Emerging Markets

Highlights We introduce our rotation graphs to assess the evolution of the relative trend and momentum of various assets. US equities remain on firm footing, but their weakening relative momentum suggests that investors may soon begin to rotate away from this market in favor of the Eurozone and EM. Cyclicals continue to dominate defensives, globally and in Europe. European value stocks are experiencing improving momentum, which suggests that a rotation out of growth equities is afoot. While European small-cap equities sport attractive fundamentals, rotational dynamics indicate it is still too early to overweight them aggressively. The energy crisis is a dominant driver of the relative sector performance in Europe and resulted in a massive shift in leadership from industrials to energy. As long as oil and natural gas act as a drag, industrials will lag. Financials are well supported. Swedish stocks have borne the brunt of the energy price spike, while Norwegian equities have been its main beneficiaries. The improvement in momentum of German stocks suggests that their relative underperformance will soon end. Spanish shares look attractive from a tactical perspective. Swiss industrials will need a recovery in EUR/CHF to outperform other European industrials. UK industrials will continue to outperform their continental competitors, while Spanish industrials have a window through which to shine. A rotation into UK financials may soon begin as their momentum improves. The darkest days for German financials are ending, while Spanish, Italian, and Swedish financials may soon witness a wave of underperformance. Spanish consumer discretionary equities are becoming more attractive compared to their European counterparts. While Dutch names continue to outperform other European tech equities, their softening momentum suggests investors are beginning to rotate out of this country. Spanish and German tech names offer an attractive diversification opportunity within the industry. Feature Methodology The combination of excess liquidity, large pools of fast money, elevated valuations across most securities, and the existence of the near-term momentum reversal effect encourage investors to rotate from one asset to the next in the hope of rapid profits. Measures to assess where each market stands in this rotational pattern can be useful for investors to catch these swings. In this optic, we introduce our rotation screener focused on equities. It is a simple tool that looks at whether a sector or a country is strengthening relative to its benchmark and whether this strength is happening at a faster or slower momentum. To measure each dimension, we use proprietary indicators of relative strength and momentum. Once each asset’s relative strength and relative momentum are established, we can position them in quadrants. We follow traditional terminology. The upper right quadrant denotes “Leading” assets, or securities that are outperforming their benchmark with strengthening momentum. The bottom right quadrant denotes “Weakening” assets, or securities that are outperforming their benchmark but with a deteriorating momentum. The bottom left quadrant denotes “Lagging” assets, or securities that are underperforming with decreasing momentum. Finally, the top left quadrant indicates “Improving” assets, or securities that are underperforming but with increasing momentum. Investors should move to overweight assets that are in the Improving quadrants and to underweight assets that are inching toward the “Lagging” from the “Weakening” quadrants. This method is very flexible and can be applied to sectors, countries, styles, and so on, as long as a benchmark is available to generate comparisons. In this report, we will analyze the following from a rotational perspective: global national markets, global cyclicals vs global defensive’s, European cyclicals vs European defensives, European sectors, European national markets, European financials, European consumer discretionaries, and European tech stocks. Global National Markets Chart 1 US equities have moved from the Leading quadrant to the Weakening one as they continue to outperform the global benchmark but with a decelerating momentum (Chart 1). This locates the US market in a risky position that could herald a period of underperformance, especially if global economic surprises accelerate. From a rotational perspective, US stocks could still experience another wave of outperformance over the coming weeks, as momentum has been firming over the past four weeks.   The Euro Area benchmark has fully moved from the Weakening quadrant in August to the Lagging one today. Investors should monitor Europe’s relative momentum closely, because a pick-up from here would push the Eurozone into Improving territory, a warning of an imminent trend change in European relative stock prices. Emerging markets have exited the Lagging zone and moved into the Improving quadrant. The move is far from decisive and remains at risk with Chinese credit growth still decelerating. The recent decline in steel prices in China suggests that construction activity in that economy continues to slow. Thus, as long as Chinese credit flows deteriorate, EM stocks will have trouble moving into the Leading quadrant. Cyclicals Vs Defensives Global defensive equities tried to move into the Leading quadrant at the end of the summer, but, ultimately, they plunged back into Lagging territory as global stocks recovered in October (Chart 2). Meanwhile, global cyclicals moved in the opposite trajectory, shifting from the Lagging quadrant to the Leading one over the past three months. Cyclicals continue to benefit from the general uptrend in the market. Even the recent decline in yields is doing little to boost the performance of defensive equities. The biggest risk to these stocks remains the Chinese economic slowdown. For now, this deterioration has not been large enough to compensate for the general vigour in profits and consumption in advanced economies. However, if inflation worries do not abate, then the Chinese slowdown will become more problematic for global cyclicals as it will raise the spectre of stagflation.  Chart 2 Chart 3 The rotational pattern for European cyclicals vs defensive stocks mimics that of global equities (Chart 3). However, European cyclicals are somewhat softer than their global equivalents, hurt by Europe’s greater exposure to the Chinese business cycle compared to the US’s exposure. European Investment Styles Chart 4 Over the past three months, European investment styles have begun a major shift. Value has moved from the Lagging quadrant to the Improving one, which suggests that flows could push value into the Leading quadrant (Chart 4). Moreover, growth has moved from the Leading quadrant to the weakening one, which created a similar dynamic as the decline in performance of the quality factor. This confirms that the rise in yields is beginning to favour a shift in style from growth to value. Meanwhile, small-cap stocks have tumbled into the Lagging quarter. We do expect attractive returns for European small-cap names over an 18- to 24-month investment horizon. However, we have not moved yet to overweight this sector of the market and rotational patterns confirm it is too early to do so safely. European Sectors Chart 5 Sectors have begun to make some important shifts in European markets (Chart 5). Tech has moved from the Leading quadrant to the weakening one. While the sector continues to outperform, it is doing so with a declining momentum, and it could soon move to the Lagging quadrant. This deteriorating price action must be monitored closely. Consumer discretionary names, which were strong performers that have become increasingly weak, have moved from the Weakening quadrant to the lagging one. However, their momentum is not deteriorating as much as it did nine weeks ago, which suggests a move to the Improving quadrant could soon be in the offing. Financials have greatly enjoyed the uptick in global yields. After a short passage through the Lagging quadrant, they have shifted into the Leading one. This suggests that the winds remain behind this sector, which we continue to overweight. Industrials and energy have become mirror images of one another, highlighting the negative impact on European economic activity and profitability of the recent surge in energy prices. The industrials have moved from the Leading quadrant to the lagging one, as the energy sector experienced the opposite direction of travel. This suggests that industrials will only recover their shine once the energy crisis abates, which will also hurt energy stocks. European National Markets Chart 6 The rotational pattern exhibited by European national markets bears their respective sectoral footprints (Chart 6). The tech-heavy Dutch market has moved from the Leading quadrant to the Weakening one, the industrials-focused Swedish market has fallen into the Lagging quadrant from the Weakening one and the Norwegian market has leapt out of Lagging into Leading territory. Hence, if the rotation out of tech deepens, The Netherlands will tumble directly into the Lagging zone, while an easing in energy prices will force Norway and Sweden to switch places on the back of a rotation out of energy into industrials. Germany is of particular interest. It is a well-diversified market that has become oversold. Moreover, as we wrote in September, its relative performance exhibits a significant discount to relative earnings. From a rotational perspective, Germany is moving to leave the Lagging quadrant; a durable shift into the Improving quadrant will sufficiently assuage traders into buying this market. This process will support our overweight position in German equities. Spain is another market we like on a tactical basis. Over the course of the past three months, it moved out of Lagging territory into the Improving zone. This price action supports our thesis that the large country-discount embedded across Spanish equity sectors is excessive and should soon dissipate. The main risk to this view would be another down leg in bond yields, which would hurt financials—a major weight in this market. Italy, too, is in the process of executing a full rotation, having exited the Weakening quadrant and moved into the Lagging one. Italian stocks have tried to punch their way into the Improving zone but have failed to do so. They will require higher yields to move out into the Improving zone durably because of the heavy financials weighting of Italian stocks. European Industrials Chart 7 Within European industrials, a rotational pattern is also evident (Chart 7). Swiss industrials have moved out of the Leading quadrant into the Lagging one as the Swiss franc continues to appreciate against the euro. The rising CHF imparts deflationary pressures into Switzerland and the SNB continues to build up its reserves. As a result, EUR/CHF will appreciate once EUR/USD finds a firmer footing. Thus, while it is too early to overweight Swiss industrials relative to those of the Eurozone, their oversold nature suggests that a rotation in favour of Swiss manufacturing businesses will soon take place. At the current juncture, Spanish industrials look appealing. They have moved out of the Lagging quadrant into the Improving one as the momentum of their relative performance improves. Additionally, they are close to moving into the leading territory. This picture is consistent with a narrowing of the discount embedded in all Spanish sectors since the pandemic broke out. Swedish industrials are also trying to exit the Lagging territory; their elevated RoE, and heavy sensitivity to the DM capex cycle indicate that they should move into the Leading quadrant in the coming weeks. UK industrials have remained in the Leading zone for the past three months, but their relative momentum is softening, which risks them being placed in the Weakening zone. The recent deterioration in GBP/EUR could provide a breath of fresh air, as it will improve the competitiveness of UK industrials compared to continental firms. Even then, for now, rotational dynamics do not flag an imminent problem for UK industrials. European Financials Chart 8 The clearest rotational pattern within European financials may be found in Sweden and the UK (Chart 8). Over the past three months, Swedish financials have fallen out of the Leading quadrant into the Weakening one, and they are inching closer toward the Lagging zone. This suggests that they could soon begin to underperform. Meanwhile, UK financials offer a mirror image as they exited the Lagging quadrant and moved into the improving one. They have yet to enter Leading territory, but seem close to doing so. The pessimism toward the UK is overdone right now. BCA’s Global Fixed-Income Strategy team expects the UK yield curve to steepen anew. UK financials would be prime beneficiaries of this dynamic. Italian and Spanish financials are also exhibiting some concerning moves lately. Both were in the Leading quadrant, but they have since shifted to the lagging one as peripheral spreads widened. Meanwhile, money seems to be moving into German financials, which have advanced from the Lagging quadrant to the Improving quadrant. While they are not as close to the Leading quadrant as their UK competitors, this shift warrants monitoring. European Consumer Discretionary Chart 9 Within the consumer discretionary space, most European countries have remained in their quadrant (Chart 9). Nonetheless, Spanish CD stocks have moved out of the Lagging zone into the Leading quadrant, while their Italian counterparts have recently entered the Weakening quadrant where they have joined French CDs. While both these countries’ consumer discretionary firms are witnessing weakening momentum, they remain in an upward trend against their European competitors. It is therefore too early to sell these countries within this industry. German Consumer discretionary equities are still in the Lagging quadrant, but they are trying to move into the Improving one, where UK CD names have remained for the past three months. European Tech Chart 10 The European tech sector is very much a story about The Netherlands versus the rest, due to the large size of the Dutch tech sector (Chart 10). For now, rotational patterns remain in favour of Dutch names; they have exited the Leading quadrant, but, while their momentum is weakening somewhat, they remain in a pronounced relative uptrend. A few small markets offer some promise. Over the past three months, both Spanish and German tech names have shifted from the Lagging quadrant into the Improving one. Their elevated momentum measures suggest that a shift into the Leading quadrant is imminent. As such, investors should consider switching some of their tech holdings into these two countries to diversify away from the Dutch behemoth.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com

Image The markets were deluged by a lot of information in late October. Several central banks made surprise moves towards tightening (the Bank of Canada, for example, ended asset purchases, and the Reserve Bank of Australia effectively abandoned its yield-curve control). Inflation continued to surprise on the upside (headline CPI in the US is now 5.4% year-on-year). But, at the same time, there were signs of faltering growth with, for example, US real GDP growth in Q3 coming in at only 2.0% quarter-on-quarter annualized, compared to 6.7% in Q2. This caused a flattening of the yield curve in many countries, as markets priced in faster monetary tightening but lower long-term growth (Chart 1). Nonetheless, equities shrugged off the barrage of news, with the S&P500 ending the month at a new high. All this highlights what we discussed in our latest Quarterly: That the second year of a bull market is often tricky, resulting in lower (but still positive) returns from equities and higher volatility. For risk assets to continue to outperform, our view of a Goldilocks environment needs to be “just right”: The economy must not be too hot or too cold. We think it will be – and so stay overweight equities versus bonds. But investors should be aware of the risks on either side. How too hot? Inflation is broadening out (at least in the US, UK, Australia and Canada, though not in the euro zone and Japan) and is no longer limited to items which saw unusually strong demand during the pandemic but where supply is constrained (Chart 2). Chart 1What Is The Message Of Flattening Yield Curves? What Is The Message Of Flattening Yield Curves? What Is The Message Of Flattening Yield Curves? Chart 2Inflation Is Broadening Out In The US Inflation Is Broadening Out In The US Inflation Is Broadening Out In The US There is a risk that this turns into a wage-price spiral as employees, amid a tight labor market, push for higher wages to offset rising prices. We find that wages tend to follow prices with a lag of 6-12 months (Chart 3). The Atlanta Fed Wage Tracker (good for gauging underlying wage pressures since it looks only at employees who have been in a job for 12 months or more) is already at 3.5% and looks set to rise further. On the back of these inflationary moves, the market has significantly pulled forward the date of central bank tightening. Futures now imply that the Fed will raise rates in both July and December next year (Chart 4) and that other major developed central banks will also raise multiple times over the next 14 months (Table 1). Breakeven inflation rates have also risen substantially (Chart 5). Chart 3Wages Tend To Rise After Prices Rise Wages Tend To Rise After Prices Rise Wages Tend To Rise After Prices Rise Chart 4Will The Fed Really Hike This Soon? Will The Fed Really Hike This Soon? Will The Fed Really Hike This Soon?   Table 1Futures Implied Path Of Rate Hikes Monthly Portfolio Update: The Risks To Goldilocks Monthly Portfolio Update: The Risks To Goldilocks Chart 5Breakevens Suggest Higher Inflation Breakevens Suggest Higher Inflation Breakevens Suggest Higher Inflation     We think these moves are a little excessive. There are several reasons why inflation might cool next year. Companies are rushing to increase capacity to unblock supply bottlenecks. For example, semiconductor production has already begun to increase, bringing down DRAM prices over the past few months (Chart 6). Another big contributor to broad-based inflation has been a 126% increase in container shipping costs since the start of the year (Chart 7). But currently the number of container ships on order is at a 10-year high; these new ships will be delivered over the next two years. Such deflationary forces should pull down core inflation next year (though we stick to our longstanding view that for multiple structural reasons – demographics, the end of globalization, central bank dovishness, the transition away from fossil fuels – inflation will trend up over the next five years). Chart 6DRAM Prices Falling As Production Ramps Up DRAM Prices Falling As Production Ramps Up DRAM Prices Falling As Production Ramps Up Chart 7All Those Ships On Order Should Bring Down Shipping Costs All Those Ships On Order Should Bring Down Shipping Costs All Those Ships On Order Should Bring Down Shipping Costs The Fed, therefore, will not be in a rush to raise rates. It does not see the labor market as anywhere close to “maximum employment” – it has not defined what it means by this, but we would see it as a 3.8% unemployment rate (the median FOMC dot for the equilibrium unemployment rate) and the prime-age participation rate back to its 2019 level (Chart 8). We continue to expect the first rate hike only in December next year. The Fed will feel the need to override its employment criterion only if long-term inflation expectations become unanchored – but the 5-year 5-year forward breakeven rate is only at 2.3%, within the Fed’s effective CPI target range of 2.3-2.5% (Chart 5). We remain comfortable with our view of only a moderate rise in long-term rates, with the US 10-year Treasury yield at 1.7% by end-2021, and reaching 2-2.25% at the time of the first Fed rate hike. It is also worth emphasizing that even a fairly sharp rise in long-term rates has historically almost always coincided with strong equity performance (Chart 9 and Table 2). This has again been evident in the past 12 months: When rates rose between August 2020 and March 2021, and then from July 2021, equities performed strongly. Chart 8We Are Not Back To "Maximum Employment" We Are Not Back To "Maximum Employment" We Are Not Back To "Maximum Employment" Chart 9Rising Rates Are Usually Accompanied By A Rising Stock Market Rising Rates Are Usually Accompanied By A Rising Stock Market Rising Rates Are Usually Accompanied By A Rising Stock Market   Table 2Episodes Of Rising Long-Term Rates Since 1990 Monthly Portfolio Update: The Risks To Goldilocks Monthly Portfolio Update: The Risks To Goldilocks But could the economy get too cold? We would discount the weak US GDP reading: It was mostly due to production shortages, especially in autos, which pushed down consumption on durable goods by 26% QoQ annualized, and by some softness in spending on services due to the delta Covid variant, the impact of which is now fading. US growth should continue to be supported by a combination of the $2.5 trillion of excess household savings, strong capex as companies boost their production capacity, and a further 5% of GDP in fiscal stimulus that should be passed by Congress by year-end. Similar conditions apply in other developed economies. Chart 10Real Estate Is A Big Part Of Chinese GDP Real Estate Is A Big Part Of Chinese GDP Real Estate Is A Big Part Of Chinese GDP We see three principal risks to this positive outlook: A new strain of Covid-19 that proves resistant to current vaccines – unlikely but not impossible. Our geopolitical strategists worry about Iran, which may have a nuclear bomb ready by December, prompting Israel to bomb the country. Iran would likely react by hampering oil supplies, even blocking the Strait of Hormuz, through which 25% of global oil flows. Chinese growth has been slowing and the impact from the problems at Evergrande is still unclear. Real estate is a major part of the Chinese economy, with residential investment comprising 10% of GDP (Chart 10) and, broadly defined to include construction and building materials, real estate overall perhaps as much as one-third. Our China strategists don’t expect the government to launch a major stimulus which would bail out the industry, since it is happy with the way that property-related lending has been shrinking in recent years (Chart 11). We expect the slowdown in Chinese credit growth to bottom out over the coming few months, but economic activity may have further to slow (Chart 12), and there is a risk that the authorities are unable to control the fallout from the property market. Chart 11Chinese Authorities Are Happy To See Slowing Property Lending Chinese Authorities Are Happy To See Slowing Property Lending Chinese Authorities Are Happy To See Slowing Property Lending Chart 12When Will Credit Growth Bottom? When Will Credit Growth Bottom? When Will Credit Growth Bottom?       Fixed Income: Given the macro environment described above, we remain underweight bonds and short duration. If we assume 1) a Fed liftoff in December 2022, 2) 100 basis points of rate hikes over the following year, and 3) a terminal Fed Funds Rate of 2.08% (the median forecast from the New York Fed’s Survey of Market Participants), 10-year US Treasurys will return -0.2% over the next 12 months, and 2-year Treasurys +0.3%.1 TIPs have overshot fair value and, although we remain neutral since they a tail-risk hedge against high inflation over the next five years, we would especially avoid 2-year TIPS which look very overvalued. We see some pockets of selective value in lower-quality high-yield bonds, specifically US Ba- and Caa-rated issues, which are still trading at breakeven spreads around the 35th historical percentile, whereas higher-rated bonds look very expensive (Chart 13). For US tax-paying investors, municipal bonds look particularly attractive at the moment, with general-obligation (GO) munis trading at a duration-matched yield higher than Treasurys even before tax considerations (Chart 14). Our US bond strategists have recently gone maximum overweight. Chart 13 Chart 14Muni Bonds Are A Steal Muni Bonds Are A Steal Muni Bonds Are A Steal     Equities: We retain our longstanding preference for US equities over other Developed Markets. US equities have outperformed this year, irrespective of whether rates were rising or falling, or how US growth was surprising relative to the rest of the world, emphasizing the much stronger fundamentals of the US market (Chart 15).  Analysts’ forecasts for the next few quarters look quite cautious, and so earnings surprises can push US stock prices up further (Chart 16). We reiterate the neutral on China but underweight on Emerging Markets ex-China that we initiated in our latest Quarterly. Our sector overweights are a mixture of cyclicals (Industrials), rising-interest-rate plays (Financials), and defensives (Heath Care). Chart 15US Equites Outperformed This Year Whatever Happened US Equites Outperformed This Year Whatever Happened US Equites Outperformed This Year Whatever Happened Chart 16Analysts Are Pessimistic About The Next Couple Of Quarters Analysts Are Pessimistic About The Next Couple Of Quarters Analysts Are Pessimistic About The Next Couple Of Quarters   Currencies: We continue to expect the US dollar to be stuck in its trading range and so stay neutral. Recent moves in prospective relative monetary policy bring us to change two of our currency recommendations. We close our underweight on the Australian dollar. The recent rise in Australian inflation (with both trimmed mean and 10-year breakevens now above 2% – Chart 17) has brought forward the timing of the first rate hike and should push up relative real rates (Chart 18). We lower our recommendation on the Japanese yen from overweight to neutral. The Bank of Japan will not raise rates any time soon, even when other central banks are tightening. This will push real-rate differentials against the yen (Chart 18, panel 2). Chart 17Australian Inflation Is Picking Up Australian Inflation Is Picking Up Australian Inflation Is Picking Up Chart 18Real Rates Moving In Favor Of The AUD And Against The JPY Real Rates Moving In Favor Of The AUD And Against The JPY Real Rates Moving In Favor Of The AUD And Against The JPY Chart 19Chinese-Related Metals' Prices Are Falling Chinese-Related Metals' Prices Are Falling Chinese-Related Metals' Prices Are Falling Commodities: We remain cautious on those industrial metals which are most sensitive to slowing Chinese growth and its weakening property market. The fall in iron ore prices since July is now being followed by aluminum. However, metals which are increasingly driven by investment in alternative energy, notably copper, are likely to hold up better (Chart 19). We are underweight the equity Materials sector and neutral on the commodities asset class. The Brent crude oil price has broadly reached our energy strategists’ forecasts of $80/bbl on average in 2022 and $81 in 2023 (Chart 20). Although the forward curve is lower than this, with December-22 Brent at only $75/bbl, it is a misapprehension to characterize this as the market forecasting that the oil price will fall. Backwardation (where futures prices are lower than spot) is the usual state of affairs for structural reasons (for example, producers hedging production forward). The market typically moves to contango only when the oil price has fallen sharply and reserves are high (Chart 21). We remain neutral on the equities Energy sector.   Chart 20Brent Has Reached Our 2022 And 2023 Forecast Level Brent Has Reached Our 2022 And 2023 Forecast Level Brent Has Reached Our 2022 And 2023 Forecast Level Chart 21Lower Oil Futures Don't Mean Oil Price Is Forecast To Fall Lower Oil Futures Don't Mean Oil Price Is Forecast To Fall Lower Oil Futures Don't Mean Oil Price Is Forecast To Fall Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com GAA Asset Allocation  

Highlights Short-term inflation risk will escalate further if politics causes new supply disruptions. Long-term inflation risk is significant as well. There is a distinct risk of a geopolitical crisis in the Middle East that would push up energy prices: the US’s unfinished business with Iran. The primary disinflationary risk is China’s property sector distress. However, Beijing will strive to maintain stability prior to the twentieth national party congress in fall 2022. South Asian geopolitical risks are rising. The Indo-Pakistani ceasefire is likely to break down, while Afghani terrorism will rebound. Book gains on our emerging market currency short targeting “strongman” regimes. Feature Chart 1 Investors are underrating the risk of a global oil shock. This was our geopolitical takeaway from the BCA Conference this year. Investors are focused on the risk of inflation and stagflation, always with reference to the 1970s. The sharp increase in energy prices due to the Arab Oil Embargo of 1973 and the Iranian Revolution of 1979 are universally cited as aggravating factors of stagflation at that time. But these events are also given as critical differences between the situation in the 1970s and today. Unfortunately, there could be similarities. From a strictly geopolitical perspective, the risk of a conflict in the Middle East is significant both in the near term and over the coming year or so. The risk stems from the US’s unfinished business with Iran. More broadly, any supply disruption would have an outsized impact as global energy inventories decline. OPEC’s spare capacity at present can cover a 5 million barrel shock (Chart 1). In this week’s report we also provide tactical updates on China, Russia, and India. Geopolitics And The 1970s Inflation Chart 2Wage-Price Spiral, Stagflation In 1970s Wage-Price Spiral, Stagflation In 1970s Wage-Price Spiral, Stagflation In 1970s Fundamentally the stagflation of the 1970s occurred because global policymakers engendered a spiral of higher wages and higher prices. The wage-price spiral was exacerbated by a falling dollar, after President Nixon abandoned the gold standard, and a commodity price surge (Chart 2). Monetary policy clearly played a role. It was too easy for too long, with broad money supply consistently rising relative to nominal GDP (Chart 3). Central banks including the Federal Reserve were focused exclusively on employment. Policymakers saw the primary risk to the institution’s credibility as recession and unemployment, not inflation. Fear of the Great Depression lurked under the surface. Fiscal policy also played a role. The size of the US budget deficit at this time is often exaggerated but there is no question that they were growing and contributed to the bout of inflation and spike in bond yields (Chart 4). The reason was not only President Johnson’s large social spending program, known as the “Great Society.” It was also Johnson’s war – the Vietnam war. Chart 3Central Banks Focused On Employment, Not Prices, In 1970s Central Banks Focused On Employment, Not Prices, In 1970s Central Banks Focused On Employment, Not Prices, In 1970s On top of this heady mix of inflationary variables came geopolitics. The Yom Kippur war in 1973 prompted Arab states to impose an embargo on Israel’s supporters in the West. The Arab embargo cut off 8% of global oil demand at the time. Oil prices skyrocketed, precipitating a deep recession (Chart 5). Chart 4Johnson's 'Great Society' And Vietnam War Spending Johnson's 'Great Society' And Vietnam War Spending Johnson's 'Great Society' And Vietnam War Spending The embargo came to a halt in spring of 1974 after Israeli forces withdrew to the east of the Suez Canal. The oil shock exacerbated the underlying inflationary wave that continued throughout the decade. The Iranian revolution triggered another oil shock in 1979, bringing the rise in general prices to their peak in the early 1980s, at which point policymakers intervened decisively. Chart 5Arab Oil Embargo And Iranian Revolution Arab Oil Embargo And Iranian Revolution Arab Oil Embargo And Iranian Revolution There is an analogy with today’s global policy mix. Fear of the Great Recession and deflation rules within policymaking circles, albeit less so among the general public. The Fed and the European Central Bank have adjusted their strategies to pursue an average inflation target and “maximum employment.” Chart 6Wage-Price Spiral Today? Wage-Price Spiral Today? Wage-Price Spiral Today? ​​​​​​ The Biden administration is reviving big government with a framework agreement of around $1.2 trillion in new deficit spending on infrastructure, green energy, and social programs likely to pass Congress before year’s end. In short, the macro and policy backdrop are changing in a way that is reminiscent of the 1970s despite various structural differences between the two periods. It is too early to declare that a wage-price spiral has developed but core inflation is rising and investors are right to be concerned about the direction and potential for inflation surprises down the road (Chart 6). These trends would not be nearly as concerning if they were not occurring in the context of a shift in public opinion in favor of government versus markets, labor versus capital, onshoring versus offshoring, and protectionism versus free trade. Investors should note that the last policy sea change (in the opposite direction) lasted roughly 30-40 years. The global savings glut – shown here as the combined current account balances of the world’s major economies – has begun to decline, implying that a major deflationary force might be subsiding. Asian exporters apparently have substantial pricing power, as witnessed by rising export prices, although they have yet to break above the secular downtrend of the post-2008 period (Chart 7). Chart 7Hypo-Globalization Is Inflationary Hypo-Globalization Is Inflationary Hypo-Globalization Is Inflationary A commodity price surge is also underway, of course, though it is so far manageable. The US and EU economies are less energy-intensive than in the 1970s and there is considerable buffer between today’s high prices and an economic recession (Chart 8). Chart 8Wage-Price Spiral Today? Wage-Price Spiral Today? Wage-Price Spiral Today? The problem is that there is a diminishing margin of safety. Furthermore, a crisis in the Middle East is not far-fetched, as there is a concrete and distinct reason for worrying about one: the US’s unresolved collision course with Iran. A crisis in the Persian Gulf would greatly exacerbate today’s energy shortages. Iran: The Risk Of An Oil Shock Iran now says it will rejoin diplomatic talks over its nuclear program in late November. This development was expected, and is important, but it masks the urgent and dangerous trajectory of events that could blow up any day now. It is emphatically not an “all clear” sign for geopolitical risk in the Persian Gulf. The US is hinting, merely hinting, that it is willing to use military force to prevent Iran from going nuclear. The Iranians doubt US appetite for war and have every reason to think that nuclear status will guarantee them regime survival. Thus the Iranians are incentivized to use diplomacy as a screen while pursuing nuclear weaponization – unless the US and Israel make a convincing display of military strength to force Iran back to genuine diplomacy. A convincing display is hard to do. A secret war is taking place, of sabotage and cyber-attacks. On October 26 a cyber-attack disrupted Iranian gas stations. But even attacks on nuclear scientists and facilities have not dissuaded the Iranians from making progress on their nuclear program yet. Iran does not want to be attacked but it knows that a ground invasion is virtually impossible and air strikes alone have a poor record of winning wars. The Iranians have achieved 60% highly enriched uranium and are expected to achieve nuclear breakout capacity – the ability to make a nuclear device – sometime between now and December (Table 1). The IAEA no longer has any visibility in Iran. The regime’s verified production of uranium metal can only be used for the construction of a warhead. Recent technical progress may be irreversible, according to the Institute for Science and International Security.1 If that is true then the upcoming round of diplomatic negotiations is already doomed. Table 1Iran’s Compliance With Nuclear Deal And Time Until Breakout (Oct 2021) Bad Time For An Oil Shock! (GeoRisk Update) Bad Time For An Oil Shock! (GeoRisk Update) American policymakers seem overconfident in the face of this clear nuclear proliferation risk. This is strange given that North Korea successfully manipulated them over the past three decades and now has an arsenal of 40-50 nuclear weapons. The consensus goes as follows: Regime instability: Americans emphasize that the Iranian regime is unstable, lacks genuine support, and faces a large and restive youth population. This is all true. Indeed Iran is one of the most likely candidates for major regime instability in the wake of the COVID-19 shock. Chart 9AIran's Economy Sees Inflation Spike ... Iran's Economy Sees Inflation Spike ... Iran's Economy Sees Inflation Spike ... ​​​​​​ Chart 9B... Yet Some Green Shoots Are Rising ... Yet Some Green Shoots Are Rising ... Yet Some Green Shoots Are Rising However, popular protest has not had any effect on the regime over the past 12 years. Today the economy is improving and illicit oil revenues are rising (Chart 9). A new nationalist government is in charge that has far greater support than the discredited reformist faction that failed on both the economic and foreign policy fronts (Chart 10). The sophisticated idea that achieving nuclear breakout will somehow weaken the regime is wishful thinking.  If it provokes US and/or Israeli air strikes, it will most likely see the people rally around the flag and convince the next generation to adopt the revolutionary cause.2 If it does not provoke a war, then the regime’s strategic wisdom will be confirmed. American military and economic superiority: Americans tend to think that Iran will back down in the face of the US’s and Israel’s overwhelming military and economic superiority. It is true that a massive show of force – combined with the sale of specialized weaponry to Israel to enable a successful strike against extremely hardened nuclear facilities – could force Iran to pause its nuclear quest and go back to negotiations. Yet the US’s awesome display of military power in both Iraq and Afghanistan ended in ignominy and have not deterred Iran, just next door, after 20 years. Nor have American economic sanctions, including “maximum pressure” sanctions since 2019. The US is starkly divided, very few people view Iran as a major threat, and there is an aversion to wars in the Middle East (Chart 11). The Iranians could be forgiven for doubting that the US has the appetite to enforce its demands. Chart 10 ​​​​​​ Chart 11 ​​​​​​ In short the US is attempting to turn its strategic focus to China and Asia Pacific, which creates a power vacuum in the Middle East that Iran may attempt to fill. Meanwhile global supply and demand balances for energy are tight, with shortages popping up around the world, giving Iran greater leverage. From an investment point of view, a crisis is likely in the near term regardless of what happens afterwards. A crisis is necessary to force the US and Iran to return to a durable nuclear deal like in 2015. Otherwise Iran will reach nuclear breakout and an even bigger crisis will erupt, potentially forcing the US and Israel (or Israel alone) to take military action. Diplomatic efforts will need to have some quick and substantial victories in the coming months to convince us that the countries have moved off their collision course. A conflict with Iran will not necessarily go to the extreme of Iran shutting down the Strait of Hormuz and cutting off 21% of the world’s oil and 26% of liquefied natural gas (Chart 12). If that happens a global recession is unavoidable. It would more likely involve lesser conflicts, at least initially, such as “Tanker War 2.0” in the Persian Gulf.3 Or it could involve a flare-up of the ongoing proxy war by missile and drone strikes, such as with the Abqaiq attack in 2019 that knocked 5.7 million barrels per day offline overnight. The impact on oil markets will depend on the nature and magnitude of the event. Chart 12 What are the odds of a military conflict? In past reports we have demonstrated that there is a 40% chance of conflict with Iran. The country’s nuclear program is at a critical juncture. The longer the world goes without a diplomatic track to defuse tensions, the more investors should brace for negative surprises. Bottom Line: There is a clear and present danger of a geopolitical oil shock. The implication is that oil and LNG prices could spike in the coming zero-to-12 months. The implication would be a dramatic “up then down” movement in global energy prices. Inflation expectations should benefit from simmering tensions but a full-blown war would cause an extreme price spike and global recession. China: The Return Of The Authoritative Person Another reason that today’s inflation risk could last longer than expected is that China’s government is likely to backpedal from overtightening monetary, fiscal, and regulatory policy. If this is true then China will secure its economic recovery, the global recovery will continue, commodity prices will stay elevated, and the inflation expectations and bond yields will recover. If it is not true then investors will start talking about disinflation and deflation again soon. We are not bullish on Chinese assets – far from it. We see China entering a property-induced debt-deflation crisis over the long run. But over the 2021-22 period we have argued that China would pull back from the brink of overtightening. Our GeoRisk Indicator for China highlights how policy risk remains elevated (see Appendix). So far our assessment appears largely accurate. The government has quietly intervened to prevent the troubled developer Evergrande from suffering a Lehman-style collapse. The long-delayed imposition of a nationwide property tax is once again being diluted into a few regional trial balloons. Alibaba founder Jack Ma, whom the government disappeared last year, has reappeared in public view, which implies that Beijing recognizes that its crackdown on Big Tech could cause long-term damage to innovation. At this critical juncture, a mysterious “authoritative” commentator has returned to the scene after five years of silence. Widely believed to be Vice Premier Liu He, a Politburo member and Xi Jinping confidante on economic affairs, the authoritative person argues in a recent editorial that China will stick with its current economic policies.4 However, the message was not entirely hawkish. Table 2 highlights the key arguments – China is not oblivious to the risk of a policy mistake. Table 2Messages From China’s ‘Authoritative Person’ On Economic Policy (2021) Bad Time For An Oil Shock! (GeoRisk Update) Bad Time For An Oil Shock! (GeoRisk Update) Readers will recall that a similar “authoritative Person” first appeared in the People’s Daily in May 2016. At that time, the Chinese government had just relented in the face of economic instability and stimulated the economy. It saw a 3.5% of GDP increase in fiscal spending and a 10.0% of GDP increase in the credit impulse from the trough in 2015 to the peak in 2016. The authoritative person was explaining that the intention to reform would persist despite the relapse into debt-fueled growth. So one must wonder today whether the authoritative person is emerging because Beijing is sticking to its guns (consensus view) or rather because it is gradually being forced to relax policy by the manifest risk of financial instability. To be fair, a recent announcement on government special purpose bonds does not indicate major fiscal easing. If local governments accelerate their issuance of new special purpose bonds to meet their quota for the year then they are still not dramatically increasing the fiscal support for the economy. But this announcement could protect against downside growth risks. The first quarter of 2022 will be the true test of whether China will remain hawkish. Going forward there are two significant dangers as we see it. The first is that policymakers prove ideological rather than pragmatic. An autocratic government could get so wrapped up in its populist campaign to restrain high housing costs that it refuses to slacken policies enough and causes a crash. The second danger is that inflation stays higher for longer, preventing authorities from easing policy even when they know they need to do so to stabilize growth. The second danger is the bigger of the two risks. As for the first risk, ideology will take a backseat to necessity. Xi Jinping needs to secure key promotions for his faction in the top positions of the Communist Party at the twentieth national party congress in 2022. He cannot be sure to succeed if the economy is in free fall. A self-induced crash would be a very peculiar way of trying to solidify one’s stature as leader for life at the critical hour. Similarly China cannot maintain a long-term great power competition with the United States if it deliberately triggers property deflation and financial turmoil. It can and will continue modernizing and upgrading its military, e.g. developing hypersonic missiles, even if it faces financial turmoil. But it will have a much greater chance of neutralizing US regional allies and creating a regional buffer space if its economic growth is stable. Ultimately China cannot prevent financial instability, economic distress, and political risk from rising in the coming years. There will be a reckoning for its vast imbalances, as with all countries. It could be that this reckoning will upset the Xi administration’s best-laid plans for 2022. But before that happens we expect policy to ease. A policy mistake today would mean that very negative economic outcomes will arrive precisely in time to affect sociopolitical stability ahead of the party congress next fall. We will keep betting against that. Bottom Line: China’s “authoritative” media commentator shows that policymakers are not as hawkish as the consensus holds. The main takeaway is that policymakers will adjust the intensity of their reform efforts to maintain stability. This is standard Chinese policymaking and it is more important than usual ahead of the political rotation in 2022. Otherwise global inflation risk will quickly give way to deflation risk as defaults among China’s property developers spread and morph into broader financial and economic instability. Indo-Pakistani Ceasefire: A Breakdown Is Nigh India and Pakistan agreed to a ceasefire along the line of control in February 2021. While the agreement has held up so far, a breakdown is probably around the corner. It was never likely to last for long. Over the short run, the ceasefire made sense for both countries: COVID-19 Risks: The first wave of the pandemic had abated but COVID-19-related risks loomed large. India had administered less than 15 million vaccine doses back then and Pakistan only 100,000. Dangerous Transitions Were Underway: With America’s withdrawal from Afghanistan in the works, Pakistan was fully focused on its western border. India was pre-occupied with its eastern front, where skirmishes with Chinese troops forced it to redirect some of its military focus. As we now head towards the end of 2021, these constraints are no longer binding. COVID-19 Risks Under Control: The vaccination campaign in India and Pakistan has gathered pace. More than 50% of India’s population and 30% of Pakistan’s have been given at least one dose. Pakistan’s Ducks Are Lined-up In Afghanistan: America’s withdrawal from Afghanistan has been completed. Afghanistan is under Taliban’s control and Pakistan has a better hold over the affairs of its western neighbor. One constraint remains: India and China remain embroiled in border disputes. Conciliatory talks between their military commanders broke down a fortnight ago. Winter makes it nearly impossible to undertake significant operations in the Himalayas but a failure of coordination today could set up a conflict either immediately or in the spring. While India may see greater value in maintaining the ceasefire than Pakistan, India has elections due in key northern states in 2022. India’s northern states harbor even less favorable views of Pakistan than the rest of India. Hence any small event could trigger a disproportionate response from India. Bottom Line: While it is impossible to predict the timing, a breakdown in the Indo-Pakistani ceasefire may materialize in 2022 or sooner. Depending on the exact nature of any conflict, a geopolitically induced selloff in Indian equities could create a much-needed consolidation of this year’s rally and ultimately a buying opportunity. Russia, Global Terrorism, And Great Power Relations Part of Putin’s strategy of rebuilding the Russian empire involves ensuring that Russia has a seat at the table for every major negotiation in Eurasia. Now that the US has withdrawn forces from Afghanistan, Russia is pursuing a greater role there. Most recently Russia hosted delegations from China, Pakistan, India, and the Taliban. India too is planning to host a national security advisor-level conference next month to discuss the Afghanistan situation. Do these conferences matter for global investors? Not directly. But regional developments can give insight into the strategies of the great powers in a world that is witnessing a secular rise in geopolitical risk. Chart 13 China, Russia, and India have skin in the game when it comes to Afghanistan’s future. This is because all three powers have much to lose if Afghanistan becomes a large-scale incubator for terrorists who can infiltrate Russia through Central Asia, China through Xinjiang, or India through Pakistan. Hence all three regional powers will be constrained to stay involved in the affairs of Afghanistan. Terrorism-related risks in South Asia have been capped over the last decade due to the American war (Chart 13). The US withdrawal will lead to the activation of latent terrorist activity. This poses risks specifically for India, which has a history of being targeted by Afghani terrorist groups. And yet, while China and Russia saw the Afghan vacuum coming and have been engaging with Taliban from the get-go, India only recently began engaging with Taliban. The evolution of Afghanistan under the Taliban will also influence the risk of terrorism for the rest of the world. In the wake of the global pandemic and recession, social misery and regime failures in areas with large youth populations will continue to combine with modern communications technology to create a revival of terrorist threats (Chart 14). Chart 14 American officials recently warned of the potential for transnational attacks based in Afghanistan to strike the homeland within six months. That risk may be exaggerated today but it is real over the long run, especially as US intelligence turns its strategic focus toward states and away from non-state actors. India, Europe, and other targets are probably even more vulnerable than the United States. If Russia and China succeed in shaping the new Afghanistan’s leadership then the focus of militant proxies will be directed elsewhere. Beyond terrorism, if Russia and China coordinate closely over Afghanistan then India may be left in the cold. This would reinforce recent trends in which a tightening Russo-Chinese partnership hastens India’s shift away from neutrality and toward favoring the US and the West in strategic matters. If these trends continue to the point of alliance formation, then they increase the risk that any conflicts between two powers will implicate others. Bottom Line: Afghanistan is now a regional barometer of multilateral cooperation on counterterrorism, the exclusivity of Russo-Chinese cooperation, and India’s strategic isolation or alignment with the West. Investment Takeaways It is too soon to play down inflation risks. We share the BCA House View that they will subside next year as pandemic effects wane. But we also see clear near-term risks to this view. In the short run (zero to 12 months), a distinct risk of a Middle Eastern geopolitical crisis looms. A gradual escalation of tensions is inflationary whereas a sharp spike in conflict would push energy prices into punitive territory and kill global demand. Over the next 12 months, China’s economic and financial instability will also elicit policy easing or fiscal stimulus as necessary to preserve stability, as highlighted by the regime’s mouthpiece. Obviously stimulus will not be utilized if the economic recovery is stable, given elevated producer prices. In a future report we will show that Russia is willing and able to manipulate natural gas prices to increase its bargaining leverage over Europe. This dynamic, combined with the risk of cold winter weather exacerbating shortages, suggests that the worst is not yet over. Geopolitical conflict with Russia will resume over the long run. Stay long gold as a hedge against both inflation and geopolitical crises involving Iran, Taiwan/China, and Russia. Maintain “value” plays as a cheap hedge against inflation. Book a profit of 2.5% on our short trade for currencies of emerging market “strongmen,” Turkey, Brazil, and the Philippines. Our view is still negative on these economies. Stay long cyber-security stocks. Over the long run, inflation risk must be monitored. We expect significant inflation risk to persist as a result of a generational change in global policy in favor of government and labor over business and capital. But the US is maintaining easy immigration policy and boosting productivity-enhancing investments. Meanwhile China’s secular slowdown is disinflationary. The dollar may remain resilient in the face of persistently high geopolitical risk. The jury is still out.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1      David Albright and Sarah Burkhard, "Iran’s Recent, Irreversible Nuclear Advances," Institute for Science and International Security, September 22, 2021, isis-online.org. 2     Ray Takeyh, "The Bomb Will Backfire On Iran," Foreign Affairs, October 18, 2021, foreignaffairs.com. 3     See Aaron Stein and Afshon Ostovar, "Tanker War 2.0: Iranian Strategy In The Gulf," Foreign Policy Research Institute, August 10, 2021, fpri.org. 4     "Ten Questions About China’s Economy," Xinhua, October 24, 2021, news.cn.     Section II: Appendix: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator United Kingdom UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan-Province of China: GeoRisk Indicator Taiwan-Province of China: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator South Africa South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Section III: Geopolitical Calendar