Emerging Markets

Executive Summary More Regional Divergences Within Our Global LEI More Regional Divergences Within Our Global LEI More Regional Divergences Within Our Global LEI The BCA global leading economic indicator (LEI) is still in a downtrend, but its diffusion index – which tends to lead the overall global LEI at major cyclical turning points – has crept higher since bottoming in January. The diffusion index is rising in part because of very marginal increases in the LEIs of a few countries, but there have been more decisive increases in the LEIs of two major countries outside the developed world – China and Brazil. There is not yet enough evidence pointing to a true bottoming of the BCA global LEI anytime soon, but an improvement in the LEI diffusion index above 50 (i.e. a majority of countries with a rising LEI) would be a more convincing signal that global growth momentum is set to rebound. Bottom Line: Given the uncertain message on growth from our global LEI, and with inflation rates still too high for central banks to pivot dovishly, we recommend staying close to neutral on overall global fixed income duration and modestly defensive on overall spread product exposure. Feature Investors can be forgiven for being a bit confused by some conflicting messages in recent global economic data. For example, US real GDP contracted in both the first and second quarter of this year – a so-called “technical recession” – and consumer confidence is at multi-decade lows, yet the US unemployment rate fell to 3.5%, the lowest level since 1969, in July. A similar story is playing out across the Atlantic, where a historic surge in energy prices was supposed to have already tipped the euro area into recession, yet real GDP expanded in both Q1 and Q2 at an above-trend pace and unemployment continues to decline. At times like the present, when market narratives do not always line up with hard data, we always believe it important to look within our vast suite of indicators to help clear the fog. One of our most trusted growth indicators, the BCA Global Leading Economic Indicator (LEI), is still falling and, thus, signaling a continued deceleration of global growth over at least the next 6-9 months. However, there are some signs of more optimistic news embedded within our global LEI stemming from outside the developed economies, which could be a potential early sign of a bottoming in global growth momentum. In this report, we dig deeper into the guts of our global LEI to assess the odds of an imminent turning point in the LEI and, eventually, global growth. This has important implications for global bond yields, which are likely to remain rangebound until there is greater clarity on global growth momentum (and inflation downside momentum). What Leads The Leading Indicator? The BCA global LEI is a composite index that combines the LEIs of 23 individual countries using GDP weights. The underlying list of countries differs from that of the widely followed OECD LEI, which is comprised of data from 33 countries but with a heavy weighting on developed market economies. The overall OECD LEI excludes important exporting countries such as Taiwan and Singapore, which are highly sensitive to changes in global growth. Most importantly, the OECD LEI omits the world’s largest economy, China. For our global LEI, we prefer to use a smaller set of countries but one that includes China and a bigger weighting on emerging market (EM) economies. For most of the nations in our global LEI, we do use the country-level LEIs produced by the OECD.1 That also includes several large and important non-OECD EM countries for which the OECD calculates LEIs - a list that includes China, Brazil, India, Russia, Indonesia and South Africa. For a few selected countries, however, we use the following data: US, Korea, Taiwan and Singapore: LEIs produced by national government data sources or, in the case of the US, the Conference Board. Argentina, Malaysia and Thailand: LEIs are produced in-house at BCA, a necessary step given the lack of domestically-produced LEIs in those countries at the time our global LEI was first constructed. We find that our global LEI leads global real GDP growth by around six months, and leads global industrial production growth by around twelve months (Chart 1). Chart 1A Gloomy Message From Our Global LEI A Gloomy Message From Our Global LEI A Gloomy Message From Our Global LEI The latest reading on the global LEI from July is pointing to a further deceleration of global GDP into a “growth recession” where GDP is expanding slower than the pace of potential global GDP growth (less than 2%). The global LEI is also pointing to an outright contraction of global industrial production, a path also signaled by the JPMorgan global manufacturing PMI index which hit a two-year low of 51.1 – closing in on the 50 level that signifies expanding industrial activity – in July. Chart 2A Ray Of Hope On Global Growth? A Ray Of Hope On Global Growth? A Ray Of Hope On Global Growth? The momentum of our global LEI is largely influenced by its breadth. Specifically, we have found that when a growing share of countries within the global LEI have individual LEIs that are rising, the overall LEI will eventually follow suit. Thus, the diffusion index of our global LEI, which measures the percentage share of countries with rising individual LEIs, is itself a fairly good leading indicator of the global LEI at major cyclical turning points. We may be approaching such a turning point, as our global LEI diffusion index has increased from a low of 9 back in January of this year to the level of 30 in July (Chart 2). In past business cycles, the diffusion index has tended to lead the global LEI by around 6-9 months, which suggests that a bottom in the actual global LEI could occur sometime in the next few months – although that outcome is conditional on the magnitude of the rise in the diffusion index. In the top half of Table 1, we list previous episodes since 1980 where the global PMI diffusion index followed a similar path to that seen in 2022 – bottoming out below 10 and then rising to at least 30. We identified nine such episodes. In the table, we also show the subsequent change in the level of the global LEI after the increase in the diffusion index. Table 1Global LEI Diffusion Index Greater Than 50 Typically Signals LEI Uptrend A Hint Of Recovery In The BCA Global Leading Economic Indicator? A Hint Of Recovery In The BCA Global Leading Economic Indicator? The historical experience shows that an increase in the diffusion index to 30 was only enough to trigger a decisive rebound in the global LEI over a 6-12 month horizon in the 2000-01 and 2008 episodes. In several episodes, the global LEI actually contracted despite the pickup in the diffusion index. Related Report  Global Fixed Income StrategyDovish Central Bank Pivots Will Come Later Than You Think In the bottom half of Table 1, we run the same analysis but define the episodes as when the diffusion index rose from a low below 10 to at least 50. Unsurprisingly, periods when at least half of the countries have a rising LEI tend to result more frequently in the overall global LEI entering an uptrend within one year – although the two most recent episodes in 2010 and 2018-19 were notable exceptions. Bottom Line: After looking at past experience, the latest pickup in the global LEI diffusion index has not been by enough to confidently forecast a rebound in the LEI – and, eventually, faster global growth. No Broad-Based Improvement In Our Global LEI When grouping the countries within our global LEI by geographical region, it is clear that there is still no sign of improvement in North America or Europe, but some signs of bottoming in Asia and Latin America (Chart 3). Typically, the regional LEIs tend to be very positively correlated during major cyclical moves in the overall LEI, with no one region being particularly better than the others at consistently leading the global business cycle. Chart 3More Regional Divergences Within Our Global LEI More Regional Divergences Within Our Global LEI More Regional Divergences Within Our Global LEI ​​​​​ Table 2Country Weightings In Our Global LEI A Hint Of Recovery In The BCA Global Leading Economic Indicator? A Hint Of Recovery In The BCA Global Leading Economic Indicator? Of course, the global LEI is a GDP-weighted index that is dominated by the US and China (Table 2). When looking at individual country LEIs, the recent improvement in the LEI diffusion index looks less impressive. Some countries, like the UK and Korea, have only seen a tiny fractional uptick in the most recent LEI reading – moves small enough to qualify as statistical noise, even though the tiniest of positive moves still register as an “increase” when calculating the diffusion index. When looking at all the individual country LEIs within our global LEI, only two countries stand out as having meaningful increases over the past few months – China and Brazil (Chart 4). In the case of China, the idea that there could be signs of improving growth runs counter to the broad swath of recent data that highlight slowing momentum of Chinese consumer spending, business investment and residential construction. However, the production-focused components of the OECD’s China LEI, which we use in our global LEI, have shown some improvement of late (Chart 5). For example, motor vehicle production grew at a 32% year-over-year rate in July according to the OECD’s data, while total construction activity (based on OECD aggregates of production by industry) rose 9% year-over-year. Chart 4LEI Improvement In China & Brazil, Sluggish Elsewhere LEI Improvement In China & Brazil, Sluggish Elsewhere LEI Improvement In China & Brazil, Sluggish Elsewhere ​​​​​ Chart 5Improvement In Some Components Of The OECD's China LEI Improvement In Some Components Of The OECD's China LEI Improvement In Some Components Of The OECD's China LEI ​​​​​ The OECD’s LEI methodology is designed to include the minimum number of data series to optimize the fit of the LEI to the growth rate of each country’s industrial production index, which does lead to some peculiar series being included in the LEIs. However, there are signs of a potential rebound in Chinese economic growth evident in indicators preferred by our emerging market strategists, like the change in overall credit and fiscal spending as a share of GDP, a.k.a. the credit and fiscal impulse (Chart 6). The latter has shown a modest improvement that is hinting at faster Chinese growth in 2023, similar to the OECD’s China LEI. Turning to Brazil, the improvement in the OECD’s LEI there is focused on more survey-based data, like confidence among manufacturers and expectations on the demand for services. However, some hard data that the OECD includes in its Brazil LEI, namely net exports to Europe, have also shown clear improvement (Chart 7). Chart 6China Credit/Fiscal Impulse Signaling A Growth Rebound China Credit/Fiscal Impulse Signaling A Growth Rebound China Credit/Fiscal Impulse Signaling A Growth Rebound Bottom Line: The modest improvement in our global LEI diffusion index is even less than meets the eye, as only China and Brazil have seen LEI increases that are meaningfully greater than zero. Chart 7Improvement In Many Components Of The OECD's Brazil LEI Improvement In Many Components Of The OECD's Brazil LEI Improvement In Many Components Of The OECD's Brazil LEI ​​​​​ Investing Around The Global LEI Chart 8Global Financial Conditions Not Signaling An LEI Rebound Global Financial Conditions Not Signaling An LEI Rebound Global Financial Conditions Not Signaling An LEI Rebound Investors spend a sizeable chunk of their time focused on the future growth outlook to make investment decisions. This would, presumably, give leading economic indicators a useful role in any investment process. However, when looking at the relationship between our global LEI and the returns on risk assets like equities and corporate credit, the correlation is highly coincident (Chart 8). In other words, risk assets are themselves leading indicators of future economic growth – so much so that equity indices are often included as a component of the leading indicators of individual countries. On that front, the recent rebound in global equity markets, and the pullback in global credit spreads from the mid-June peak, could be signaling a more stable growth outlook that would be reflected in a bottoming of our global LEI. However, the monetary policy cycle matters, as evidenced by the correlation between the shape of government bond yield curves and our global LEI (bottom panel). That relationship is less strong than that of the LEI and equity/credit returns, but there are very few examples where yield curves are flat, or even inverted as is now the case in the US, and leading indicators are rising. Chart 9Stay Neutral On Overall Duration Exposure Stay Neutral On Overall Duration Exposure Stay Neutral On Overall Duration Exposure In the current environment where more central banks are worrying more about overshooting inflation than slowing growth, a turnaround in our global LEI will be difficult to achieve until inflation is much closer to central bank target levels, allowing policymakers to loosen policy and steepen yield curves. We do not expect such a scenario to unfold over at least the next 12-18 months, given broad-based entrenched inflation pressures in global services and labor markets. While leading indicators may not be of much value in forecasting risk assets, we do find value in using them to forecast moves in government bond yields. Regular readers of BCA Research Global Fixed Income Strategy will be familiar with our Global Duration Indicator, comprised of growth-focused measures that have historically had a leading relationship to the momentum (annual change) in developed market bond yields (Chart 9). The Duration Indicator contains both the global LEI and its diffusion index, as well as the ZEW expectations indices for the US and Europe. Three of those four indicators remain at depressed levels suggesting waning bond yield momentum. Overshooting global inflation has weakened the correlation between bond yield momentum and our Duration Indicator over the past year. However, with global commodity and goods inflation now clearly decelerating, we expect bond momentum to begin tracking growth dynamics more closely again. This leads us to expect bond yields to remain trapped in ranges over at least the balance of 2022, defined most prominently by the 10-year US Treasury yield trading between 2.5% and 3%. Bottom Line: Given the uncertain message on growth from our global LEI, and with inflation rates still too high for central banks to pivot dovishly, we recommend staying close to neutral on overall global fixed income duration and modestly defensive on overall spread product exposure.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1   Details on how the OECD calculates the individual country leading economic indicators can be found here: http://www.oecd.org/sdd/leading-indicators/compositeleadingindicatorsclifrequentlyaskedquestionsfaqs.htm\   GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark A Hint Of Recovery In The BCA Global Leading Economic Indicator? A Hint Of Recovery In The BCA Global Leading Economic Indicator? The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) A Hint Of Recovery In The BCA Global Leading Economic Indicator? A Hint Of Recovery In The BCA Global Leading Economic Indicator?

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

Executive Summary With the fourth Taiwan Strait crisis materializing, the odds of a major war between the world’s great powers have gone up. Our decision trees suggest the odds are around 20%, or double where they stood from the Russian war in Ukraine alone. The world is playing “Russian roulette” … with a five-round revolver. Going forward, our base case is for Taiwan tensions to flatten out (but not fall) after the US and Chinese domestic political events conclude this autumn. However, if China escalates tensions after the twentieth national party congress, then the odds of an invasion will rise significantly. If conflict erupts in Taiwan, then the odds of Russia turning even more aggressive in Europe will rise. Iran is highly likely to pursue nuclear weapons. Not A Lot Of Positive Catalysts In H2 2022 Roulette With A Five-Shooter Roulette With A Five-Shooter Tactical Recommendation Inception Date Return LONG US 10-YEAR TREASURY 2022-04-14 1.3% LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 13.8% Bottom Line: Investors should remain defensively positioned at least until the Chinese party congress and the US midterm election conclude this fall. Geopolitical risk next year will depend on China’s actions in the Taiwan Strait. Feature Chart 1Speculation Rising About WWIII Roulette With A Five-Shooter Roulette With A Five-Shooter Pessimists who pay attention to world events have grown concerned in recent years about the risk that the third world war might break out. The term has picked up in online searches since 2019, though it is the underlying trend of global multipolarity, rather than the specific crisis events, that justifies the worry (Chart 1).1 What are the odds of a major war between the US and China, or the US and Russia? How might that be calculated? In this report we present a series of “decision trees” to formalize the different scenarios and probabilities. If we define WWIII as a war in which the United States engages in direct warfare with either Russia or China, or both, then we arrive at a 20% chance that WWIII will break out in the next couple of years! Those are frighteningly high odds – but history teaches that these odds are not unrealistic and that investors should not be complacent. Political scientist Graham Allison has shown that the odds of a US-China war over the long term are about 75% based on historical analogies. The takeaway is that nations will have to confront this WWIII risk and reject it for the global political environment to improve. Most likely they will do so as WWIII, and the risk of nuclear warfare that it would bring, constitutes the ultimate constraint. But the current behavior of the great powers suggests that they have not recognized their constraints yet and are willing to continue with brinksmanship in the short term. The Odds Of A Chinese Invasion Of Taiwan The first question is whether China will invade Taiwan. In April 2021 we predicted that the fourth Taiwan Strait crisis would occur within 12-24 months but that it would not devolve into full-scale war. This view is now being tested. In Diagram 1 we provide a decision tree to map out China’s policy options toward Taiwan and assign probabilities to each option. Diagram 1Decision Tree For Fourth Taiwan Strait Crisis (Next 24 Months) Roulette With A Five-Shooter Roulette With A Five-Shooter While China has achieved the capability to invade Taiwan, the odds of failure remain too high, especially without more progress on its nuclear triad. Hence we give only a 20% chance that China will mobilize for invasion immediately. Needless to say any concrete signs that China is planning an invasion should be taken seriously. Investors and the media dismissed Russia’s military buildup around Ukraine in 2021 to their detriment. At the same time, there is a good chance that the US and China are merely testing the status quo in the Taiwan Strait, which will be reinforced after the current episode. After all, this crisis was the fourth Taiwan Strait crisis – none of the previous crises led to war. If Presidents Biden and Xi Jinping are merely flexing their muscles ahead of important domestic political events this fall, then they have already achieved their objective. No further shows of force are necessary on either side, at least for the next few years. We give 40% odds to this scenario, in which the past week’s tensions will linger but the status quo is reinforced. In that case, the structural problem of the Taiwan Strait would flare up again sometime after the US and Taiwanese presidential elections in 2024, i.e. outside the time frame of the diagram. Unfortunately we are pessimistic over the long run and would give high probability to war in Taiwan. For that reason, we give equal odds (40%) to a deteriorating situation within the coming two years. If China expands drills and sanctions after the party congress, after Xi has consolidated power, then it will be clear that Xi is not merely performing for his domestic audience. Similarly if the Biden administration continues pushing for tighter high-tech export controls against China after the midterm election, and insists that US allies and partners do the same, then the US implicitly believes that China is preparing some kind of offensive operation. The danger of invasion would rise from 20% to 40%. Even in that case, one should still believe that crisis diplomacy between the US and China will prevent full-scale war in 2023-24. But the risk of miscalculation would be very high. The last element of this decision tree holds that China will prefer “gray zone tactics” or hybrid warfare rather than conventional amphibious invasion of the kind witnessed in WWII. The reasons are several. First, amphibious invasions are the most difficult military operations. Second, Chinese forces are inexperienced while the US and its allies are entrenched. Third, hybrid warfare will sow division among the US allies about how best to respond. Fourth, Russia has demonstrated several times over the past 14 years that hybrid warfare works. It is a way of maximizing strategic benefits and minimizing costs. The world knows how the West reacts to small invasions: it uses economic sanctions. It does not yet know how the West reacts to big invasions. So China will be incentivized to take small bites. And yet in Taiwan’s case those tactics may not be sustainable. Our Taiwan decision tree does not account for the likelihood that a hybrid war or “proxy war” will evolve into a major war. But that likelihood is in fact high. So we are hardly overrating the risk of a major US-China war. Bottom Line: Over the next two years, the subjective odds of a US-China proxy war over Taiwan are about 32% while the odds of a direct US-China war are about 4%. The true test comes after Xi Jinping consolidates power at this fall’s party congress. We expect Xi to focus on rebooting the economy so we continue to favor emerging Asian markets excluding China and Taiwan. The Odds Of Russian War With NATO The second question is whether Russia’s war in Ukraine will morph into a broader war with the West. The odds of a major Russia-West war are greater in this case than in China’s, as a war is already raging, whereas tensions in the Taiwan Strait are merely shadow boxing so far. An investor’s base case should hold that the Ukraine war will remain contained in Ukraine, as Europeans do not want to fight a devastating war with Russia merely because of the Donbas. But things often go wrong in times of war. The critical question is whether Russia will attack any NATO members. That would trigger Article Five of the alliance’s treaty, which holds that “an armed attack against one or more [alliance members] in Europe or North America shall be considered an attack against them all,” justifying the use of armed force if necessary to restore security. Since Russia’s invasion of Ukraine this year, President Biden has repeatedly stated that the US will “defend every inch of NATO territory,” including the Baltic states of Latvia, Lithuania, and Estonia, which joined NATO in 2004. This is not a change of policy but it is the US’s red line and highly likely to be defended. Hence it is a major constraint on Russia. In Diagram 2 we map out Russia’s different options and assign probabilities. Diagram 2Decision Tree For Russia-Ukraine War (Next 24 Months) Roulette With A Five-Shooter Roulette With A Five-Shooter We give 55% odds that Russia will declare victory after completing the conquest of Ukraine’s Donbas region and the land bridge to Crimea. It will start looking to legitimize its conquests by means of some diplomatic agreement, i.e. a ceasefire. This is our base case for 2023. There is evidence that Russia is already starting to move toward diplomacy.2 The reason is that Russia’s economy is suffering, global commodity prices are falling, Russian blood and treasure are being spent. President Putin will have largely achieved his goal of hobbling Ukraine as long as he controls the mouth of the Dnieper river and the rest of the territory he has invaded. Putin needs to seal his conquests and try to salvage the economy and society. The sooner the better for Russia, so that Europe can be prevented from forming a consensus and implementing a full natural gas embargo in the coming years. However, there is a risk that Putin’s ambition gets the better of him. So we give 35% odds that the invasion expands to southwestern Ukraine, including the strategic port city of Odessa, and to eastern Moldova, where Russian troops are stationed in the breakaway region of Transdniestria. This new campaign would render Ukraine fully landlocked, neutralize Moldova, and give Russia greater maritime access. But it would unify the EU, precipitate a natural gas embargo, and weaken Russia to a point where it could become desperate. It could retaliate and that retaliation could conceivably lead to a broader war. We allot only a 7% chance that Putin attacks Finland or Sweden for attempting to join NATO. Stalin failed in Finland and Putin’s army could not even conquer Kiev. The UK has pledged to support these states, so an attack on them will most likely trigger a war with NATO. A decision to attack Finland would only occur if Russia believed that NATO planned to station military bases there – i.e. Russia’s declared red line. Any Russian attack on the Baltic states is less likely because they are already in NATO. But there is some risk it could happen if Putin grows desperate. We put the risk of a Baltic invasion at 3%. In short, if Russia uses its energy stranglehold on Europe not to negotiate a favorable ceasefire but rather to expand its invasions, then the odds of a broader war will rise. Bottom Line: The result is a 55% chance of de-escalation over the next 24 months, a 35% chance of a small escalation (e.g. Odessa, Moldova), and a 10% chance of major escalation that involves NATO members and likely leads to a NATO-Russia war. Tactically, investors should buy developed-market European currency and assets if the global economy rebounds and Russia makes a clear pivot to halting its military campaign and pursuing ceasefire talks. Cyclically, there needs to be a deeper US-Russia understanding for a durable bull market in European assets. The Odds Of US-Israeli Strikes On Iran The third geopolitical crisis taking place this year could be postponed as we go to press – if President Biden and Ayatollah Ali Khamenei agree to rejoin the 2015 US-Iran nuclear deal. But we remain skeptical. The Biden administration wants to rejoin the 2015 nuclear deal and free up about one million barrels per day of Iranian crude oil to reduce prices at the pump before the midterm election. US grand strategy also wants to engage with Iran and stabilize the Middle East so that the US can pivot to Asia. The EU is proposing the deal since it has even greater need for Iranian resources and wants to prevent Iran from getting nuclear weapons. Russia and China are also supportive as they want to remove US sanctions for trading with Iran and do not necessarily want Iran to get nukes. There is only one problem: Iran needs nuclear weapons to ensure its regime’s survival over the long run. The question is whether Khamenei is willing to authorize a deal with the Americans a second time. The first deal was betrayed at great cost to his regime. President Ebrahim Raisi, who hopes to replace the 83-year-old Khamenei before long, is surely staunchly opposed to wagering his career and personal security on whether Republicans win the 2024 election. Iran has already achieved nuclear breakout capacity – it has enough 60%-enriched uranium to construct nuclear devices – and it is unclear why it would achieve this capacity if it did not ultimately seek to obtain a nuclear deterrent. Especially given that it may someday need to protect its regime from military attacks by the US and its allies. However, our conviction level is medium because President Biden wants to lift sanctions and can do so unilaterally. The Biden administration has not taken any of the preliminary actions to make a deal come together but that could change.3 There is a good cyclical case to be made for short-term, stop-gap deal. According to BCA’s Commodity & Energy Strategist Bob Ryan, Saudi Arabia and the UAE only have about 1.5 million barrels of spare oil production capacity between them. The EU oil embargo and western sanctions on Russia will force about two million barrels per day to be stopped, soaking up most of OPEC’s capacity. Hence the Biden administration needs the one million barrels that Iran can bring. We cannot deny that the Iranians may sign a deal to allow Biden to lift sanctions. That would benefit their economy. They could allow nuclear inspectors while secretly shifting their focus to warhead and ballistic missile development. While Iran will not give up the long pursuit of a nuclear deterrent, it is adept at playing for time. Still, Iran’s domestic politics do not support a deal – and its grand strategy only supports a deal if the US can provide credible security guarantees, which the US cannot do because its foreign policy is inconsistent. US grand strategy supports a deal but only if it is verifiable, i.e. not if Iran uses it as cover to pursue a bomb anyway. Iran has not capitulated after three years of maximum US sanctions, a pandemic, and global turmoil. And Iran sees a much greater prospect of extracting strategic benefits from Russia and China now that they have turned aggressive against the West. Moscow and Beijing can be strategic partners due to their shared acrimony toward Washington. Whereas the US can betray the Raisi administration just as easily as it betrayed the Rouhani administration, with the result that the economy would be whipsawed again and the Supreme Leader and the political establishment would be twice the fools in the eyes of the public. Diagram 3 spells out Iran’s choices. Diagram 3Decision Tree For Iran Nuclear Crisis (Next 24 Months) Roulette With A Five-Shooter Roulette With A Five-Shooter If negotiations collapse (50% odds), then Iran will make a mad dash for a nuclear weapon before the US and Israel attack. If the US and Iran agree to a deal (40%), then Iran might comply with the deal’s terms through the 2024 US election, removing the issue from investor concerns for now. But their long-term interest in obtaining a nuclear deterrent will not change and the conflict will revive after 2024. If talks continue without resolution (10%), Iran will make gradual progress on its nuclear program without the restraints of the deal (though it may not need to make a mad dash). In short, Russia and China need Iran regardless of whether it freezes its nuclear program, whereas the US and Israel will form a balance-of-power Abraham Alliance to contain Iran even if it does freeze its nuclear program. Bottom Line: Investors should allot 40% odds to a short-term, stop-gap US-Iran nuclear deal. The oil price drop would be fleeting. Long-term supply will not be expanded because the US cannot provide Iran with the security guarantees that it needs to halt its nuclear program irreversibly. The Odds Of World War III Now comes the impossible part, where we try to put these three geopolitical crises together. In what follows we are oversimplifying. But the purpose is to formalize our thinking about the different players and their options. Diagram 4 begins with our conclusions regarding the China/Taiwan conflict, adjusts the odds of a broader Russian war as a result, and adds our view that Iran is highly likely to pursue nuclear weapons. Again the time frame is two years. Diagram 4Decision Tree For World War III (Next 24 Months) Roulette With A Five-Shooter Roulette With A Five-Shooter The alternate conflict scenario to WWIII consists of “limited wars” – a dangerous concept that refers to hybrid and proxy wars in which the US is not involved, or only involved indirectly. Or it could be a conflict with Iran that does not involve Russia and China. We begin with China because China is the most capable and most ambitious global power today. China’s strategic rise is upsetting the global order and challenging the United States. We also start with China because we have some evidence this year that Russia does not intend to expand the war beyond Ukraine. Either China takes further aggressive action in Taiwan – creating a unique opportunity for Russia to take greater risks – or not. If not, then the odds of WWIII fall precipitously over the two-year period. This scenario is our base case. But if China attacks Taiwan and the US defends Taiwan, we give a high probability to Russia invading the Baltics. If China stages hybrid attacks and the US only supports Taiwan indirectly, then we increase the odds of Russian aggression only marginally. The result is 20% odds of WWIII, i.e. a direct war between the US and Russia, or China, or both. Whether this war could remain limited is debatable. War gaming since 1945 shows that any war between major nuclear powers will more likely escalate than not. But nuclear weapons bring mutually assured destruction, the ultimate constraint. The nuclear escalation risk is why we round down the probability of WWIII in our decision trees. The more likely 59% risk scenario of “limited wars” may seem like a positive outcome but it includes major increases in geopolitical tensions from today’s level, such as a Chinese hybrid war against Taiwan. Bottom Line: According to this exercise the odds of WWIII could be as high as 20%. This is twice the level in our Russia decision tree, which is appropriate given that our Taiwan crisis forecast has materialized. The critical factor is whether Beijing continues escalating the pressure on Taiwan after the party congress this fall. That could unleash a dangerous chain reaction. The global economy and financial markets still face downside risk from geopolitics but 2023 could see improvements if Russia moves toward a ceasefire and China delays action against Taiwan to reboot its economy. Investment Takeaways When Russia invaded Ukraine earlier this year, our colleague Peter Berezin, Chief Global Strategist, argued that the odds of nuclear Armageddon were 10%. At very least this is a reasonable probability for the odds that Russia and NATO come to blows. Now the expected Taiwan crisis has materialized. We guess that the odds of a major war have doubled to 20%. The corollary is an 80% chance of a better outcome. Analytically, we still see Russia as pursuing a limited objective – neutralizing Ukraine so that it cannot be prosperous and militarily powerful – while China also pursues a limited objective – intimidating Taiwan so that it pursues subordination rather than nationhood. Unless these objectives change, we are still far from World War III. The world can live with a hobbled Ukraine and a subordinated Taiwan. However, there can be no denying that the trajectory of global affairs since the 2008 global financial crisis has followed a pathway uncomfortably similar to the lead up to World War II: financial crisis, economic recession, deflation, domestic unrest, currency depreciation, trade protectionism, debt monetization, military buildup, inflation, and wars of aggression. If roulette is the game, then the odds of a global war are one-sixth or 17%, not far from the 20% outcome of our decision trees. Even assuming that we are alarmist, the fact that we can make a cogent, formal argument that the odds of WWIII are as high as 20% suggests that investors should wait for the current tensions over Ukraine and Taiwan to decrease before making large new risky bets. A simple checklist shows that the global macro and geopolitical context is gloomy (Table 1). We need improvement on the checklist before becoming more optimistic. Table 1Not A Lot Of Positive Catalysts In H2 2022 Roulette With A Five-Shooter Roulette With A Five-Shooter Chart 2Stay Defensively Positioned In H2 2022 Stay Defensively Positioned In H2 2022 Stay Defensively Positioned In H2 2022 Specifically what investors need is to be reasonably reassured that Russia will not expand the war to NATO and that China will not invade Taiwan anytime soon. This requires a new diplomatic understanding between the Washington and Moscow and Washington and Beijing that forestalls conflict. That kind of understanding can only be forged in crisis. The relevant crises are under way but not yet complete. There is likely more downside for global equity investors before war risks are dispelled through the usual solution: diplomacy. Wait for concrete and credible improvements to the global system before taking a generally overweight stance toward risky assets. Favor government bonds over stocks, US stocks over global stocks, defensive sectors over cyclicals, and disfavor Chinese and Taiwanese currency and assets (Chart 2).     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1      See Graham Allison, Destined For War: Can America and China Escape Thucydides’s Trap? (New York: Houghton Miffin Harcourt, 2017). 2     For example, the Turkish brokered deal to ship grain out of Odessa, diplomatic support for rejoining the 2015 Iran nuclear deal, referendums in conquered territories like Kherson, and attempts to build up leverage in arms reduction talks. Cutting off Europe’s energy is ultimately a plan to coerce Europe into settling a ceasefire favorable for Russia. 3     Iran is still making extraneous demands – most recently that the IAEA drop a probe into how certain manmade uranium particles appeared in undisclosed nuclear sites in Iran. The IAEA has not dropped this probe and its credibility will suffer if it does. Meanwhile Biden is raising not lowering sanctions on Iran, even though sanction relief is a core Iranian demand. Biden has not removed the Iranian Revolutionary Guards or the Qods Force from the terrorism list. None of these hurdles are prohibitive but we would at least expect to see some movement before changing our view that a deal is more likely to fail than succeed. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades ()

Executive Summary Oil Markets Remain Tight Oil Markets Remain Tight Oil Markets Remain Tight US and Iranian negotiators received an EU proposal for reviving the Iran nuclear deal on Monday, which could return ~ 1mm b/d of oil to markets.  The EU’s embargo of Russian seaborne crude imports, which commences December 5, will remove 90% of seaborne imports of Russian crude (~ 2.3mm b/d) by year-end.  In February 2023, another 800k b/d of refined products will be embargoed.  December also will usher in insurance and reinsurance sanctions on shipping Russian oil – arguably the strongest sanctions the EU, UK and US can impose. Without those Iranian barrels, the determination of the EU, UK and US to enforce a Russian oil embargo will be suspect. We give odds of 60% to a US-Iran deal getting done in the near term.  Our Geopolitical Strategy maintains the likelihood of a deal is 40% at best. Bottom Line: Oil markets are pricing in the likelihood of large energy supply dislocations over the next couple of months.  The evolution of prices hinges upon the degree to which the EU’s embargo on Russian oil imports is implemented.  A revived Iran nuclear deal with the West would offset some of the embargoed Russian oil.  Even so, oil balances still will remain tilted to deficit conditions in 2023.  We continue to expect Brent will move above our 2022 $110/bbl expectation by 4Q22, and average $117/bbl next year. Feature US and Iranian negotiators received a proposal from EU negotiators for reviving the Iran nuclear deal on Monday.1 If the US and Iran can agree, the door opens for 1mm b/d of Iranian oil to return to markets. These barrels are becoming increasingly important to the EU, especially following the suspension of southerly flows of oil on Russia’s Druzhba pipeline due to a payment dispute.2 Brent popped ~ $1.50/bbl Tuesday morning as the Druzhba news broke, and the backwardation in the forward market increased (Chart 1). Brent gave back these early gains by the end of trading, following news a Hungarian refiner transferred the fee required to use the Ukrainian section of the pipeline.3 Chart 1Oil Markets Remain Tight Oil Markets Remain Tight Oil Markets Remain Tight Complicated Motives On All Sides The EU obviously has an interest in freezing Iran’s nuclear program and accessing more Iranian fossil fuels while it is locked in an energy struggle with Russia – hence the its proposal to revive the Iran nuclear deal. However, the US and Iranian positions are more complicated. Iranian’s Supreme Leader Ali Khamenei has an interest in removing the US’s economic sanctions – and in obtaining deliverable nuclear weapons, notes Matt Gertken, BCA Research’s chief geopolitical strategist. Khamenei’s plan is to develop a nuclear weapon so that Iran can deter any aggression from a future US administration or the Abraham alliance. This is the path to regime survival, power succession, and national security. Hence Iran will not freeze its nuclear program over the long run. But Khamenei may wish to buy time while the Democrats still run the White House. Chart 2KSA, UAE Preserving Spare Capacity Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over We’ve noted repeatedly the Biden administration has been pressing the Kingdom of Saudi Arabia (KSA) and the United Arab Emirates (UAE) – the only states in OPEC 2.0 able to raise output and maintain production at higher levels – to increase output for the better part of this year. These efforts yielded only a 100k b/d production increase earlier this month. KSA and the UAE insist they are close to the maximum levels of oil they can supply to the market, given their current production and the need to maintain minimal spare capacity (Chart 2).4 KSA’s max capacity is 12mm b/d. The Kingdom will be producing at or slightly above 11mm b/d later this year to offset declines in non-core OPEC 2.0 production. KSA’s trying to get its max capacity to 13mm b/d, but that will take until 2027, according to the state oil company ARAMCO. UAE’s max capacity is 4mm b/d. It will be producing at or close to 3.5mm b/d this year, and after that they’ll want to hang on to that last bit as spare capacity. UAE’s trying to get its spare capacity to 5mm b/d, but that’s going to take until 2030, according to its state oil company ADNOC. There’s an increasing risk to the Russian output arising from the EU embargo scheduled to take effect December 5, and sanctions on providing insurance and reinsurance to ships carrying Russian material. If the EU/UK/US embargo is successful and results in Russia being forced to shut in 2mm b/d by the end of next year, per our expectation, KSA and UAE spare capacity will not cover the loss of production, and falling output within OPEC 2.0. Given these dynamics – and the expectation at least some of the sanctions will stick after Dec. 5 – KSA and UAE have to hang on to those last barrels to be able to meet the increasingly likely loss of Russian shut-in production. Additional spare capacity is not available in the US shales, or in any of the other producing provinces outside OPEC 2.0 sufficient to cover the loss of Russian barrels. Indeed, output from OPEC 2.0 outside the core producers has been trending lower for years (Chart 3).5 Complicating a deal with Iran is the possibility it could re-open the breach between the US and KSA. If KSA wanted to express its displeasure with a US-Iran deal it wouldn’t need to do much to re-balance the market: If the Kingdom does not offset production losses by the rest of OPEC 2.0, or step up to cover, e.g., Libyan production – now back on the market with just under 500k b/d – global supply falls and prices rise, all else equal.6 Chart 3KSA, UAE Are Core OPEC 2.0 Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over Our Geopolitical Strategy gives 40% odds of an Iran deal and 60% odds that negotiations fall apart (or drag on without resolution). We make the odds higher – 60% chance of success – given the compelling interest of the Biden administration to get more oil into the market going into midterms in November, and a general interest in the West to offset potential losses of Russian volumes to sanctions that kick in in December. The difference in these views hinges on what Iran will do, as the Biden administration is seeking a deal. Sanctions Kicking In In December The EU is set to roll into its embargo of Russian oil imports on December 5. If fully implemented, ~ 2.3mm b/d of seaborne imports of Russian crude oil will be excluded from EU markets by year-end. Beginning in February, another 800k b/d of refined products will be embargoed. EU, UK and US shipping insurance and reinsurance sanctions also are set to kick in in December. These arguably are the strongest sanctions available to the West in its effort to take Russian oil and refined products off the market (no insurance means no shipping). The EU recently relaxed sanctions on buying and transporting Russian crude oil, which will allow additional volumes of oil to be purchased and transported to end-use markets.7 While this will let a little more Russian oil into the market in the near term, we believe it opens the possibility of additional exceptions being made by the EU to make more oil available, if prices move sharply higher on the back of increasing supply scarcity. The EU and US are looking a bit wobbly on the insurance and reinsurance bans due to kick in in December.8 If they relax or forego these sanctions in some fashion, more Russian crude and products will flow to market in 4Q22 than currently is anticipated. This would undermine US efforts to secure a price cap on Russian oil sales. Slower sanction enforcement is a path available to Biden that does not involve bowing to Iran’s various demands. Some, but not all, of the Russian volumes lost to EU exports will continue to be scooped up by China and India, which have become the largest buyers of Russian oil following the sanctions imposed by the West after the invasion of Ukraine.9 India loaded 29.5mm barrels of Russian crude in July – a record – while China loaded 18.1mm barrels. These levels likely will fall, but these two states will remain big buyers of Russian crude and products going forward. Household Budgets Will Remain Strained High energy prices – particularly for gasoline and diesel fuel – and falling real incomes have eaten into US household budgets, and are a key factor for Biden’s low approval ratings (Chart 4). July US CPI was unchanged from June and was 8.5% higher y-o-y. While the gasoline price index dropped from June, it remained one of the main contributors to the high energy index. (Chart 5).10 Based on the sharp increase in gasoline prices over the first six months of this year, we estimate the cost of running a car is 50% higher in 1H22 vs. 1H21 in the US. Chart 4Wealth Destruction Key To Low Biden Approval Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over Chart 5Energy Driving High US Prices Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over US gasoline and distillate prices have rolled over since mid-June, driven by high refined-product prices, which weakened demand, and fear of global recession as central banks tighten monetary policy. Higher Russian crude output in 1H22 – up 3.6% to ~ 10.1mm b/d – partly contributed to weaker product prices. However, this trend likely will reverse: Russian crude output in 2Q22 was down 1.1% y/y to 9.7mm b/d, based on our estimates. We expect prices of gasoline and diesel fuel to remain at elevated levels, given low inventories (Chart 6), and a second consecutive year of lower US refining capacity (Chart 7). Higher crude oil prices brought about by Russian oil and product embargoes will feed into these refined product prices, pushing them higher. Chart 6Low Product Stocks… Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over Chart 7…And Refining Capacity Are Bullish For Petrol Products Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over There is scope for an increase in gasoline demand over the rest of the driving season, while elevated US and overseas distillate demand will support diesel and heating oil prices. The eurozone’s record high inflation in July was driven by energy prices (Chart 8), indicating high energy prices are a problem for households worldwide. According to the Household Electricity Price Index, residential electricity prices in EU capitals were more than 70% higher in 1H22 y/y. The IMF expects high fuel prices will increase EU households’ share of energy expenditure by 7% in 2022.11 In response to high energy prices, governments are enacting policies such as price caps and direct transfers to lower the damage to household wealth.12 An unintended consequence of this will be high prices for longer, as consumers will not register the signal the market is sending via higher prices to encourage lower demand. This will result in continued draws on inventories. Chart 8High Energy Prices Responsible For Eurozone Inflation High Energy Prices Responsible For Eurozone Inflation High Energy Prices Responsible For Eurozone Inflation Investment Implications With EU sanctions scheduled to become effective December 5, oil markets are focused on supply measures that could sharply reduce Russian oil exports. This makes the US-Iran negotiations to revive the Iran nuclear deal critically important. Agreement to restore the deal could return 1mm b/d of oil to markets at a time when supplies are at risk of contracting sharply going into 2023. Failure to restore these volumes will tighten supply significantly if the EU’s embargo of Russian oil imports is successful. We give the restoration of the Iran nuclear deal a 60% chance of success. In and of itself, the return of Iranian oil exports will not offset all of the potential loss of Russian crude oil exports to the EU. That said, the evolution of crude oil prices hinges upon the degree to which the EU’s embargo on Russian oil imports is implemented. There's a subtle point to be aware of in the evolution of US-Iran negotiations: The Biden administration could just turn a blind eye to Iranian crude sales, without agreeing to revive the nuclear deal being negotiated. Signing a deal, on the other hand, would be more positive for supply than merely not contesting Iranian's renewed exports of 1mm b/d of crude. It is worthwhile bearing in mind that the point of the deal is that Iran pauses its nuclear program, which reduces war risk in the medium term, or as long as deal is in force. Reducing the level of agita in the region, at least for a couple of years, is a net benefit. Our geopolitical strategist Matt Gertken notes, "If Iranians sign a deal, then they are endorsing Biden and the Democratic Party for 2024, meaning they want a Democratic White House in the US through 2028. There would be no reason to sign it unless you plan to implement at least through 2024." We remain bullish oil, and continue to expect Brent to trade above $110/bbl on average this year, and $117/bbl next year. We remain long the XOP ETF to retain our exposure to oil and gas E+Ps.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com     Commodities Round-Up Energy: Bullish The EIA expects US natural gas inventories to finish the injection season at ~ 3.5 Tcf – 6% below the five-year average – at the end of October (Chart 9). LNG exports are expected to average 11.2 Bcf/d, which, if realized, will be 14% over 2021 levels. The EIA increased its estimate of LNG exports on the back of an earlier-than-expected return of Freeport LNG exports. For 2023, the EIA expects US LNG exports will average 12.7 Bcf/d. Close to 70% of the 57 bcm of US LNG exports are being shipped to Europe, where it is helping offset the cutoff of Russian gas supplies following the war in Ukraine. In 1H22, the US became the world’s largest exporter of LNG. Dry gas production in the US is expected to average just under 97 Bcf/d in 2022, a 3% increase over 2021 levels. Base Metals: Bullish Total Chinese copper imports for July were up 9.3% at ~464kt for July, despite economic weakness and a property market slowed by companies' payment defaults and lower consumer confidence in real estate groups. Copper in SHFE warehouses were at 35kt which is 65% lower y/y as of the week ending August 5th, while stocks in China’s copper bonded inventories were 40% lower y/y at 262kt for the month of June. Low copper prices and Chinese stocks, and high imports indicate that the world’s largest copper consumer is capitalizing on weak prices to restock low inventories. Precious Metals: Bullish The World Gold Council reported gold ETF outflows for the third consecutive month in July at 80.1 tons (Chart 10) due to low gold prices, a strong USD and a hawkish Fed. The latest July US CPI data was unchanged from June, as high prices due to pandemic induced supply chain bottlenecks eased. Inflation remains well above target. Despite the mildly positive inflation data, we expect the Fed to hike interest rates again in September. The magnitude of this hike will depend on the August US CPI and employment prints, given the Fed’s data dependency. By year-end, if the Russian oil embargo and insurance bans on shipping vessels are implemented in their current form, high crude oil prices will feed into inflation, and the Fed will be forced to remain aggressive. Chart 9 Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over Chart 10 Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over     Footnotes 1     Please see Agreement on nuclear deal within reach but obstacles remain published by politico.com on August 8, 2022. 2     Please see Russia suspends oil exports via southern leg of Druzhba pipeline due to transit payment issues published by reuters.com on August 9, 2022. 3    Please see Oil drops on Druzhba pipeline news and U.S. inflation expectations published by reuters.com on August 10, 2022.  According to the International Association of Oil Transporters, the Druzhba pipeline capacity is ~ 1.3mm b/d.  In July, its southern leg supplying Hungary, the Czech Republic and was carrying ~ 230k b/d, according to OilX, a satellite service monitoring oil and shipping movements globally. 4    Please see Tighter Oil Markets On The Way, which we published on July 21, 2022, for additional detail. 5    Please see footnote #4. 6    The background factor in this situation is Russia’s involvement in Libya’s civil disorder.  We noted in our July 14, 2022 report Russia Pulls Oil, Gas Supply Strings: “Sporadic force majeure declarations and output losses in Libya, where Russian mercenaries actively support Khalifa Haftar’s Libyan National Army (LNA), continue to make supply assessments difficult.” 7     Please see How the EU Will Allow a Slight Increase in Russian Oil Exports published by Bloomberg.com on August 1, 2022. 8    Please see US warns of surge in fuel costs as it renews push for Russian oil price cap published by ft.com on July 26, 2022. 9    Please see Russian crude prices recover on strong India, China demand, and Column-Russian crude is more reliant on India and China, but signs of a peak: Russell | Reuters, published by reuters.com on August 7 and August 9, 2022. 10   After fuel oils, the 44% y-o-y increase in the gasoline price index was the largest contributor to the increase in the energy index. 11    Please see Surging Energy Prices in Europe in the Aftermath of the War: How to Support the Vulnerable and Speed up the Transition Away from Fossil Fuels, published by the IMF on July 29, 2022. 12    For an example of such policy, please see State aid: Commission approves Spanish and Portuguese measure to lower electricity prices amid energy crisis     Investment Views and Themes Strategic Recommendations Trades Closed in 2022

Executive Summary Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation Inflation is not about oil, food or used car prices. Looking at prices of individual components of a consumer basket is akin to missing the forest for the trees. Despite the latest drop in US headline inflation, various core CPI measures continue trending up and registered considerable month-on-month rises in July. Wages and, more specifically, unit labor costs are the true measure of genuine and persistent inflation. US wage growth is very elevated, and the pace of unit labor cost gains has surged to a 40-year high. The conditions for sustainable and persistent disinflation in the US are not yet present. US inflation will prove to be much stickier and more entrenched than many market participants presently believe. The recovery in China will be U- rather than V-shaped, with risks tilted to the downside. The mainland’s property market breakdown is structural, not cyclical. Excesses are very large, and problems are snowballing, rendering the enacted policy stimulus insufficient. Bottom Line: US core inflation lingering above 4% and easing financial conditions will compel the Fed to continue hiking rates. This will cap global risk asset prices and put a floor under the US dollar.  We continue to recommend an underweight allocation to EM in global equity and credit portfolios. Consistently, we are also reluctant to chase EM currencies higher. Feature The bullish macro narrative circulating in the investment community is that conditions for a cyclical rally in global risk assets have fallen into place. Specifically: US inflation will drop sharply as US growth has crested and commodity prices have plunged; The Fed is nearing the end of a tightening cycle; China has stimulated sufficiently, and its economy is about to recover, which will boost economic conditions among its trading partners in general and EM in particular. These assumptions along with the fact that the S&P 500 index has found support at a 3-year moving average – a proven line of defense – suggest that US share prices have likely bottomed (Chart 1). Are we witnessing déjà vu of the 2011, 2016, 2018 and 2020 market bottoms? Chart 1Déjà Vu? Is 2022 Like The 2011, 2016 And 2018 Bottoms In The S&P 500? Déjà Vu? Is 2022 Like The 2011, 2016 And 2018 Bottoms In The S&P 500? Déjà Vu? Is 2022 Like The 2011, 2016 And 2018 Bottoms In The S&P 500? We have reservations about all of the above fundamental conjectures. We elaborate on these reservations in this report. On the whole, we contend that the current environment is different, and the roadmaps of all post-2009 equity market bottoms are not necessarily currently applicable. BCA’s Emerging Markets Strategy team believes that (1) US consumer price inflation is much more entrenched and will prove stickier than is commonly believed; and (2) the Chinese property market’s breakdown is structural, not cyclical; hence, the recovery will not gain traction easily.  Is This The End Of The US Inflation Problem? Not Quite This week’s US inflation data confirmed that headline CPI inflation has probably peaked: prices in several categories plunged. However, inflation is not about oil, food or used car prices. Chart 2 reveals that historically there have been several episodes whereby core inflation remains elevated despite plunging oil prices. Chart 2US Core Inflation Does Not Always Follow Oil Prices US Core Inflation Does Not Always Follow Oil Prices US Core Inflation Does Not Always Follow Oil Prices Looking at price dynamics among the individual components of the CPI basket is akin to missing the forest for the trees. Inflation is a very inert and persistent phenomenon. Underlying inflation does not change its direction often and/or quickly. That is why we believe that it is premature to celebrate the end of the US inflation problem. A few observations on this matter: Despite the drop in US headline inflation, various core CPI measures − like trimmed-mean CPI, median CPI and core sticky CPI − all continue trending up and registered substantial month-on-month rises in July (Chart 3). The range of core inflation based on these annual and month-month annualized rates is between 4-7%. In brief, the rate of genuine/sticky inflation is well above the Fed’s 2% target. Given its unconditional commitment to bringing inflation down to 2%, the Fed will continue hiking interest rates ceteris paribus. Chart 3US Core CPI Measures Are Still Very High US Core CPI Measures Are Still Very High US Core CPI Measures Are Still Very High Chart 4US Wages Growth Has Been Surging US Wages Growth Has Been Surging US Wages Growth Has Been Surging   We continue to emphasize that wages and, more specifically, unit labor costs are the true measures of persistent and genuine inflation. We have written at length about why wages and unit labor costs are more important to inflation than oil or food prices. US wage growth is very elevated and is accelerating (Chart 4). Unit labor costs, calculated as hourly wages divided by productivity, have also been surging to a 40-year high (Chart 5, top panel). Chart 5Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation The reason for this very strong wage growth and swelling unit labor costs is the very tight labor market. The bottom panel of Chart 5 demonstrates that labor demand is still outpacing labor supply by a wide margin. Hence, wage inflation will not subside until the unemployment rate rises meaningfully. Bottom Line: Conditions for sustainable and persistent disinflation in the US are not yet present.  Inflation will prove to be much stickier and more entrenched than many market participants presently believe. Core inflation lingering above 4% and easing financial conditions will compel the Fed to continue hiking rates. This will cap risk asset prices and put a floor under the US dollar.   China: Is This Time Different? If one believes that China’s current business cycle is similar to all previous ones seen since 2009, odds are that a buying opportunity in China-related financial markets is at hand. Chart 6 illustrates that the credit and fiscal spending impulse leads the business cycle by about nine months. Given that this impulse bottomed late last year, a trough in the Chinese business cycle is due. Chart 6Is A Recovery In China's Business Cycle Imminent? Is A Recovery In China's Business Cycle Imminent? Is A Recovery In China's Business Cycle Imminent? It is always risky to suggest that this time is different. Nevertheless, at the risk of being wrong, we contend that a combination of (1) property markets woes, (2) an impending export contraction, and (3) the dynamic zero-COVID policy will reduce the multiplier effect of current stimulus measures. Hence, a meaningful recovery in economic activity will likely fail to materialize in the coming months. The challenges facing the mainland property market are now well known. Yet, excesses are very large, and problems are snowballing, making policy stimulus insufficient. In particular: Authorities are contemplating bailout funds for property developers in the range of RMB 300-400 billion to enable them to complete housing that has been pre-sold. This is not sufficient financing for overall property construction. Table 1How Large Are Property Developers Bailout Funds? Déjà Vu? Déjà Vu? Table 1 illustrates that these amounts are equal to just 3-4% of annual fixed-asset investment in real estate excluding land purchases, 1.5-2% of total financing of developers, and 3-4% of the advance payments that property developers received for pre-sold housing in 2021. Property developers will not be receiving any cash upon the completion and delivery of presold housing units because they were paid in advance. Hence, without liquidating their other assets, homebuilders cannot repay the bailout financing. Consequently, only state financing can work here because, from the viewpoint of providers of this financing, this scheme de-facto means throwing good money after bad. The property industry in China is extremely fragmented. This makes bailouts difficult to organize and execute. There are officially about 100,000 property developers in China. The overwhelming majority of them are not state-owned companies. Plus, the two largest property developers, Evergrande (before defaulting) and Country Garden, had only 3.8% and 3.3% of market share respectively in 2020. The failure of homebuilders to complete and deliver pre-sold housing units could unleash a death spiral for them. In recent years, 90% of housing units have been pre-sold, i.e., buyers made advance payments/prepayments, often taking out mortgages (Chart 7, top panel). Witnessing the inability of developers to deliver on presold units, a rising number of people may decide to wait to buy. The largest source of developers’ financing – advance payments for pre-sold housing units – might very well dry up. This source has accounted for 50% of real estate developers’ total financing in recent years (Chart 7, bottom panel). In brief, a vicious cycle is possible. The lack of financing for homebuilders bodes ill for construction activity (Chart 8). Chart 7China: Housing Presales And Pre-Payments Are Critical To Developers China: Housing Presales And Pre-Payments Are Critical To Developers China: Housing Presales And Pre-Payments Are Critical To Developers Chart 8Lack Of Homebuilder Financing = Shrinking Construction Activity Lack Of Homebuilder Financing = Shrinking Construction Activity Lack Of Homebuilder Financing = Shrinking Construction Activity Chart 9Chinese Property Developers Are Extremely Leveraged Chinese Property Developers Are Extremely Leveraged Chinese Property Developers Are Extremely Leveraged Besides, property developers are very leveraged with an assets-to-equity ratio close to nine (Chart 9). They have grown accustomed to borrowing heavily to accumulate real estate assets. They have been starting but not completing construction (Chart 10, top panel). We have been referring to this phenomenon as the biggest carry trade in the world. The bottom panel of Chart 10 shows two different measures of residential floor space inventories held by property developers. One measure subtracts completed floor space from started floor space, and another one deducts sold floor space from started floor space. On both measures, residential inventories are enormous. In theory, they could raise funds by selling their real estate assets. However, if they all try to sell simultaneously, there will not be enough buyers, and asset prices will plunge, which could lead to a full-blown debt deflation spiral. The last time the real estate market was similarly distressed in 2014-15, the central bank launched the Pledged Supplementary Lending (PSL) facility. This was effectively a QE program to monetize housing. This was the reason why housing recovered strongly in 2016-2017. There is currently no such program up for discussion. On the whole, odds are that the current property market breakdown is structural, not cyclical. Financial markets – the prices of stocks and USD bonds of property developers – convey a similar message and continue to plunge (Chart 11). Chart 10Excessive Property Inventories Excessive Property Inventories Excessive Property Inventories Chart 11No Green Light From Property Stocks And Corporate Bond Prices No Green Light From Property Stocks And Corporate Bond Prices No Green Light From Property Stocks And Corporate Bond Prices Chart 12There Has Been No Recovery In China Without A Revival in Real Estate There Has Been No Recovery In China Without A Revival in Real Estate There Has Been No Recovery In China Without A Revival in Real Estate Without an improvement in the housing market, a meaningful business cycle recovery is unlikely in China. Chart 12 illustrates that all recoveries in the Chinese broader economy since 2009 occurred alongside a revival in property sales. The importance of the property market goes beyond its size. Rising property prices lift household and business confidence, boosting aggregate spending and investment. The sluggish housing market and falling house prices will impair consumer and business confidence. This, along with uncertainty related to the dynamic zero-COVID policy, will dent consumer spending and private investments. Finally, the upcoming contraction in Chinese exports will dampen national income growth. Taken together, the multiplier effect of stimulus in the upcoming months will be lower than it has been in previous periods of stimulus. There are two areas that will see meaningful improvement in the coming months: infrastructure spending and autos. BCA’s China Investment Strategy service discussed the outlook for auto sales in a recent report. Chart 13Green Shoots In China's Infrastructure Investment Green Shoots In China's Infrastructure Investment Green Shoots In China's Infrastructure Investment On the infrastructure front, there has been mixed evidence of an improvement in activity. The top and middle panels of Chart 13 demonstrate that Komatsu machinery’s operational hours and the number of approved infrastructure projects might be bottoming. However, the installation of high-power electricity lines has fallen to a 15-year low (Chart 13, bottom panel).   As we elaborated in last month’s report, the new financing/stimulus for infrastructure development will not result in new investments. Rather, it will by and large offset the drop in local government (LG) revenues from land sales this year. In short, there is little new stimulus for infrastructure beyond what was approved in the budget plan earlier this year. Bottom Line: The recovery in China will be U- rather than V-shaped, with risks tilted to the downside. Investment Recommendations Our bias is that the rebound in global risk assets could last for a few more weeks. The basis is that investor positioning in risk assets was very light when this rebound began. Plus, falling oil prices could reinforce the idea among investors that US inflation is no longer a problem. Looking beyond the next several weeks, the outlook for global and EM risk assets is dismal. Markets will realize that the Fed cannot halt its tightening with core inflation well above 4-5%. Hawkish Fed policy and contracting global trade will boost the US dollar and weigh on cyclical assets. We continue to recommend an underweight allocation to EM in global equity and credit portfolios. Consistently, we are also reluctant to chase EM currencies higher. EM local bonds offer value, as we have argued over the past couple of months, but for now we prefer to focus on yield curve flattening trades. We continue betting on yield curve flattening/inversion in Mexico and Colombia and are long Brazilian 10-year domestic bonds while hedging the currency risk. In addition, we recommend investors continue receiving 10-year swap rates in China and Malaysia.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)