, which are both struggling with political upheaval (Chart 3). Chart 2China's Private Sector Still Depressed​​​​​ ​​​​​​ In addition China is keeping a stranglehold over Covid-19. This “Zero Covid” policy minimizes deaths but suppresses economic activity. Strict policy has also left the population with a very low level of natural immunity and the new Omicron variant is even more contagious than other variants. Hence the regime is highly likely to double down to prevent an explosive outbreak. The service side of the economy will continue to suffer if strict lockdowns are maintained, exacerbating household and business financial difficulties (Chart 4). Yet in other countries around the world, government decisions to return to lockdowns have sparked unrest. Chart 4Zero Covid Policy: Not Sustainable Beyond 2022 China’s “Misery Index” (unemployment plus inflation) is rising sharply. While misery is ostensibly lower than that of other emerging markets, China’s unemployment data is widely known to be unreliable. If we take a worst-case scenario, looking at youth unemployment and fuel prices, misery is a lot higher (Chart 5). The youth, who are having the hardest time finding jobs, are also the most likely to protest if conditions become intolerable (Chart 6). Of course, if social unrest is limited to students, it will lack support among the wider populace. But it is inflation, not youth activism, that is the reason for China’s authorities to be concerned, as inflation is a generalized problem that affects workers as well as students. Chart 5China's Misery Index Is Higher Than It Looks​​​​​ Chart 6China's Troubled Youth Why would protesters stick their necks out knowing that the Communist Party will react ferociously to any sign of instability during President Xi Jinping’s political reshuffle? True, mainland Chinese do not have the propensity to political activism that flared up in protests in Hong Kong in recent years. Also the police state will move rapidly to repress any unrest. Yet the entire focus of Xi Jinping’s administration, since 2012, has been the restoration of political legitimacy and prevention of popular discontent. Xi has cracked down on corruption, pollution, housing prices, education prices, and has announced his “Common Prosperity” agenda to placate the low and middle classes.2 The regime has also cracked down on the media, social media, civil society, and ideological dissent to prevent political opposition from taking root. If the government were not concerned about social instability, it would not have been adopting these policies. Disease, often accompanied by famines or riots, has played a role in the downfall of six out of ten dynasties, so Beijing will not be taking risks for granted (Table 1). Table 1Disease And Downfall Of Chinese Dynasties Social instability would have a major impact as it would affect China’s stability and global investor sentiment toward China. Western democracies would penalize China for violations of human rights, leaving China even more isolated. Bottom Line: Investors should stay short the renminbi and neutral Chinese equities. Foreign investors should steer clear of Chinese bonds in the event of US sanctions. After the party congress this fall there will be an opportunity to reassess whether Xi Jinping will “let a hundred flowers bloom,” thus improving the internal and external political and investment environment, but this is not at all clear today. Black Swan #2: Russia Invades All (Not Just Part) Of Ukraine US-Russia relations are on the verge of total collapse and Russian equities have sold off, in line with our bearish recommendations in reports over the past two years. Russia’s threat of re-invading Ukraine is credible. Western nations are still wishy-washy about the counter-threat of economic sanctions, judging by German Chancellor Olaf Scholz’s latest comments, and none are claiming they will go to war to defend Ukraine.3 Russia is looking to remove the threat of Ukraine integrating militarily and economically with the West. The US and UK are providing Ukraine with defense weaponry even as Russia specifically demands that they cease to do so. President Putin may choose short-term economic pain for long-term security gain. The consensus view is that if Russia does invade, it will undertake a limited invasion. But what if Russia invades all of Ukraine? To be clear, a full invasion is unlikely because it would be far more difficult and costly for Russia. It would go against Putin’s strategy of calculated risk and limited conflict. Table 2 compares Russia and Ukraine in size and strength, alongside a comparison of the US and Iraq in 2002. This is not a bad comparison given that Ukraine’s and Iraq’s land area and active military personnel are comparable. Table 2Russia-Ukraine Balance Of Power 2022 Compared To US-Iraq 2002 Russia would be biting off a much bigger challenge than the US did. Ukraine’s prime age population is 2.5 times larger than Iraq’s in 2002, and its military expenditure is three times bigger. The US GDP and military spending were 150 and 250 times bigger than Iraq’s, while Russia’s GDP and military spending are about ten times bigger than Ukraine’s today. Iraq was not vital to American national security, whereas Ukraine is vital to Russia; Russia has more at stake and is willing to take greater risks. But Ukraine is in better shape to resist Russian occupation than Iraq was to resist American. The point is that the US invasion went smoothly at first, then got bogged down in insurgency, and ultimately backfired both in political and geopolitical terms. Russia would be undertaking a massive expense of blood and treasure that seems out of proportion with its goal, which is to neutralize Ukraine’s potential to become a western defense ally and host of “military infrastructure.” However, there are drawbacks to partial invasion. The remainder of the Ukrainian state would be unified and mobilized, capable of integrating with the western world, and willing to support a permanent insurgency against Russian troops in eastern Ukraine. Russia has forces in Belarus, Crimea, and the Black Sea, as well as on Ukraine’s eastern border, giving rise to fears that Russia could attempt a three-pronged invasion of the whole country. In short, it is conceivable that Russian leaders could make the Soviet mistake of overreaching in the military aims, or that a war in eastern Ukraine could inadvertently expand into the west. If Russia tries to conquer all of Ukraine, the global impact will be massive. A war of this size on the European continent for the first time since World War II would shake governments and populations to their bones. The borders with Poland, Romania, the Baltic states, Slovakia, Hungary, Finland and the Black Sea area would become militarized (Map 2). NATO actions to secure its members and fortify their borders would exacerbate tensions with Russia and fan fears of a wider war. Trade flows would become subject to commerce destruction, affecting even neutral nations, including in the Black Sea. Energy supplies would tighten further, sending Russia and probably Europe into recession. The disruption to business and travel across eastern Europe would be deep and lasting, not only due to sanctions but also due to a deep risk-aversion that would affect foreign investors in the former Soviet Union and former Warsaw Pact. Germany would be forced to quit sitting on the fence, as it would be pressured by the US and the rest of Europe to stand shoulder to shoulder in the face of such aggression. Finland and Sweden would be much more likely to join NATO, exacerbating Russia’s security fears. Russia would suffer a drastic loss of trade, resulting in recession, and its currency collapse would feed inflation (Chart 7). Chart 7Inflation Poses Long-Term Threat To Putin Regime Ultimately the consequences would be negative for the Putin regime and Russia as a result of recession and international isolation. But in the short run the Russian people would rally around the flag and support a war designed to prevent NATO from stationing missiles on their doorstep. And their isolation would not be total, as they would strengthen ties with China and conduct trade via proxy states in the former Soviet Union. Bottom Line: A full-scale invasion of all of Ukraine is highly unlikely because it would be so costly for Russia in military, economic, and political terms. But the probability is not zero, especially because a partial re-invasion could lead to a larger war. While global investors would react in a moderate risk-off matter to a limited war in eastern Ukraine, a full-scale war would trigger a massive global flight to safety as it would call into question the entire post-WWII peace regime in Europe. Black Swan #3: Israel Attacks Iran The “bull market in Iran tensions” continues as there is not yet a replacement for the 2015 nuclear deal that the US abrogated. Our 2022 forecast that the UAE would get caught in the crossfire was confirmed on January 17 when Iran-backed Houthi rebels expanded their range of operations and struck Abu Dhabi (Map 3). The secret war is escalating and US-led diplomacy is faltering. Iran is not going to give up its nuclear program. North Korea achieved nuclear arms and greater military security and is now developing first and second strike capabilities. Meanwhile Ukraine, which faces another Russian invasion, exemplifies what happens to regimes that give up nuclear arms (as do Libya and Iraq). Iran appears to be choosing the North Korean route. While we cannot rule out a minor agreement between President Biden and Iranian President Ebrahim Raisi, we can rule out a substantial deal that halts Iran’s nuclear and missile progress. Here’s why: Any day now Iran could reach nuclear “breakout capacity,” with enough highly enriched uranium to construct a nuclear device (Table 3).4 Table 3Iran’s Violations Of 2015 Nuclear Deal Since US Exit Within Iran’s government, the foreign policy doves have been humiliated and kicked out of office while the hawks are fully in control. No meaningful agreement can be reached before 2024 because of the risk that the US will change ruling parties again and renege on any promises. Iran is highly incentivized to make rapid progress on its nuclear program now. The US will not be able to lead the P5+1 coalition to force Iran to halt its program because of its ongoing struggles with Russia and China. China is striking long-term cooperation deals with Iran. Israel has a well-established record of taking unilateral action, specifically against regional nuclear programs, known as the “Begin Doctrine.”5 Israel’s threats are credible on this front, although Iran is a much greater operational challenge than Iraq or Syria. Iran’s timeline from nuclear breakout to deliverable nuclear weapon is 12-24 months.6 Iran’s missile program is advanced. Missile programs cannot be monitored as easily as nuclear activity, so foreign powers base the threshold on nuclear capability rather than missile capability. Iran had a strong incentive to move slowly on its nuclear and missile programs in earlier years, to prevent US and Israeli military interference. But as it approaches breakout capacity it has an incentive to accelerate its tempo to a mad dash to achieve nuclear weaponization before the US or Israel can stop it. Now that time may have come. The Biden administration is afraid of higher oil prices and Israeli domestic politics are more divided and risk-averse than before. And yet Iran’s window might close in 2025, as the US could turn aggressive again depending on the outcome of the 2024 election. Hence Iran has an incentive to make its dash now. The US and Israel will restate their red lines against Iranian nuclear weaponization and brandish their military options this year. But the Biden administration will be risk-averse since it does not want to instigate an oil shock in an election year. Israel is more likely than the US to react quickly and forcefully since it is in greatest danger if Iran surprises the world with rapid weaponization. Here are the known constraints on unilateral Israeli military action: Limited Israeli military capability: Israel would have to commit a large number of aircraft, leaving its home front exposed, and even with US “bunker buster” bombs it may not penetrate the underground Fordow nuclear facility.7 Limited Israeli domestic support: The Israeli public is divided on whether to attack Iran. The post-Netanyahu government recently came around to endorsing the US’s attempt to renegotiate the nuclear deal. Limited US support: Washington opposes Israeli unilateralism that could entangle the US into a war. Israel cannot afford to alienate the US, which is its primary security guarantor. Iranian instability: The Iranian regime is under economic distress due to “maximum pressure” sanctions. It is vulnerable to social unrest, not least because of its large youth population. These constraints have been vitiated in various ways, which is why we raise this Israeli unilateralism as a black swan risk: Where there’s a will, there’s a way: If Israel believes its existence will be threatened, it will be willing to take much greater operational risks. It has already shown some ability to set back Iran's centrifuge program beyond the expected.8 Israeli opinion will harden if Iran breaks out: If Iran reaches nuclear breakout or tests a nuclear device, Israeli opinion will harden in favor of military strikes. Prime Minister Naftali Bennett has an incentive to take hawkish actions before he hands the reins of government over to a partner in his ruling coalition as part of a power-sharing agreement. The ruling coalition is so weak that a collapse cannot be ruled out. US opposition could weaken: Biden will have to explore military options if talks fail and Iran reaches nuclear breakout capacity. Once the midterms are over, Israel may have even more freedom to act, while a gridlocked Biden may be looking to shift his focus to foreign policy. Iranian stability: Iran’s social instability has not resulted in massive unrest or regime fracture despite years of western sanctions and a global recession/pandemic. Yet now energy prices are rising and Iran has less reason to believe sanction regimes will be watertight. From Israeli’s point of view, even regime change in Iran would not remove the nuclear threat once nuclear weapons are obtained. Finally, while Israel cannot guarantee that military strikes would successfully cripple Iran’s nuclear program and prevent weaponization, Israel cannot afford not to try. It would be a worse outcome to stand idly by while Iran gets a nuclear weapon than to attack and fail to set that program back. Hence the likeliest outcome over the long run is that Iran pursues a nuclear weapon and Israel attacks to try to stop it, even if that attack is likely to fail (Diagram 1). Diagram 1Game Theory: Will Israel Attack Iran? Bottom Line: A unilateral Israeli strike is unlikely but would have a massive impact, as 21% of global oil and 26% of natural gas flows through the Strait of Hormuz, and conflict could disrupt regional energy production and/or block passage through the strait itself. Black Swan #4: Cyber Attacks Spill Into Real World Investors are very aware of cyber security risks – it holds a respectable though not commanding position in the ranks of likely crisis events (Table 4). Our concern is that a cyber attack could spill over into the real world, impairing critical infrastructure, supply chains, and/or prompting military retaliation. Table 4Cyber Events Underrated In Consensus View Of Global Risks Russian attacks on US critical infrastructure by means of ransomware gangs disrupted a US fuel pipeline, meat-packing plant, and other critical infrastructure in 2021. Since then the two countries have engaged in negotiations over cyber security. The Russian Federal Security Bureau has cracked down on one of the most prominent gangs, REvil, in a sign that the US and Russia are still negotiating despite the showdown over Ukraine.9 Yet a re-invasion of Ukraine would shatter any hope of cooperation in the cyber realm or elsewhere. Russia is already using cyberattacks against Ukraine and these activities could expand to Ukraine’s partners if the military conflict expands. Should the US and EU impose sweeping sanctions that damage Russia’s economy, Russia could retaliate, not only by tightening energy supply but also by cyber attacks. Any NATO partners or allies would be vulnerable, though some states will be more reactive than others. Interference in the French election, for example, would be incendiary. The key question is: if Russia strikes NATO states with damaging cyber attacks, at what point would it trigger Article V, the mutual defense clause? There are no established codes of conduct or red lines in cyber space, so the world will have to learn each nation’s limits via confrontation and retaliation. Similar cyber risks could emerge from other conflicts. China is probably not ready to invade Taiwan but it has an interest in imposing economic costs on the island ahead of this fall’s midterm elections. Taiwan’s critical role in the semiconductor supply chain means that disruptions to production would have a global impact. Israel and the US have already used cyber capabilities to attack Iran and set back its nuclear program. These capabilities will be necessary as Iran approaches breakout capacity. Yet Iran could retaliate in a way that disrupts oil supplies. North Korea began a new cycle of provocations last September, accelerated missile tests over the past four months, and is dissatisfied with the unfinished diplomatic business of the Trump administration. In the wake of the last global crisis, 2010, it staged multiple military attacks against South Korea. South Korea may be vulnerable due to its presidential elections in May. The semiconductor or electronics supply chain could be interrupted here as well as in Taiwan. Bottom Line: There is no code of conduct in cyber space. As geopolitical tensions rise, and nations test the limits of their cyber capabilities, there is potential for critical infrastructure to be impaired. This could exacerbate supply chain kinks or provoke kinetic responses from victim nations. Black Swan #5: OPEC 2.0 Falls Apart The basis of the OPEC 2.0 cartel is Russian cooperation with Saudi Arabia to control oil supply and manage the forward price curve. Backwardation, when short-term prices are higher than long-term, is ideal for these countries since they fear that long-term prices will fall. In a world where Moscow and Riyadh both face competition from US shale producers as well as the green energy revolution, cooperation makes sense. Yet the two sides do not trust each other. Cooperation broke down both in 2014 and 2020, sending oil prices plunging. Falling global demand ignited a scramble for market share. Interestingly, Russian military invasions have signaled peak oil price in 1979, 2008, and 2014. Russia, like other petro-states, has greater room for maneuver when oil revenues are pouring in. But high prices also incentivize production, disincentivize cartel discipline, and trigger reductions in global demand (Chart 8). Chart 8Russian Invasions And Oil Price Crashes Broadly speaking, Saudi oil production rose modestly during times of Russian military adventures, while overall OPEC production was flat or down, and Russian/Soviet production went up (Chart 9). Chart 9Saudi And OPEC Oil Production During Russian Military Adventures Since 2020, we have held that OPEC 2.0 would continue operating but that the biggest risk would come in the form of a renewed US-Iran nuclear deal that freed up Iranian oil exports. In 2014, the Saudis increased production in the face of the US shale threat as well as the Iranian threat. This scenario is still possible in 2022 but it has become a low-probability outcome. Even aside from the Iran dynamic, there is some probability that Russo-Saudi cooperation breaks down as global growth decelerates and new oil supply comes online. Bottom Line: The world’s inflation expectations are elevated and closely linked to oil prices. Yet oil prices hinge on an uneasy political agreement between Russia and Saudi Arabia that has fallen apart twice before. If Russia invades Ukraine, or if US withdraws sanctions on Iran, for example, then Saudi Arabia could make a bid to expand its market share and trigger price declines in the process. Two Bonus Black Swans: Turkey And Venezuela Turkey lashes out: Our Turkish Political Capital Index shows deterioration for President Recep Erdogan’s political capital across a range of variables (Table 5). With geopolitical pressures increasing, and domestic politics heating up ahead of the 2023 elections, Erdogan’s behavior will become even more erratic. His foreign policy could become aggressive, keeping the lira under pressure and/or weighing on European assets. Table 5Turkey: Erdogan’s Political Capital Wearing Thin Venezuela’s Maduro falls from power: Venezuelan regime changes often follow from military coups. These coups do not only happen when oil prices collapse – sometimes the army officers wait to be sure prices have recovered. Coup-throwers want strong oil revenues to support their new rule. An unexpected change of regimes would affect the oil market due to this country’s giant reserves. Bottom Line: Turkey’s political instability could result in foreign aggression, while Venezuela’s regime could collapse despite the oil price recovery. Investment Takeaways We are booking profits on our tactical long trades on large caps and defensive sectors. We will convert these to relative trades: long large caps over small caps, and long defensives over cyclicals. We also recommend converting our tactical long Japan trade into long Japanese industrials / short German industrials equities. If US-Russia diplomacy averts a war we will reconsider.     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      “Gray Rhino” is a term coined by author Michele Wucker to describe large and probable risks that people neglect or avoid. For more, see thegrayrhino.com. 2     Xi Jinping recently characterized the “common prosperity” agenda as follows: “China has made it clear that we strive for more visible and substantive progress in the well-rounded development of individuals and the common prosperity of the entire population. We are working hard on all fronts to deliver this goal. The common prosperity we desire is not egalitarianism. To use an analogy, we will first make the pie bigger, and then divide it properly through reasonable institutional arrangements. As a rising tide lifts all boats, everyone will get a fair share from development, and development gains will benefit all our people in a more substantial and equitable way.” See World Economic Forum, “President Xi Jinping’s message to The Davos Agenda in full,” January 17, 2022, weforum.org. 3     Chancellor Scholz, when asked whether Germany would avoid using the Nord Stream II pipeline if Russia re-invaded Ukraine, said, "it is clear that there will be a high cost and that all this will have to be discussed if there is a military intervention against Ukraine.” He was speaking with NATO Secretary-General Jens Stoltenberg. See Hans Von Der Burchard, “Scholz: Germany will discuss Nord Stream 2 penalties if Russia attacks Ukraine,” Politico, January 18, 2022, politico.eu. 4     For the Begin Doctrine, see Meir Y. Soloveichik, “The Miracle of Osirak,” Commentary, April 2021, commentary.org. 5     The estimate of 12-24 months to mount a nuclear warhead on a missile has been cited by various credible sources, including David Albright and Sarah Burkhard, “Highlights of Iran’s Perilous Pursuit of Nuclear Weapons,” Institute for Science and International Security, August 24, 2021, isis-online.org, and Eric Brewer and Nicholas L. Miller, “A Redline for Iran?” Foreign Affairs, December 23, 2021, foreignaffairs.com. 6     See Edieal J. Pinker, Joseph Szmerekovsky, and Vera Tilson, “Technical Note – Managing a Secret Project,” Operations Research, February 5, 2013, pubsonline.informs.org, as well as “What Can Game Theory Tell Us About Iran’s Nuclear Intentions?” Yale Insights, March 17, 2015, insights.som.yale.edu.  7     See Josef Joffe, “Increasingly Isolated, Israel Must Rely On Nuclear Deterrence,” Strategika 35 (September 2016), Hoover Institution, hoover.org. 8     The sabotage of the Iran Centrifuge Assembly Center at the Natanz nuclear facility in July 2020 “set back Iran’s centrifuge program significantly and continues to do so,” according to David Albright, Sarah Burkhard, and John Hannah, “Iran’s Natanz Tunnel Complex: Deeper, Larger Than Expected,” Institute for Science and International Security, January 13, 2022, isis-online.org. For a recent positive case regarding Israel’s capabilities, see Mitchell Bard, “Military Options Against Iran,” Jewish Virtual Library, American-Israeli Cooperative Enterprise, January 2022, jewishvirtuallibrary.org.  9     For the FSB and REvil, see Chris Galford, “Russian FSB arrests members of REvil ransomware gang following attacks on U.S. infrastructure,” Homeland Preparedness News, January 18, 2022, homelandprepnews.com. For the Colonial Pipeline and JBS attacks, and other ransomware attacks, see Jonathan W. Welburn and Quentin E. Hodgson, “How the United States Can Deter Ransomware Attacks,” RAND Blog, August 9, 2021, rand.org. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)