Emerging Markets

Highlights The implementation of an oil-price hedging strategy by Russia’s government – consisting of put buying a la Mexico’s strategy for putting a floor under government revenues – would force us to re-consider our bullish view. On the one hand, systematically hedging forward revenues when deferred prices met the government’s budget threshold – currently $42.40/bbl for Urals crude oil – would tangibly increase Russia’s impact on forward price discovery.  This could become one of the tools available to OPEC 2.0 that allow it to influence the shape of the forward curve, perhaps supporting a backwardation benefiting member states.  On the other, hedging government revenues could free Russia and its oil companies from supporting the OPEC 2.0 framework, thus returning the swing-producer responsibilities for balancing the market to OPEC. Significant obstacles stand in the way of implementing a hedging program by the Russian government.  Hedging even volumes in futures could overwhelm the supply of liquidity in these markets, particularly in the deferred contracts: Average daily Brent volumes are ~ 700mm b/d for the entire market.1 Feature OPEC 2.0’s mostly successful production management scheme is a key factor driving our bullish view of oil. The coalition led by KSA and Russia is keeping output constrained while global demand recovers from the COVID-19 pandemic. This will tighten global supply-demand balances and reduce inventories (Chart of the Week). This dynamic drives our expectation that prices will remain around current levels for 2H20 – at ~ $44/bbl for Brent – and, based on our modeling, push prices to $65/bbl on average next year. At the end of the day, OPEC 2.0 is a quasi-cartel operating under a Declaration of Cooperation signed by the original cartel and non-OPEC producers led by Russia in late 2016 and renewed and expanded periodically since then. Without this cooperation, it is highly doubtful oil prices would have recovered from the demand-destruction visited upon the market by the COVID-19 pandemic as quickly as they have. Chart of the WeekOPEC 2.0 Production Discipline Underpins Our Bullish Oil View OPEC 2.0 Production Discipline Underpins Our Bullish Oil View OPEC 2.0 Production Discipline Underpins Our Bullish Oil View Nor is it likely the inventory overhang dogging markets since the end of the 2014-16 market-share war launched by KSA, then compounded by waivers on Iranian oil-export sanctions in November 2018 by the US, could have been addressed as effectively as they were prior to the pandemic’s arrival. In all likelihood, a punishing continuation of low prices would have been required to destroy enough production globally – in OPEC and ex-OPEC – into 2017 for prices to finally recover. OPEC 2.0’s Days Numbered? We have long argued the OPEC 2.0 framework benefitted Russia and KSA more than unrestrained production, which, left unchecked, would keep prices closer to $30/bbl than $70/bbl. The leadership of Russia’s oil sector has been a reluctant participant in the coalition’s production-management scheme. This was apparent in every meeting of OPEC 2.0 up to an including it March 2020 meeting in Vienna, where an extension of the coalition’s production cut advanced by KSA was nixed by Russia. A brief market-share war followed just as the COVID-19 pandemic started advancing beyond China’s borders, resulting in lockdowns and unprecedented demand destruction. OPEC 2.0 was then reconstituted, and the production cuts it agreed have restored balance to the market. However, this balance is tentative. On the demand side, a second wave of the pandemic is spreading, and with it the risk widespread lockdowns again are mandated. This would lead to another round of demand destruction if the scale of the lockdowns approached that of the first wave seen in 1H20. This is not our base case, but it is a risk we have been highlighting repeatedly in our reports. We find KSA’s GDP increases ~ 1% when EM oil consumption goes up by one percent, while Russia’s GPD increases by ~ 0.5%. On the supply side, we have long argued the OPEC 2.0 framework benefitted Russia and KSA more than unrestrained production, which, left unchecked, would keep prices closer to $30/bbl than $70/bbl.2 In the current arrangement, KSA and Russia are able to grow their GDPs as they see fit, with KSA apparently targeting EM sales, which will grow as those economies grow, and Russia apparently pursuing a strategy that centers on making its barrels available to trading markets and EM buyers (Charts 2A and 2B).3 Chart 2AKSA Benefits From EM GDP Growth ... KSA Benefits From EM GDP Growth ... KSA Benefits From EM GDP Growth ... Chart 2B... As Does Russia ... As Does Russia ... As Does Russia This arrangement can endure as long as the OPEC 2.0 members' revenues – particularly those of its leadership – are at risk from uncontrolled production – e.g., another market-share war. A New Game? If, however, one or both of OPEC 2.0's leaders is able to hedge its revenue, the game changes. If it is Russia, as President Putin has suggested, and the government is able to hedge the ~ 40% or so of the federal budget covered by oil and gas revenues, the game changes profoundly (Chart 3). The only motive for Russia to participate in the OPEC 2.0 framework is to keep prices from collapsing below the level assumed for budgeting purposes. This is $42.40/bbl for Urals, the benchmark Russian crude traded in global markets (Chart 4). At present, OPEC 2.0 production discipline is contributing to holding prices just above this level, as member states calibrate their output consistent with the recovery in global demand. Chart 3Russia's Budget Relies Heavily On Oil & Gas Revenues Russia's Budget Relies Heavily On Oil & Gas Revenues Russia's Budget Relies Heavily On Oil & Gas Revenues Chart 4OPEC 2.0 Cuts Contribute To Stronger Urals Crude Price OPEC 2.0 Cuts Contribute To Stronger Urals Crude Price OPEC 2.0 Cuts Contribute To Stronger Urals Crude Price Of course, if Russia were able to hedge the oil and gas revenues funding its budget, this production discipline would not be needed in the short term – it could produce at will knowing there is a floor under revenue. Crude-oil futures and options markets cannot handle the volume Russia likely would require to fully hedge the oil and gas revenues funding its budget. That’s a big IF, however. The demand destruction caused by the COVID-19 pandemic in the first five months of this year was responsible for the loss of up to 25% of Russia’s oil, gas and coal exports, which translated into a 50% loss of export revenues and a 25% decline in budget as prices and volumes fell, according to the Carnegie Moscow Center.4 Russia’s GDP is expected to fall by 6% this year, according to the World Bank, in the wake of the pandemic.5 Crude-oil futures and options markets cannot handle the volume Russia likely would require to fully hedge the oil and gas revenues funding its budget. Brent futures and options open interest on the Intercontinental Exchange (ICE) total 3.34 billion barrels on July 21, 2020 (Chart 5). This is spread across the whole term structure. Worthwhile considering that just 1mm b/d of production hedged for 1 year = 365mm bbls = ~ 11% of total Brent open interest. Such a large concentration of open interest accounted for by one entity – even if it is a bona fide government – would, perforce, raise regulators concerns over market manipulation.6 Chart 5Russia's Hedging Volumes Likely Would Swamp Futures Markets Russia's Hedging Volumes Likely Would Swamp Futures Markets Russia's Hedging Volumes Likely Would Swamp Futures Markets Broadening OPEC 2.0’s Tool Kit The successful implementation of a hedging strategy by Russia would force us to re-consider our bullish oil view. Even though we view the likelihood Russia’s government will adopt a full revenue hedging program to be low, we think the argument that it – and KSA – could hedge discrete exposures over time makes sense. These markets exist to process information via trading activities. If there are discrete exposures Russia hedges that keep Brent forward curves backwardated, for example, this would affect the hedging economics of US shale producers protecting their revenues one to three years into the future (Chart 6). Hedging in future while keeping production in the prompt-delivery months in line with OPEC 2.0 quotas would support a backwardation. Prices in the deferred part of the curve would be lower than at the front, which would produce less revenue for hedgers, while higher prices in the front of the curve would redound to OPEC 2.0 member states’ benefit, whose term contracts and spot sales typically reference spot prices. Chart 6Discrete Hedging Could Support Backwardation Discrete Hedging Could Support Backwardation Discrete Hedging Could Support Backwardation This would tangibly increase Russia’s impact on forward price discovery. Indeed, hedging could become one of the tools available to OPEC 2.0 that allow it to influence the economics of oil production by US shale producers, among others. Bottom Line: The successful implementation of a hedging strategy by Russia would force us to re-consider our bullish oil view – there would be little or no need for the Russian government to demand its producers adhere to an OPEC 2.0 production quota if the government is able to hedge its revenue. (Whether those producers choose to hedge is another matter entirely.) We do not give a high probability to the Russian government adopting a Mexico-style hedging program to put a floor under its budget revenues. We cannot dismiss the possibility that discrete exposures could be hedged to support a backwardated forward curve structure going forward, however.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Commodities Round-Up Energy: Overweight Brent prices have been remarkably steady at ~ $43/bbl in July, balancing expectations of a sustained global economic recovery and the risk of a second wave of lockdowns. Rising COVID-19 cases in the US pose a risk to oil demand as the US still represents ~ 20% of global demand. Brent futures spreads – 1ST vs. 12th – moved from -$1.38/bbl to -$3.29/bbl, suggesting the pace of drawdowns in inventories slowed in recent weeks. Nonetheless, we continue to expect a persistent supply deficit in 2H20 and 2021, pushing prices above $60/bbl next year.7 Base Metals: Neutral Base metals are mostly flat since last week after moving up 23% since March. A continuation of recent trends is largely dependent on China’s economic outlook as it represents ~ 50% of global BM demand. The IMF expects China’s GDP to reach its pre-crisis level somewhere this quarter and to resume trend growth afterward (Chart 7). Monetary policy needs to remain accommodative for such a recovery to occur. Historically, policymakers in China have favored easy monetary policy for at least three quarters following a crisis. This implies the accommodative stance should be maintained until year-end, supporting metals’ prices.8 Precious Metals: Neutral We are putting a stop-loss of $1,850/oz on our long gold recommendation at tonight’s close (Chart 8). We remain constructive on the gold market, but believe the market is out over its skis presently, as investors have realized central banks globally likely will not move to raise rates this year, or perhaps even next year. The Fed, in particular, has been consistently signaling its intent to remain accommodative in its effort to reflate the US economy.9 Ags/Softs:  Underweight The USDA this week reported 72% of the corn crop was in good to excellent condition for the week ended July 26 in the 19 states accounting for 91% of the crop last year. For beans, 72% of the crop was reported in good to excellent condition, up sharply from last year’s level of 54% in the 18 states accounting for 96% of the crop. Chart 7 Russia Again Examines Oil Hedging Russia Again Examines Oil Hedging Chart 8 Gold Is Due For A Breather Gold Is Due For A Breather   Footnotes 1     Russia came close to setting up an oil-hedging program in 2009, following the collapse of oil prices during the Global Financial Crisis (GFC). Please see Russia considers oil price hedges modeled on Mexico’s system published by worldoil.com July 22, 2020. 2     See, e.g., How Long Will The Oil-Price Rout Last?, which we published March 9, 2020. It is available at ces.bcaresearch.com. 3    In previous research, we found KSA real GDP (in 2010 constant USD published by the World Bank) benefits more than Russia when EM GDP growth expands, while Russia benefits more from increases in Brent prices. For this report we updated that analysis and looked only at EM oil consumption, while including lagged USD and Brent crude oil prices as common regressors. We find KSA’s GDP increases ~ 1% when EM oil consumption goes up by one percent, while Russia’s GPD increases by ~ 0.5%. Please see our earlier research report entitled Sussing Out OPEC 2.0's Production Cuts, U.S. Waivers On Iran Sanctions, which we published on April 11, 2019, when KSA and Russia again were contesting the necessity of production cuts. 4    Please see The Oil Price Crash: Will the Kremlin’s Policies Change?, by Tatiana Mitrova, which was published by the Carnegie Moscow Center July 8, 2020. Russia presently exports ~ 5mm b/d of oil, which is down from earlier levels of ~ 5.5mm b/d due to the OPEC 2.0 cuts it is observing. We do not have the disposition of revenue sources funding Russia’s budget (primarily oil and gas), and therefore cannot calculate the precise hedging volume Russia’s government would need to cover to provide a floor for all of its fiscal obligations. 5    Please see Recession and Growth under the Shadow of a Pandemic published by the Bank July 6, 2020. 6    Russia’s central bank came out against the hedging proposal, citing the lack of liquidity available for large-scale programs. Please see Russia central bank opposes using wealth fund to hedge oil revenues, governor says published by uk.reuters.com July 24, 2020. 7     Please see Balance Of Oil-Price Risk Remains To The Upside, which we published last week. It is available at ces.bcaresearch.com. 8    Please see Chinese Stocks: Stay Invested published by BCA Research’s China Investment Strategy July 22, 2020. It is available at cis.bcaresearch.com. 9    Please see What A Weaker US Dollar Means For Global Bond Investors published by BCA Research’s Global Fixed Income Strategy July 28, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Russia Again Examines Oil Hedging Russia Again Examines Oil Hedging Commodity Prices and Plays Reference Table Trades Closed in Summary of Closed Trades Russia Again Examines Oil Hedging Russia Again Examines Oil Hedging

Highlights The decade-long US equity market outperformance versus the rest of the world could be nearing its end. We are upgrading EM stocks from underweight to neutral within a global equity portfolio. We reiterate the change in our US dollar outlook from bullish to bearish. The concentration risk in EM (specifically in North Asia) mega-cap stocks, poor fundamentals in EM outside North Asia, and a potential flare-up in US-China tensions are the reasons why we are reluctant to be overweight EM stocks. Feature We recommended the short EM equities / long S&P 500 position in late 2010,1 and have reiterated this strategy consistently over the past decade. Since its inception, this trade has produced a 193% gain with extremely low volatility (Chart 1). We recommend taking profits on this position for the reasons elaborated in this report. Chart 1Book Profits On Our Short EM Stocks / Long S&P 500 Strategy Book Profits On Our Short EM Stocks / Long S&P 500 Strategy Book Profits On Our Short EM Stocks / Long S&P 500 Strategy Chart 2Equity Strategy Of the Decade: The Risk-Reward Is No Longer Attractive Equity Strategy Of the Decade: The Risk-Reward Is No Longer Attractive Equity Strategy Of the Decade: The Risk-Reward Is No Longer Attractive Consistently, we are upgrading EM stocks from underweight to neutral within a global equity portfolio. Our decade-long equity sector theme – introduced in our June 8, 2010 report2 – has been to underweight resources and overweight technology and healthcare (Chart 2). This sector strategy has been one of the reasons for underweighting EM and favoring the US market in a global equity portfolio over the past decade. Going forward, the risk-reward of this sector strategy is no longer attractive. Regarding EM absolute performance, we recommend that absolute-return investors remain on standby for a correction before going long the EM equity benchmark. The End Of US Equity Outperformance The decade-long US equity market outperformance versus the rest of the world could be nearing its end.It is widely known that this decade’s US equity outperformance was largely due to FAANGM stocks (Facebook, Amazon, Apple, Netflix, Google and Microsoft). The FAANGM rally meets many of the criteria for a bubble, as we elaborated in our July 16 report. Our FAANGM equity index – an equal-weighted average of the six stocks – has increased almost 20-fold in real (inflation-adjusted) terms since January 2010 (Chart 3). Chart 3Each Decade = One Mania Take Profits On The Short EM / Long S&P 500 Position Take Profits On The Short EM / Long S&P 500 Position Its rise is on par with the magnitude of the bull market in the Nasdaq 100 index through the 1990s, or of Walt Disney. through the 1960s, and it well exceeds other bubbles, as illustrated on Chart 3. All price indexes are shown in real (inflation-adjusted) terms. FAANGM stocks have greatly benefited from the recent “work from home” and other societal shifts and have been outperforming through the March financial carnage. It has made them unassailable in the eyes of investors. Yet, even great companies have a fair price, and considerable price overshoots will not be sustainable in the long term. We sense that a growing number of investors deem the US FAANGM and EM mega-cap stocks to be invincible. When some stocks are regarded as unbeatable, their top is not far. Therefore, it is highly unlikely that the FAANGM will outperform in the next selloff. Rather, the odds are that they will underperform because these stocks are extremely expensive, overbought, over-hyped and over-owned. The decade-long US equity market outperformance versus the rest of the world could be nearing its end. Apart from technology and FAANGM, US equities are facing a mediocre profit outlook. As long as the pandemic is not contained, America’s consumer and business confidence will remain lackluster, and, as a result, a recovery in their spending will be subdued. Chart 4US Stocks Are Not Cheap After Removing Market-Cap Bias US Stocks Are Not Cheap After Removing Market-Cap Bias US Stocks Are Not Cheap After Removing Market-Cap Bias Notably, the broad US equity market is also expensive. The equal-weighted US equity index is trading at a 12-month forward P/E ratio of 21 (Chart 4, top panel). The risks associated with domestic politics are rising in the US. Social, political and economic divisions have been magnified by both the pandemic and the economic downtrend. Social and political tensions will likely flare up around the November elections. Our colleagues from the Geopolitical team argue that a contested election is possible and could lead to a crisis of presidential legitimacy in the US. Finally, the US equity market cap has reached 58% of the global market cap, the highest on record. Gravity forces are likely to kick in sooner than later, capping US equity outperformance. Bottom Line: The tailwinds supporting the US equity outperformance are fading. We are booking gains on the short EM stocks / long S&P 500 strategy. Consistently, we are also closing the short EM banks / long US banks and short Chinese banks / long US banks positions. They have produced a 75% gain and an 11% loss, respectively. Downgrading The US Dollar Outlook = Upgrading The EM View We had been bullish on the US dollar and bearish on EM currencies since early 2011 (Chart 5, top panel), but on July 9 made a major change in our currency strategy: we switched our shorts in EM currencies away from the US dollar to against an equal-weighted basket of the euro, Swiss franc and the yen. Since then, the EM ex-China equal-weighted currency index has rebounded versus the US dollar, but has depreciated against the basket of the euro, CHF and JPY (Chart 5, bottom panel). Chart 5EM Currencies Have Bottomed Versus The US Dollar But Not Against Other Safe-Heavens EM Currencies Have Bottomed Versus The US Dollar But Not Against Other Safe-Heavens EM Currencies Have Bottomed Versus The US Dollar But Not Against Other Safe-Heavens While the US dollar could rebound in the short term, especially versus EM currencies, any rebound will likely prove to be short-lived. From now on, the strategy for the greenback should be selling into strength. Here is why: As US inflation rises in the coming years and the Fed refuses to raise interest rates, US real rates will drop further and, as a result, the US dollar will depreciate. A central bank that is behind the inflation curve is bearish for a nation’s currency. The main reason for turning negative on the US dollar structurally is the rising determination by the Federal Reserve to stay behind the inflation curve in the years to come. This strategy will instigate an inflation outbreak. Falling real interest rates have caused a plunge in the US dollar, as well as a surge in precious metal prices, in recent weeks. In fact, risk-on currencies have lately underperformed safe-haven currencies, such as the CHF and JPY (Chart 6). This market move confirms that the dollar’s recent plunge is due to fears of its debasement, not to robust growth in the world economy and in EM/China. As US inflation rises in the coming years and the Fed refuses to raise interest rates, US real rates will drop further and, as a result, the US dollar will depreciate.    Colossal debt monetization. The Fed is undertaking an immense monetization of public and private debt. The current situation, involving the Fed’s purchases of securities, is different from the one following the Lehman crisis. Back in 2008-2014, the Fed’s QE program did not produce an exponential rise in money supply. The US broad money supply (M2) was rising at a single-digit rate between 2009 and 2014 (Chart 7). Presently, US M2 growth has exploded to 24% from a year ago. Chart 6Risk-On Currencies Are Underperforming Safe-Heaven Ones Risk-On Currencies Are Underperforming Safe-Heaven Ones Risk-On Currencies Are Underperforming Safe-Heaven Ones Chart 7Helicopter' Money in the US Helicopter' Money in the US Helicopter' Money in the US The pace of US broad money growth is much higher than that of many advanced and developing economies. Chart 8 shows new money creation as a share of GDP across various economies. It demonstrates that Japan and the US are now experiencing the quickest rate of new money creation in the world.   In short, even though debt monetization is occurring in many advanced and EM economies, the US is doing it on an unprecedented scale. Chart 8Money Creation As % Of GDP In 2Q2020 Take Profits On The Short EM / Long S&P 500 Position Take Profits On The Short EM / Long S&P 500 Position “Helicopter” money will eventually lift inflation. The latest surge in the US money supply has only partially offset the collapse in its velocity. Consequently, America’s nominal GDP has plunged. This stems from the following identity: Nominal GDP = Price Level x Output Volume = Velocity of Money x Money Supply Solving the above equation for inflation, we get: Price Level = (Velocity of Money x Money Supply) / (Output Volume) Going forward, the velocity of US money will likely recover, for it is closely associated with consumers’ and businesses’ willingness to spend. At that point, rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP. Meantime, the pandemic will probably reduce potential output. The outcome of higher nominal spending and reduced potential productive capacity will be higher inflation. In sum, US inflation will rise well above 2% in the coming years. Yet, the Fed will stay put amid rising inflation. The upshot will be a structural downtrend in the US dollar. Whilst there are many arguments against rising inflation, we are leaning toward the view that US inflation will begin rising as of next year. We will elaborate on this inflation outlook in our future reports.     Rising political and social uncertainty in the US will weigh on the greenback. The failure by the US authorities to contain the spread of the pandemic will continue fueling political and social upheavals. This could culminate in a harshly contested presidential election and a reduction in the US dollar’s allure for foreign investors.    Portfolio inflows into the US will turn into outflows. The stellar performance of US equities attracted portfolio inflows into the US over the last 10 years. These capital inflows, in turn, boosted the greenback. But these dynamics are about to be reversed. Chart 9The US's Net International Investment Position Is At A Record Low The US's Net International Investment Position Is At A Record Low The US's Net International Investment Position Is At A Record Low The top panel of Chart 9 shows that the US’s net international investment position in equities is at its lowest point since 1986. This means that foreign ownership of US stocks exceeds US resident ownership of foreign equities by a record amount. This reflects the fact that investors have by a large margin favored the US versus other bourses. As American share prices outperformed their international peers, both domestic and foreign investors have poured more capital into US equities. As the US relative equity performance reverses, equity capital will flow out of the US, thus dragging down the US dollar. Chart 10 shows that the trade-weighted dollar tracks the relative performance of the S&P500 versus the global equity benchmark in local currency terms. Regarding debt securities, the US’s net international investment position has widened to  - US$8.5 trillion (Chart 9, bottom panel). Not all fixed-income investors hedge currency risk. As the dollar slides, there will be growing pressure on foreign fixed-income investors to hedge their dollar exposure or sell US and buy non-US debt securities. Chart 10A Top In The US$ = The End Of The US Equity Outperformance? A Top In The US$ = The End Of The US Equity Outperformance? A Top In The US$ = The End Of The US Equity Outperformance? Bottom Line: Immense public debt monetization leading to higher inflation down the road and the Fed falling behind the curve, will produce a lasting and considerable downtrend in the US dollar in the coming years. Why Not Overweight EM Stocks? There are a number of reasons why – for now – we are only upgrading EM equities to neutral, rather than to overweight within a global equity portfolio, and why we are still reluctant to recommend buying EM stocks for absolute-return investors:   Concentration risk in EM mega-cap stocks. As US FAANGM share prices come under selling pressure, contagion will spill over to EM mega-cap stocks. The latter have been responsible for a large share of gains in the EM equity index and, conversely, their pullback will considerably impact the EM benchmark’s performance. The top six companies combined account for about 24% of the MSCI EM equity market cap. To compare, US FAANGM (Facebook, Apple, Amazon, Netflix, Google and Microsoft) also account for 24% of the S&P 500 market cap. Hence, the concentration risk in EM equity space is as high as in the US. Geopolitical risk. A potential flare up in in geopolitical tensions will weigh on Chinese, South Korean and Taiwanese stocks. Given that they make up about 65% of the MSCI EM index equity market cap, the EM benchmark will suffer in absolute terms and be unlikely to outperform the global equity index. Faced with decreased approval in regard to his handling of the pandemic, and to a lesser extent, the economy and other social issues, President Trump could well resort to geopolitics to “rally Americans behind the flag.” He may, for example, ramp up tensions with China in an attempt to make geopolitics and China the focal points of the forthcoming presidential election. China will certainly retaliate. The South China Sea, Taiwan, technology transfers, treatment of multinational companies in both China and the US, as well as North Korea, could be focal points of a confrontation. This will weigh on business confidence in Asia and on capital spending. In our opinion, markets are vulnerable to such geopolitical risks. Poor domestic fundamentals in EM outside China, Korea and Taiwan. Fundamental backdrops remain inferior in many EM economies outside the North Asian ones. The number of new infections continues to rise in India, Indonesia, The Philippines, Brazil, Mexico, Colombia and Peru. Many EM economies will only slowly return to normalcy. In certain countries, banking systems were already in poor health, and things have gotten much worse after the crash in economic activity. As to the positives for EM, they are as follows: Rising Chinese demand will boost EM exports to China and help revive their growth. EM equity valuations are very appealing versus the S&P 500 (Chart 11). The bottom panel of Chart 11 shows that EM’s cyclically-adjusted P/E ratio relative to that in the US is over one standard deviation below its mean. Based on the 12-month forward P/E ratio for an equal-weighted index, EM stocks are cheaper than US ones (please refer to Chart 4 on page 4).  EM currencies are also cheap (Chart 12). While they might experience a short-term setback, as a global risk-off phase takes place, EM exchange rates have probably seen their lows versus the US dollar. Chart 11EM Stocks Offer Value Versus The S&P 500 EM Stocks Offer Value Versus The S&P 500 EM Stocks Offer Value Versus The S&P 500 Chart 12EM Currencies Are Cheap EM Currencies Are Cheap EM Currencies Are Cheap The US dollar’s weakness will mitigate risks for EM issuers of US dollar bonds and, thereby, induce more flows into EM sovereign and corporate credit markets. In short, EM local currency bonds will assuredly benefit from the US dollar’s slide. We have been neutral on both EM local currency bonds and EM sovereign and corporate credit, and are waiting for a correction before upgrading to overweight. In nutshell, little or no stress in EM fixed-income markets bodes well for EM share prices. Bottom Line: Risks to EM equity relative performance are presently balanced. A neutral allocation is warranted for now. EM relative equity performance versus DM is only slightly above its recent low (Chart 13, top panel). It is, therefore, a good juncture to move the EM equity allocation from underweight to neutral. In addition, both the EM equal-weighted and small-cap equity indexes are not yet signaling a broad-based and sustainable outperformance (Chart 13, middle and bottom panels). Chart 13EM Relative Equity Performance Is In A Bottom-Out Phase EM Relative Equity Performance Is In A Bottom-Out Phase EM Relative Equity Performance Is In A Bottom-Out Phase Some FAQs Question: Wouldn’t the US dollar rally if global stocks sell off? The greenback will likely attempt to rebound from current oversold levels when and as a global risk-off phase sets in. EM high-beta currencies could experience a non-trivial setback but will remain above their March lows. Yet, any rebound in the US dollar versus European currencies and the Japanese yen will be fleeting and moderate. On July 9, in anticipation of US dollar weakness, we booked profits on the short EM currencies/long US dollar strategy and recommended shorting several EM currencies versus an equal-weighted basket of the euro, CHF and JPY. This strategy remains intact for now. Our short list of EM currencies includes: BRL, CLP, ZAR, TRY, IDR, PHP and KRW. Odds are that EM stocks will likely be broadly flattish relative to those in DM amid the next sell off. Chart 14EM Stocks Have Been Low Beta EM Stocks Have Been Low Beta EM Stocks Have Been Low Beta Question: Aren’t EM stocks high-beta and won’t they underperform if, and as, global stocks sell off? The EM equity index has had a beta lower than one since 2013 (Chart 14). Odds are that EM stocks will likely be broadly flattish relative to those in DM amid the next sell off. Within the DM equity space, the US will likely underperform both Europe and Japan in common currency terms. Question: Which equity markets do you favor within the EM space? Our current overweights are China, Thailand, Russia, Peru, Pakistan and Mexico. Our underweights are Indonesia, India, Hong Kong, the Philippines, Turkey, South Africa, Chile and Brazil. Question: Which currencies and local currency bond markets do you recommend overweighting for dedicated EM managers? We recommended going long the Czech koruna versus the US dollar last week. Other currencies that we favor within the EM space are SGD, TWD, THB, MXN and RUB. As for local currency bonds or swap rates, our top picks are Mexico, Russia, Korea, India, China, Malaysia, Thailand, Peru, Ukraine and Pakistan. As always, the list of country recommendations for equities, fixed-income and currencies is available at the end of our reports (please refer to pages 14-15) or on the website.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Footnotes 1Please see Emerging Markets Strategy Weekly Reports "Inflation, Overheating And The Stampede Into Bonds," dated November 30, 2010, and "Emerging Markets In 2011: Not The Best Play In Town," dated December 14, 2010. 2Please see Emerging Markets Strategy Special Report "How To Play Emerging Market Growth In The Coming Decade," dated June 8, 2010   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Dear Clients, This month we offer you a Special Report on Russia and cyber security by our colleague and friend, Elmo Wright. Elmo recently retired from US Army civil service after 43 years working in intelligence, either on active duty, reserves, or as a civilian. From 2018 to 2020, he served as the senior civilian executive at the US Army National Ground Intelligence Center.  He has served on five continents and provided analysis of the most pressing global trends in national security and intelligence. In this Special Report with BCA’s Geopolitical Strategy team, Elmo analyzes Russia’s cyber capabilities and argues that structural and cyclical factors, including COVID-19, will ensure the continued salience of Russian and global cyber security challenges in the coming years. His thesis reinforces our recommendation that investors buy cyber security equities. Elmo’s work for this report is in his personal capacity and does not represent any position of the US government. Only publicly available information was used as background research material for Elmo’s contribution to the report. All very best, Matt Gertken Vice President Geopolitical Strategy Mathieu Savary Vice President The Bank Credit Analyst As the US elections come closer, there will be a return to news about Russia and its potential interference via social media. Russia will continue to use cyber, both state sponsored attacks, and in coordination with criminal groups, to advance Russian national security objectives. In contrast to nuclear doctrine, there is no commonly accepted framework for cyber warfare between Russia and other nations that provides understandable signals for escalation, de-escalation, appropriate targets, or goals. US efforts to conduct military operations against Russia or China would likely be countered by Russian or Chinese cyber operations before any physical military operations could be initiated. Cyber security stocks offer a way for investors to capitalize on our long-term themes of nationalism, multipolarity, and de-globalization. The ISE Cyber Security Index offers value relative to the broad NASDAQ and S&P 500 indexes as well as the S&P tech sector. Chart II-1Russian Cyber Interference Resurfaces Around US Elections Russian Cyber Interference Resurfaces Around US Elections Russian Cyber Interference Resurfaces Around US Elections As the national elections in the US come closer, there will be a return to news about Russia and its potential interference via social media. Indeed Russia is making headlines even as we go to press. This report aims to provide context for Russian cyber capabilities in general as a contributor to overall geopolitical instability (Chart II-1). We forecast Russia will continue to use cyber, both state sponsored attacks, and in coordination with criminal groups, to advance Russian national security objectives. As background, the word cyber is commonly accepted to be derived from cybernetics, a phrase attributed to Norbert Wiener, an MIT scientist. The phrase itself is related to the ancient Greek word for steering or helmsman, in other words, control. Chart II-2Russian Excellence In Math Makes It Competitive In Cybernetics August 2020 August 2020 Russia has a long history of excellence in science, especially theoretical work in mathematics and physics (Chart II-2). Those fields can explain natural phenomena in formulas and mathematical relationships. The Soviets believed that centralized state planning that manipulated data in formulas could lead to better outcomes in all aspects of the society. Although central state economic planning did not work out for the Soviet economy, Soviet military science built on the concept of data relationships in formulas to develop its theory of troop control, a derivative of reflexive control, that is, the presenting of data to the recipient, either friendly or enemy, in order to get that recipient to act in a way favorable to Soviet military plans. One can see the Soviets embraced the idea of cybernetics as very congruent to their desire for top down control. Russia, as the core part of the Soviet Union, retained significant numbers of scientists and mathematicians who were naturally drawn to the ability of computers to take data and manipulate that data according to formulas. Other Russian scientists and mathematicians emigrated to the West where their expertise was rewarded in the rise in the use of computers to manipulate data. Over time, the term cyber has come to be associated with many aspects of computers, especially the intellectual and physical structures hidden behind the direct interface of a person with a keyboard and screen. Russian expertise in the use of computers to do cyber work was not limited to working for the State. As the Soviet Union broke apart and many people lost their jobs working for the State, there were those persons who took their talents to criminal ventures. And in the symbiotic nature of society in Russia, many of those who went into criminal ventures were former intelligence and security personnel who could maintain their connection to the official organizations that were successors to the KGB, the GRU, and others. Russia is the source of the most sophisticated cyber threats to the US. Senior Russian military officials, such as General Valery Gerasimov, Chief of the General Staff of the Russian Federation armed forces, equivalent to the US Chairman of the Joint Chiefs of Staff, have noted the growth of nonmilitary means of achieving strategic goals, and specifically in the information space. Gerasimov, in an article in 2013, has been widely quoted that all elements of national power have to be harnessed, including cyber capabilities. One Soviet and Russian military concept that relates to the information space is maskirovka, the use of camouflage, deception, and disinformation to confuse the enemy. Maskirovka is intimately connected with the Soviet/Russian concept of “active measures”. Active measures include actions taken generally by intelligence services to provide propaganda, false information, and otherwise sow discord and confusion among the enemy ranks at all levels of war as well as in the political, economic, and social spheres. In today’s time period, cyber, especially social media, offers the opportunity for the wide spread of aspects of maskirovka and active measures to all users, as well as targeted groups (Chart II-3). Reporting indicates a continued Russian emphasis on cyber as a means for active measures concealed by maskirovka. Chart II-3Social Media Offers Russia An Opportunity For The Spread Of Maskirovka August 2020 August 2020 Wikileaks has provided a platform for the dissemination of information normally hidden from the general public. It is noteworthy how much of the information on the Wikileaks platform relates to the US and the West, and relatively little on Russia. Possible factors that explain that characteristic include the disparity in penalties for disclosing information between the US and the West versus Russia; the greater number of journalists and other persons involved in the media, both for profit and personal reasons, in the West; and the language barriers involved in understanding Russian versus English. A final possible factor in Wikileaks greater dissemination of Western information might be an aspect of active measures undertaken by Russia. There are numerous actions attributed to Russian state actors in the cyber field in the recent past (Table II-1). They include a distributed denial of service attack on Estonia (2007); hacking the Ministry of Defense in the country of Georgia during a military conflict (2008); attacks on Ukrainian energy infrastructure (2015); and the hacking of the Democratic National Committee (2016). Chancellor Angela Merkel recently publicly named and shamed Russia for a cyber-attack on Germany circa 2015 (Appendix). Table II-1Russian State Actors Responsible For Many Of This Year’s Cyber Attacks August 2020 August 2020 Chart II-4Russian Use Of Cyber Is A Top Threat To The US August 2020 August 2020 Senior US officials have cited Russia as the source of the most sophisticated cyber threats to the US, both for espionage and state sponsored attacks against US national security capabilities such as energy, transportation, and telecommunications infrastructure; as well as for criminal activity such as ransom ware and identity theft. Russian use of cyber, both state sponsored and sponsoring criminal actors, has been the top threat to the US in each of the US intelligence community’s annual threat assessments for 2017, 2018, and 2019 (Chart II-4). Although the 2020 annual threat assessment was not made public in Congressional testimony, there’s little reason to suspect that Russian use of cyber would not continue to be cited as the top threat. Other nation states have state sponsored cyber capabilities which are of national security concern to the US, including China, Iran, and North Korea. These nation states are called out in the US intelligence community Annual Threat Assessments. Each of these nation states has been identified as committing intelligence and economic cyber attacks against the US and other Western nations. The recent speech by the Director of the Federal Bureau of Investigation designates China as the top threat. Given the nature of the internet, the pathway of a cyber attack will likely bounce around multiple countries before reaching its intended target. As the Director notes, forensic identification of the source of a cyber attack takes time and expertise. However, there is a clear record of specifically identifying the state sponsored entity that commits attacks on US or Western government information technology and infrastructure. More likely than confusing one state sponsored cyber actor from one country to another would be the potential blending of criminal elements across national boundaries. In this case, cyber criminal elements with Russian backgrounds or connections are clearly the most capable. Cyber-crime is rising despite deterrence. The stages of cyber conflict include reconnaissance, penetration, mapping, exfiltration, and operations. The US National Security Agency has an extensive technical cyber threat framework which goes into much detail. Cyber security professionals note the ongoing actions in cyber space and the attempts by elements suspected to be linked to Russia to gain and maintain access to US networks for potential military operations, or to exfiltrate data for criminal or other purposes. Part of the frustration of cyber security experts is the lack of transparency and timely reporting of those affected by malign cyber activities. Although some cyber activities may go on for multiple months, the exfiltration of data, or the emplacement of malware may only take a few seconds. Many networks lack the ability to detect penetration and mapping. Companies with large resources devoted to cyber security may have that investment negated if they have affiliations with other companies with lax cyber security which can allow for hostile intrusions into the connected network. Chart II-5Unlike Nuclear Doctrine, Cyber Lacks A Framework To Control Escalation August 2020 August 2020 Unfortunately, public and open attribution for cyber attacks has lagged. As an example, although the attack on the Democratic National Committee email servers was noted in 2016, it was not until 2018 that specific Russian individuals were charged with the crime. Factors that cause lags in public and open attribution include the difficulty of tracing specific computer code through cyberspace; the disjointed nature of the internet; the lack of an easy and accepted mechanism for involvement of US intelligence agencies in providing assistance to private sector parties; and the reticence of individuals and organizations negatively affected by cyber attacks to publicly disclose their injuries. Doctrine for the use of nuclear weapons developed over a period of years in the US and the West and in the Soviet bloc. The Soviets developed a coherent doctrine for the use of nuclear weapons that was understandable to the West. Arms control agreements between nuclear powers established mechanisms for controlling escalation of tensions (Chart II-5). The Soviet doctrine was adopted by the Russians after the breakup of the Soviet Union. Russia and Western nations continue to have a common understanding of the role of nuclear weapons in military affairs that allows for discussion of escalation and de-escalation. In contrast to nuclear doctrine, there is no commonly accepted framework for cyber warfare between Russia and other nations that provides understandable signals for escalation, de-escalation, appropriate targets, or goals. This is reflected in the Russian information security doctrine of 2016 which notes “The absence of international legal norms regulating inter-State relations in the information space…” The US Director of National Intelligence also noted this lack of agreement in his annual threat assessment testimony of 2017. Chart II-6Rapid Growth Of Internet Raises Vulnerability To Harmful Actions August 2020 August 2020 The rapid growth of the internet, and reliance on it by government and private sectors reflects its founding as an open system, vulnerable to negative actors and actions (Chart II-6). The intermingling of hardware and software, the information infrastructure used both by individuals and states, by the private sector and by government, makes separating doctrine and practice for cyberwar from legitimate use very difficult. Since non-cyber military capabilities, both conventional, and nuclear, rely upon the use of commercial information technology infrastructure, the use of offensive cyber is subject to the problem of blowback. As the NotPetya incident of 2018 indicated, damage from malware installed on one computer can rapidly spread across networks, industries, and international boundaries. The code for StuxNet and the code released by the more recent hack of CIA cyber tools have been noted in other cases of cyber attacks. The view of the international cyber environment by Russia is very similar to views in the US and the West. The Russian national security doctrine of 2015 notes “... An entire spectrum of political, financial-economic, and informational instruments have been set in motion in the struggle for influence in the international arena. Increasingly active use is being made of special services' potential … The intensifying confrontation in the global information arena caused by some countries' aspiration to utilize informational and communication technologies to achieve their geopolitical objectives, including by manipulating public awareness and falsifying history, is exerting an increasing influence on the nature of the international situation.” Although much of the Russian information security doctrine of 2016 is concerned with noting threats to Russia’s information space, what might be called counterintelligence in other documents, there are key comments that note the suitability of using attacks in the information space as an effective means of projecting Russian power, such as “… improving information support activities to implement the State policy of the Russian Federation …” As per usual Soviet and Russian state doctrinal documents, the 2016 doctrine notes all the negative activity of other actors in this field. This practice is consistent with historical Soviet and Russian open press documents which ascribe to other states the activities in which Russia engages or plans to engage. Chart II-7Cyber Attacks Are On The Rise August 2020 August 2020 Unlike other forms of national security alliances, such as for intelligence, there is little public literature on cyber alliances, especially for offensive action. For example, the US and Israel have never publicly acknowledged a government alliance to emplace the StuxNet virus into the Iranian nuclear development program. Should there be offensive cyber alliances in the West, it is likely they fall along traditional intelligence and defense lines. There is no public reporting on any sort of offensive cyber alliances that involve Russia. There are public efforts at common standards for information technology security, but these efforts are foundering on citizen and government concerns over privacy, as well as commercial  proprietary advantage. It is an open question as to whether cyber alliances among friendly nations would deter would-be cyber attackers or hackers. Certainly the growth of complaints to the FBI’s Internet Crime Complaint Center would indicate that statements of deterrence and even prosecutions are failing to reduce cyber attacks (Chart II-7). Both the US national intelligence community and private sector cybersecurity companies agree Russia has a sophisticated state sponsored effort to acquire intelligence via hacking and insert favorable themes into cyberspace via the use of social media. There is also agreement that Russia state elements have a close relationship with criminal elements which can provide a plausibly deniable means of engaging in cyber warfare activities favorable to Russia, as well as engaging in activities for illegal economic advantage. For example, see this quote from the CYBEREASON Intel team: “The crossing of official state sponsored hacking with cybercriminal outfits has created a specter of Russian state hacking that is far larger than their actual program. This hybridization of tools, actors, and missions has created one of the most potent and ill-defined advanced threats that the cybersecurity community faces. It has also created the most technically advanced and bold cybercriminal community in the world. When, as a criminal, your patronage is the internal security service that is charged with tracking and arresting cybercrime, your only concern becomes staying within their defined bounds of acceptable risk and not what global norms, laws, or even domestic Russian law states.” The US Department of Justice in June 2020 noted a Russian national was sentenced to prison for malicious cyber activities. Key points of his illegal activity were the operation of websites open only to Russian speakers, and the vetting or recommendation of other criminals before allowing entry to the websites. One analysis of this situation notes the ties to Russian state security organs and personnel which likely held up the Russian national’s extradition for trial in the US. Government leaders in the US have noted the potential for major cyber attacks in the US affecting physical infrastructure and causing significant economic and social damage, including further attacks on the political election process. However, they have been reticent to state any explicit sort of retaliation. The US Cyber Command notes it is actively combatting hostile cyber actors. Therefore, the question remains open as to what level of cyber attacks would be considered serious enough to be treated as an act of war by the US. There has been public speculation of both Russian and Chinese implants of malware into the US information technology infrastructure that might be activated in the case of open hostilities. US efforts to conduct military operations against Russia or China would likely be countered by Russian or Chinese cyber operations before any physical military operations could be initiated, especially since US based forces would have to transit oceans, taking many days, when cyber operations could happen in seconds. China, Russia, and Iran will also increasingly become victims of cyber attacks. Russian “gray zone” tactics, that is, actions short of large scale conventional war, many of which involve cyber attacks, active measures, and maskirovka, are the subject of much Department of Defense planning and action. To combat such gray zone activity analysis from the RAND Corporation notes the need for a spectrum of diplomatic, informational, military, and economic actions, which would involve commercial partners and allied nations. The difficulty of coordinating such counter action is one reason the Russians continue their gray zone efforts. Russia’s unique characteristics, some of which are weaknesses compared to the US and the West, are indicative of why Russia engages in state sponsored as well as criminal cyber activities (Chart II-8). Russian scientific history, the intertwining of state and criminal elements, and continent-spanning location are factors which promote the use of cyber. Russia’s economic position vis-à-vis the US, Russia’s relative lack of military power projection capability beyond the states on its borders (the Near Abroad), except for its nuclear forces, and Russia’s declining demographic situation are negative factors which push Russia to use cyber as a cost effective means of advancing national security and economic policy (Chart II-9). Despite US and Western imposed sanctions on Russia for past misdeeds, none of the factors noted above will be changed in the near future. Therefore, those factors, and published Russian doctrine should indicate to Western governments and businesses that Russia will continue to use cyber as a means to advance Russian national security objectives, as well as a means to siphoning off wealth from the West via criminal activities. Chart II-8Russia's Relative Weakness Drives Engagement In Cyber Activities Russia's Relative Weakness Drives Engagement In Cyber Activities Russia's Relative Weakness Drives Engagement In Cyber Activities Chart II-9Deteriorating Demographics Also Drive Russia’s Cyber Activities August 2020 August 2020   US preparedness for Russian cyber activity in the upcoming months should be greater given several factors. First, there is clearly awareness of a Russian cyber threat to US interests across government and in the private sector. Second, the US has established new organizations, shifted resources of money and people, and had practice defending against cyber attacks since the 2016 US election cycle. However, the US information technology infrastructure is vast and porous, making it hard to protect against every threat. Russian cyber actors, both state sponsored and criminal, are smart and persistent. Investment Takeaways Cyber security companies offer a way for investors to capitalize on major themes arising from the COVID-19 crisis and its aftermath. These themes include not only changes in worker behavior, e-commerce, corporate culture, and network security, but also our major geopolitical themes like nationalism and the retreat from globalization. Reports as we go to press that Russian hackers have targeted vaccine developers in the US, UK, and Canada underscore the point. The trend is not limited to Russia or COVID-19 vaccines. It is all too apparent from the actions of Russia and China – as well as the increasing efforts by the US and its allies to patrol their own cyber realms, IT systems, and ideological discourse – that governments view the Internet as a frontier to be conquered and fortified rather than as a free space of human exchange in which globalization can operate unfettered (Map II-1). Map II-1Governments View The Internet As A Frontier To Be Conquered August 2020 August 2020 Formal measures of country risk are inadequate but provide some perspective as to which countries and companies are least prepared. The International Telecommunication Union (ITU) is the United Nations body charged with monitoring information technology and communications. It ranks countries according to their commitment to cyber security and their exposure to cyber security risks (Chart II-10). Chart II-10Countries Have An Imperative To Strengthen Cyber Security August 2020 August 2020 We take these rankings with a grain of salt knowing that advanced countries like the US and UK rank near the top of the list, and yet are the prime targets of hackers and thus face enormous cyber security risks. What is clear is that no country is safe and every country has an economic and national security imperative to strengthen its cyber security. These indexes also suggest that several European countries are less well prepared than one would think and that emerging markets are grossly underprepared. China, Russia and Iran should not be thought of only as aggressors – they will increasingly become targets as the West seeks to counteract them. As Russia expands operations it becomes a target of cyber counter-strikes as well as economic sanctions. And as China accelerates its drive to become a high tech giant, it encourages economic decoupling from the West and retaliation for its use of cyber-theft and state-based hacking. There are two main cyber security equity indexes – the NASDAQ CTA Cybersecurity Index (NQCYBR) and NASDAQ ISE Cyber Security Index (HXR). These indexes trade in line with each other and have rallied extensively since the COVID-19 crisis (Chart II-11). Investors are aware that the surge in working from home and companies conducting operations off-site, as well as geopolitical great power struggle, have created extensive new vulnerabilities and capex requirements. On April 24, we recommended that investors go long the ISE index relative to the S&P 500 information technology sector. We are also going long the ISE index relative to the NASDAQ on a strategic horizon. Tech has been the prime beneficiary of the COVID-19 crisis while the necessary corollary of the tech companies’ continued success is the need for security of their information, property, and customers (Chart II-12). We also favor the ISE index because it has a slightly heavier cyclical component due to the fact that 13% of its companies are in the industrial sector, compared to 10% for the CTA index. The industrial side should benefit more as economies reopen and recover. Chart II-11Cyber Security Stocks Have Benefited From COVID-19 ... Cyber Security Stocks Have Benefited From COVID-19 ... Cyber Security Stocks Have Benefited From COVID-19 ... Chart II-12... But Not So Much Relative To Broad Tech Sector ... But Not So Much Relative To Broad Tech Sector ... But Not So Much Relative To Broad Tech Sector   These indexes are tracked by two ETFs. The First Trust NASDAQ Cybersecurity ETF (CIBR) tracks the NASDAQ CTA index with an emphasis on larger companies, while the ETFMG Prime Cyber Security ETF (HACK) tracks the ISE index, companies with market capitalization lower than $250 million, and a slightly lower exposure to the communications sector as opposed to IT and software. The HACK ETF has lagged the CIBR this year so far and offers an opportunity for investors to invest in data protection and up-and-coming firms. Over the past ten years cyber security has proven to be a volatile investment space with rapidly increasing competition for market share. But the secular tailwinds are powerful and a diversified exposure to the sector will be rewarding for investors positioning for the post-COVID-19 world. Elmo Wright Consulting Editor Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Appendix Table II-1Major Cyber-Attacks Over The Past Decade August 2020 August 2020 Works Cited Coats, Dan. “Statement For The Record Worldwide Threat Assessment Of The Us Intelligence Community,” May 23, 2017. Coats, Dan. “Statement For The Record Worldwide Threat Assessment Of The Us Intelligence Community,” March 6, 2018. Coats, Dan. “Annual Threat Assessment Opening Statement,” January 29, 2019. CyberReason Intel Team, “Russia And Nation-State Hacking Tactics: A Report From Cybereason Intelligence Group,” cybereason.com, June 5, 2017. Department of Justice, “Russian National Sentenced To Prison For Operating Websites Devoted To Fraud And Malicious Cyber Activities”, June 26, 2020. Department of Justice, “U.S. Charges Russian FSB Officers And Their Criminal Conspirators For Hacking Yahoo And Millions Of Email Accounts, Fsb Officers Protected, Directed, Facilitated And Paid Criminal Hackers”, March 15, 2017. Gerasimov, Vasily. “The Value Of Science In Prediction,” Military Industrial Courier, Feb 27, 2013. Federal Bureau of Investigation, “Internet Crime Complaint Center Marks 20 Years From Early Frauds to Sophisticated Schemes, IC3 Has Tracked the Evolution of Online Crime,” May 8, 2020. Fedorov, Yuriy Ye. “Arms Control In The Information Age” Symposium “Emerging Challenges In The Information Age,” 23 January 2002, Arlington, Virginia. Galeotti, Mark. “The ‘Gerasimov Doctrine’ And Russian Non-Linear War,” In Moscow’s Shadows, July 6, 2014. Greenberg, Andy. “The Untold Story Of Notpetya, The Most Devastating Cyberattack In History,” Wired Magazine, August 22, 2018. Krebs, Brian. “Why Were the Russians So Set Against This Hacker Being Extradited?,” Krebs on Security, Nov 18, 2019. Lusthaus, Jonathan.  “Cybercrime in Southeast Asia Combating a global threat locally,” May 20, 2020. Mattis, James. Department of Defense, “Summary Of The 2018 National Defense Strategy Of The United States Of America”. Meakins, Joss. “Living in (Digital) Denial: Russia’s Approach To Cyber Deterrence,” Russia Matters, July 2018. Ministry of Foreign Affairs of the Russian Federation. “Doctrine Of Information Security Of The Russian Federation,” Dec 5, 2016. Nakasone, Paul.  “Cybercom Commander Briefs Reporters At White House,” Department of Defense video briefing, Aug 2, 2018. National Security Agency, “NSA/CSS Technical Cyber Threat Framework V2”, a report from: Cybersecurity Operations The Cybersecurity Products And Sharing Division, 29 November 2018. Pettijohn and Wasser.  “Competing In The Gray Zone,” RAND Corporation, 2019.  Putin, Vladimir.  “Strategy of National Security of the Russian Federation,” Office of the President of the Russian Federation, Dec 31, 2015. Russian National Security Strategy 31 Dec 2015, Russia Matters. Snegovaya, Maria. “Putin’s Information Warfare In Ukraine: Soviet Origins Of Russia's Hybrid Warfare,” Institute for the Study of War, Sep 22, 2015. Tsygichko, V. N. “About Categories of “Correlation Of Forces” for Potential Military Conflicts in the New Era,” Symposium “Emerging Challenges In The Information Age,” 23 January 2002, Arlington, Virginia. Wiener, Norbert, Cybernetics: Or Control and Communication in the Animal and the Machine. Cambridge, Massachusetts: MIT Press, (1948).

Highlights The tech sector is in a manic phase. This mania has further room to run because inflation will remain low for at least the next two years and global central banks will maintain very easy policy conditions, which will cap the upside in bond yields. Tech will have its day of reckoning when inflation can rise and the sector’s weight will drag down the market. Bubbles are prone to severe corrections; this one is no exception. In the near term, tech earnings will probably miss lofty embedded expectations. The falling dollar is a problem for the sector and the election season introduces great risks. In the near term, inflation breakeven rates, the silver-to-gold ratio and the deep cyclicals-to-defensives ratio will all rise further. Industrials have a window to outperform technology. Feature The S&P 500 continues its ascent, increasingly driven higher by surging tech stocks. The extreme resilience of a few tech titans has resulted in an incredibly concentrated equity market, in which the capitalization of Google, Amazon, Microsoft, Apple and Facebook equals that of 224 deep and early cyclical stocks in the S&P 500. Such a narrow market raises three questions: is the tech sector in a bubble? What will pop this bubble? If the tech bubble bursts, will the S&P 500 shrug it off or decline with giant technology firms? We believe that tech stocks are in a bubble and the mania will expand further as long as inflation remains low and monetary conditions stay accommodative, despite occasional pullbacks. Moreover, the broad market will suffer when the bubble eventually bursts. Each Decade Has Its Bubble BCA Research’s Emerging Market Strategy team recently demonstrated that each decade in the past 60 years has experienced its own financial excess (Chart I-1).1 Three forces fueled each of these manias: an extended phase of easy monetary policy; a narrative that drove funds towards fashionable assets; and an extended period of superior returns that accentuated the inevitability of participating in the bubble. Chart I-1Each Decade Has Its Bubble August 2020 August 2020 In the 1960s, the mania surrounded the so-called “Nifty 50” stocks, as exemplified by Disney. The Nifty 50 were large-cap companies with solid franchises and a proven track record of dividend growth. Meanwhile, the period of low inflation from 1960 to 1966 allowed the US Federal Reserve to keep the unemployment rate below NAIRU, which indicated that policy was accommodative. When inflation began to rise in 1966, the Fed lifted interest rates to 7.75% in 1973, and the bubble evaporated with the recession started that year. In the 1970s, the mania involved precious metals, such as gold and silver. Precious metals benefited from the 33% fall in the dollar, the surge in inflation from 2.9% in 1970 to 14.7% in 1980, and the Fed’s incapacity to get ahead of the inflation curve through most of the decade. Then-Fed Chair Paul Volcker burst this bubble when he boosted interest rates to 19% in 1981 to kill off inflation, which also started the 93% dollar rally that culminated in 1985. Tech stocks are in a bubble and the mania will expand further as long as inflation remains low and monetary conditions stay accommodative. In the 1980s, the mania centered on Japan. The Japanese economy experienced a miraculous post-war expansion, with real GDP per capita surging by a cumulative average growth rate of 7% between 1945 and 1980. By the mid-1980s, the prevailing belief was that Japanese firms would dominate every industry. Moreover, after the Ministry of Finance allowed the yen to surge following the September 1985 Plaza Accord, the Bank of Japan (BoJ) cut interest rates by 2.5%, creating very easy domestic monetary conditions. This lax policy setting unleashed a surge in credit and asset valuations that pushed up the Nikkei-225 five times by the end of the decade and resulted in an 860% increase in the value of Japanese banks. The BoJ lifted interest rates by 3.5 percentage points between 1987 and 1990. The market peaked in December 1989 and the Nikkei collapsed by 82% during the next 19 years. In the 1990s, tech stocks and the NASDAQ captured investors’ imagination. The internet, computing power and software, all drove an increase in productivity growth to a two-decade high and investors understood that the sector’s earnings prowess was only beginning. Moreover, as inflation fell through the 1990s, then-Fed Chairman Alan Greenspan kept policy rates more or less flat for four years before cutting the fed funds rate by 75 basis points in 1998. Additionally, around the turn of the millennium, the Fed increased the size of its balance sheet by $90 billion as a precautionary measure against Y2K. Consequently, with the ensuing euphoria, investors pushed the NASDAQ’s valuation to a P/E ratio of 72, extrapolating far into the future much-too-strong earnings growth. The bubble imploded when the Fed normalized policy. We are not even thinking about thinking about raising rates. In the 2000s, the dominant story was the unstoppable upswing of the Chinese economy, the nation’s rapid urbanization and insatiable thirst for commodities. The lack of investment in commodity extraction through the 1990s exacerbated the rally in natural resources. The easy Fed policy implemented in the wake of the tech crash of 2000 to 2003, and the dollar’s 40% plunge between 2002 and 2008 added to the bullish mix in favor of resources. Commodity indices surged and iron ore, which derives a particularly large share of demand from construction in China, increased 12-fold between 2000 and 2011. The rise in the broad trade-weighted dollar that began in 2011 along with a slowdown in Chinese growth initiated in 2010 ultimately quashed commodities. Is The Tech Bubble About To End? Chart I-2The Drivers Of The Tech Bubble The Drivers Of The Tech Bubble The Drivers Of The Tech Bubble Historically, bubbles often abort at the end of the decade in which they materialize. Will the ongoing mania suffer the same fate as its predecessors? For now, the pillars of the tech bubble remain intact. The strength of tech stocks reflects both their superior ability to generate cash flow growth and the structural decline in bond yields (Chart I-2). It is easy to understand why superior cash flow growth would result in strong tech performance, but the role of lower yields is not obvious. Tech stocks derive a large proportion of their intrinsic value from long-term deferred earnings and the terminal value of those cash flows. These distant profits are sensitive to fluctuations in the discount rate and, therefore, their present value soars when bond yields fall. The ability of tech to generate expanding earnings remains intact. Companies have curtailed capital expenditures due to the COVID-19 crisis, but they continue to spend on their software and hardware needs (Chart I-3). The growing prevalence of work-from-home arrangements and the proliferation of global cyberattacks (see Section II) will only feed the tech sector’s profit outperformance. Crucially, easy money and low interest rates will endure for an extended period. As Fed Chair Jerome Powell stated, “We are not even thinking about thinking about raising rates.” Our BCA Fed Monitor confirms this message (Chart I-4). Chart I-3Robust Tech Spending Robust Tech Spending Robust Tech Spending Chart I-4Easy Money As Far As The Eye Can See Easy Money As Far As The Eye Can See Easy Money As Far As The Eye Can See   Chart I-5Inflation Is The Tech Slayer Inflation Is The Tech Slayer Inflation Is The Tech Slayer Ultimately, much will depend on inflation. As BCA Research’s Equity Sector Strategy service recently demonstrated, the tech sector abhors rising inflation.2 Even during the seemingly unstoppable technology surge in the 1990s, the sector’s outperformance ended following an increase in core CPI (Chart I-5). Tech’s business model is optimized for deflationary conditions, especially when compared with other cyclical industries. Moreover, rising inflation puts upward pressure on interest rates and ultimately requires greater real interest rates to control accelerating CPI increases. Climbing real interest rates disproportionally hurt growth stocks, due to their heightened sensitivity to discount rates. Inflation will stay low as long as the labor market remains far from full employment. The slow progress in employment indicators suggests that the unemployment rate will be above NAIRU for at least two to three years (Chart I-6). Moreover, our Global CPI diffusion Index is also consistent with extended muted inflation (Chart I-7, top panels). The slowdown in money velocity and the weakness in the demand (as approximated by the smoothed growth rate of retail sales relative to average weekly earnings) will only exacerbate low inflation in the coming year or two (Chart I-7, bottom panels). Chart I-6Far From Full Employment Far From Full Employment Far From Full Employment Chart I-7For Now, Disinflation Dominates For Now, Disinflation Dominates For Now, Disinflation Dominates   In this context, valuations have room for more expansion. The NASDAQ may be pricey, but it is far from the 1990s’ nosebleed levels when nominal 10-year yields stood at 6.8% compared with today’s 0.55%, and 10-year TIPS yielded 4.3% and not their current -0.9%. In effect, both the equity risk premium and long-term expected growth rates embedded in tech stocks are much more conservative than in the late 1990s. The equity risk premium and long-term expected growth rates embedded in tech stocks are much more conservative than in the late 1990s. Finally, investors have largely missed the rally in stocks, which implies that a large proportion of the gains in tech stocks have not accrued to many investors. Since 2010, companies have been the main buyers of stocks while households and pension plans have constantly sold the asset class (Chart I-8). Additionally, investor sentiment remains firmly bearish and cash holdings of investors and households have surged in the wake of the COVID-19 pandemic (Chart I-9). Thus, there is a lot of pent-up demand for financial assets. TINA (‘there is no alternative’) will invite investors to pour funds into equities with 10-year yields stuck near 0.6% and short rates at zero. Tech stocks will benefit from this trend. Chart I-8Households And Pension Plans Have Divested Households And Pension Plans Have Divested Households And Pension Plans Have Divested Chart I-9Not A Generalized Euphoria... Not A Generalized Euphoria... Not A Generalized Euphoria...     Practical Considerations For Investors Bubbles are highly dangerous for investors. A lack of participation in a mania often results in disastrous underperformance for institutional investors, but staying invested in the bubbly asset too long can be even more lethal for a portfolio’s performance. This dichotomy means that as long as there is low inflation and accommodative policy, we cannot underweight or overweight tech stocks. BCA Research’s equity strategists are neutral on tech, but within the sector they overweight the more defensive software and services components relative to the high-beta hardware and equipment industry groups.3 Three potential risks that can crystalize a period of correction in tech stocks over the remainder of 2020. Another risk inherent to bubbles is that they are often volatile; the current tech exuberance will not be different. In the second half of the 1990s, the NASDAQ experienced ten 10% or more corrections and tumbled by more than 20% in 1998 before leaping to new highs. Currently, we monitor three potential risks that can crystalize a period of correction in tech stocks over the remainder of 2020. Risk 1: Tech Earnings Do Not Meet The Hype Chart I-10...But A Localized Euphoria ...But A Localized Euphoria ...But A Localized Euphoria Today, tech stocks are vulnerable to a sharp pullback because investors are willing to bid up these shares in light of their perceived high growth rate (Chart I-10). This sector-specific euphoria increases the likelihood that if second-quarter tech earnings disappoint, then a significant correction will occur in widely held companies. The stock prices of Microsoft, Netflix and Snapchat have been punished following disappointing Q2 results. Retail investors indirectly amplify the risk created by potential earnings disappointments. Users of free trading apps (e.g.: Robinhood) are the marginal buyers, but more importantly their order flows are sold to large institutional houses who front-run these small players. Large investors with immense buying power can swing the price of the stocks popular with retail investors. Hence, when small investors unload due to bad news, a selling deluge ensues. Risk 2: A Weak Dollar Tech stocks thrive with a strong dollar because it is synonymous with low inflation and low yields. Consequently, a rising USD puts upward pressure on tech multiples. Moreover, a depreciating dollar is linked to robust global growth, which lifts the earnings prospects of other deep cyclical stocks more than tech equities, hurting the latter’s relative performance. The US election also creates a serious risk for tech stocks. The dollar is falling prey to a confluence of factors. The outlook for the US balance-of-payments is deteriorating sharply as the twin deficit explodes higher. Moreover, the national savings rate will remain in a downtrend after 2020 (Chart I-11). The US fiscal deficit will narrow from its current level of at least 18% of GDP, but it will not return for many years to the 4.6% of GDP that prevailed in 2019. The unemployment rate will stay above NAIRU for at least two to three years and the median voter increasingly favors economic populism. These two forces will generate high levels of spending. Meanwhile, a negative nominal output gap will weigh on tax revenues. Concerning private savings, the household savings rate will normalize from its April high of 33% of disposable income because consumer confidence will improve, thanks to strong consumer balance sheets and a limited decline in household net worth (Chart I-12). Chart I-11Vanishing US Savings Vanishing US Savings Vanishing US Savings Chart I-12Household Balance Sheets Are Alright Household Balance Sheets Are Alright Household Balance Sheets Are Alright   Chart I-13Forget The Breakup Songs For Now Forget The Breakup Songs For Now Forget The Breakup Songs For Now A poor balance of payments would not be a hurdle for the dollar if US real interest rates were high and foreign investors had confidence in the US economy, but neither of these conditions exists. US real interest rates have fallen relative to the rest of the world and the economic impact of the second wave of COVID-19 infections in the US partly explains the strength in the euro. Moreover, the recently agreed EUR750 billion of common bond issuance by the EU will curtail the probability of a euro breakup, which will compress European risk premia (Chart I-13). This development is highly positive for the euro, which could quickly move toward the 1.20 to 1.25 zone. The global economic recovery amplifies the negative impulse for the dollar. We have often argued that the USD is a countercyclical currency (Chart I-14).4  Hence, the recent uptick in Chinese stimulus and the positive outlook for the global industrial cycle bodes poorly for the US dollar. Moreover, a weak dollar can unleash a feedback loop that supercharges global growth. According to the Bank for International Settlements, foreign issuers have emitted $12-$14 trillion of USD-denominated liabilities. A weak dollar would diminish the cost of servicing this debt and ease global financial conditions, which would boost the world’s economic outlook. The brightening outlook would further feed the dollar’s weakness and underpin its momentum behavior (Chart I-14, bottom panel). Shifting international flows create the last major headwind for the US dollar. Fund repatriation by US economic agents has been a critical driver of the dollar since 2014. The USD rallied in tandem with a surge of repatriation in the wake of the Tax Cuts and Jobs Act of 2017, despite the lack of appetite for US assets by foreigners (Chart I-15). Now that the effect of the tax cuts has passed, repatriations are dwindling from their 2019 peak. Meanwhile, foreign investors’ appetite for dollar assets is not returning, especially as flows into US Treasurys are collapsing (Chart I-15, bottom panel). Chart I-14The Dollar Feedback Loop The Dollar Feedback Loop The Dollar Feedback Loop Chart I-15Flows Are Turning Against The Greenback Flows Are Turning Against The Greenback Flows Are Turning Against The Greenback   The dollar’s recent rally runs the risk of a short-term pause. Our USD Capitulation Index is at a level consistent with a short-term rebound (Chart I-16). Nonetheless, the list of dollar-bearish factors noted above suggests that any rebound in the dollar would be temporary. Risk 3: The Election Run-Up The US election also creates a serious risk for tech stocks. President Trump’s approval rating remains in tatters despite the vigorous rebound in equities since March 23 (Chart I-17). His support at this stage of the presidential cycle clearly lags that of previous presidents who were re-elected (Chart I-17, bottom panel). Consequently, our Geopolitical Strategy team assigns a subjective probability of 35% that he will remain in the White House next January.5 This creates two problems for investors. When cornered, President Trump often lashes out at foreign economies, which leads to geopolitical tensions. The heated rhetoric toward China will likely worsen in the coming three months, which raises the prospect of another leg in the US-Sino trade war, with negative effects for tech firms that extract 58% of their revenues from abroad. Furthermore, if former Vice-President Joe Biden clinches the presidency, then the Senate will turn Democrat. The Democrats will likely reverse Trump’s corporate tax cuts, which would hurt all stocks and prompt some liquidation in tech holdings. Chart I-16A Temporary Dollar Bounce Is Likely A Temporary Dollar Bounce Is Likely A Temporary Dollar Bounce Is Likely Chart I-17President Trump"s Disapproval Rating Is A Danger President Trump"s Disapproval Rating Is A Danger President Trump"s Disapproval Rating Is A Danger   The tech industry remains an attractive target for populist ire because of its wide profit margins and elevated concentration and market power. During the run-up to November 3rd, investors will be reminded that politicians on both sides of the aisle want to regulate tech. Investors will need to raise the equity risk premium for the sector as these voices get louder. Implications For The Broad Market The strength of the tech sector will be tested in the coming two quarters. Any short-term interruption to the mania prompted by the three aforementioned risks will cause a correction in the S&P 500 because the tech sector (including Google, Amazon, Facebook and Netflix) represents 40% of the index’s market capitalization (Chart I-18). As our equity strategist recently highlighted, without its five largest components (Apple, Microsoft, Amazon, Google and Facebook), the S&P 500 would have increased by only 23% in the past five years instead of its current 54% return. To add color to those numbers, these five tech titans have added $4.8 trillion to the S&P 500 market capitalization versus $3.8 trillion added by the next 495 companies.6   Any short-term interruption to the mania will cause a correction in the S&P 500. Despite this risk, we continue to anticipate that the S&P 500 will find a floor between 2800 and 2900.7 Some crucial factors underpin equities. Global monetary policy remains extraordinarily accommodative, China is stimulating aggressively, Washington will not let a large fiscal cliff destroy the recovery ahead of a presidential election, and the weaker dollar has a reflationary impact on global economic activity. Additionally, we still expect the second wave of COVID-19 to be less deadly than the first and result in much more limited lockdowns compared with March and April. BCA’s neutral stance on tech remains appropriate even after the short-term dynamics discussed above are factored in. The absence of inflationary pressures in the next two years or so and the position of global central banks that they will maintain loose monetary conditions until inflation has overshot a 2% target indicate that conditions persist for an expanding tech mania. Moreover, the dollar’s weakness is unlikely to last more than 12 to 18 months. The US still possesses a higher trend growth rate than the rest of the G-10 and sports a higher neutral rate of interest (Chart I-19). Additionally, China will ultimately rein in its ongoing credit expansion, which will hurt the global industrial cycle. Hence, the deterioration of interest rate differentials between the US and the rest of the world is temporary. Chart I-18The 1% Vs The 99% The 1% Vs The 99% The 1% Vs The 99% Chart I-19The US Still Has Stronger Trend Growth The US Still Has Stronger Trend Growth The US Still Has Stronger Trend Growth   The Return Of The Inflation Trade Chart I-20Will Yields Move Up? Will Yields Move Up? Will Yields Move Up? To navigate what will remain a trendless but volatile market until the presidential election, we still favor trades levered to the global economic recovery. Inflation breakeven rates can climb further. The inflation trade is back in fashion, with an increase in gold and commodity prices. The weakness in the dollar and the fall in real interest rates are both reflationary, and they will accelerate the uptick in inflation expectations, especially because global central banks have promised to stay behind the inflation curve as the economy recovers. Mounting inflation expectations will also create some near-term upside risks for nominal bond yields. Since the Global Financial Crisis (GFC), an average of the ISM manufacturing survey and its prices paid component have provided useful early signals for yields. This indicator has turned sharply higher (Chart I-20). Moreover, commercial banks are quickly accumulating securities on their balance sheets, which is creating a lot of liquidity. Banks have been able to increase their book value despite generous loan-loss provisions, therefore, they will be able to transform this liquidity into loans when the economic outlook clears enough to ease credit standards. Bond yields will sniff out this situation ahead of time. Central banks want to maintain loose monetary conditions, but there is a limit to how much additional easing they will tolerate as the economy recovers and fiscal support remains generous. Hence, while inflation breakeven rates can move up, the decline in real yields has reached an advanced stage. In this context, if central banks do not provide further accommodation and inflation expectations go up, then real interest rates will cease to decline and nominal rates will start to drift higher. Silver will continue to outperform gold. While we have been positive on gold and gold stocks since June 2019,8 more recently we have strongly favored silver. Industrial uses constitute a larger share of the demand for silver than that of gold. As a result, the silver-to-gold ratio is highly pro-cyclical. While gold is vulnerable to an increased improvement in economic sentiment (Chart I-21), silver will continue to shine in an environment where inflation expectations increase further and economic activity is recovering. We continue to like global deep cyclical equities relative to defensive ones. We continue to like global deep cyclical equities relative to defensive ones. The pickup in China’s economic activity, as captured by our China Economic Diffusion Index, remains consistent with upside to this trade (Chart I-22). Domestic growth will accelerate further in the second half of 2020 because China’s credit flows continue to increase as a share of GDP, especially when companies have yet to spend the funds borrowed in the second quarter. Additionally, infrastructure spending will continue to expand as local governments have only issued 50% of their annual quota of special bonds (Chart I-22, bottom panel). Chart I-21A Risk For Gold A Risk For Gold A Risk For Gold Chart I-22China Is On The Go China Is On The Go China Is On The Go   An outperformance of deep cyclicals relative to defensive equities is also consistent with higher inflation expectations, a rising silver-to-gold ratio and a weaker US dollar (Chart I-23). The near-term outlook also supports buying industrial equities relative to tech stocks. While we have been positive on both materials and industrials, the former has lagged tech. However, our BCA Technical Indicator for US industrial stocks is massively oversold relative to the tech sector (Chart I-24). In light of a declining dollar, rising inflation breakeven rates, strengthening commodity prices and accelerating Chinese credit flows, the probability that industrials outperform tech for three to six months is rapidly escalating. Chart I-23The Inflation Trades The Inflation Trades The Inflation Trades Chart I-24Long Industrials / Short Tech Long Industrials / Short Tech Long Industrials / Short Tech   Our relative profits indicator between the industrial and tech sectors is rebounding from depressed readings. The global economic recovery will lift industrials’ revenues more than it will help the tech sector’s income because it will allow weak industrial production levels to improve relative to stable IT spending. Moreover, the industrial wage bill is well contained compared with the tech wage bill. The probability that industrials outperform tech for three to six months is rapidly escalating. Finally, our valuation indicator also favors industrials. Relative to tech stocks, industrial equities are trading at their largest discount since the aftermath of the GFC, suggesting that there is little downside left in this price ratio, at least as long as the dollar is correcting. Mathieu Savary Vice President The Bank Credit Analyst July 30, 2020 Next Report: August 27, 2020   II. Russia And Cyber Security After COVID-19 Dear Clients, This month we offer you a Special Report on Russia and cyber security by our colleague and friend, Elmo Wright. Elmo recently retired from US Army civil service after 43 years working in intelligence, either on active duty, reserves, or as a civilian. From 2018 to 2020, he served as the senior civilian executive at the US Army National Ground Intelligence Center.  He has served on five continents and provided analysis of the most pressing global trends in national security and intelligence. In this Special Report with BCA’s Geopolitical Strategy team, Elmo analyzes Russia’s cyber capabilities and argues that structural and cyclical factors, including COVID-19, will ensure the continued salience of Russian and global cyber security challenges in the coming years. His thesis reinforces our recommendation that investors buy cyber security equities. Elmo’s work for this report is in his personal capacity and does not represent any position of the US government. Only publicly available information was used as background research material for Elmo’s contribution to the report. All very best, Matt Gertken Vice President Geopolitical Strategy Mathieu Savary Vice President The Bank Credit Analyst As the US elections come closer, there will be a return to news about Russia and its potential interference via social media. Russia will continue to use cyber, both state sponsored attacks, and in coordination with criminal groups, to advance Russian national security objectives. In contrast to nuclear doctrine, there is no commonly accepted framework for cyber warfare between Russia and other nations that provides understandable signals for escalation, de-escalation, appropriate targets, or goals. US efforts to conduct military operations against Russia or China would likely be countered by Russian or Chinese cyber operations before any physical military operations could be initiated. Cyber security stocks offer a way for investors to capitalize on our long-term themes of nationalism, multipolarity, and de-globalization. The ISE Cyber Security Index offers value relative to the broad NASDAQ and S&P 500 indexes as well as the S&P tech sector. Chart II-1Russian Cyber Interference Resurfaces Around US Elections Russian Cyber Interference Resurfaces Around US Elections Russian Cyber Interference Resurfaces Around US Elections As the national elections in the US come closer, there will be a return to news about Russia and its potential interference via social media. Indeed Russia is making headlines even as we go to press. This report aims to provide context for Russian cyber capabilities in general as a contributor to overall geopolitical instability (Chart II-1). We forecast Russia will continue to use cyber, both state sponsored attacks, and in coordination with criminal groups, to advance Russian national security objectives. As background, the word cyber is commonly accepted to be derived from cybernetics, a phrase attributed to Norbert Wiener, an MIT scientist. The phrase itself is related to the ancient Greek word for steering or helmsman, in other words, control. Chart II-2Russian Excellence In Math Makes It Competitive In Cybernetics August 2020 August 2020 Russia has a long history of excellence in science, especially theoretical work in mathematics and physics (Chart II-2). Those fields can explain natural phenomena in formulas and mathematical relationships. The Soviets believed that centralized state planning that manipulated data in formulas could lead to better outcomes in all aspects of the society. Although central state economic planning did not work out for the Soviet economy, Soviet military science built on the concept of data relationships in formulas to develop its theory of troop control, a derivative of reflexive control, that is, the presenting of data to the recipient, either friendly or enemy, in order to get that recipient to act in a way favorable to Soviet military plans. One can see the Soviets embraced the idea of cybernetics as very congruent to their desire for top down control. Russia, as the core part of the Soviet Union, retained significant numbers of scientists and mathematicians who were naturally drawn to the ability of computers to take data and manipulate that data according to formulas. Other Russian scientists and mathematicians emigrated to the West where their expertise was rewarded in the rise in the use of computers to manipulate data. Over time, the term cyber has come to be associated with many aspects of computers, especially the intellectual and physical structures hidden behind the direct interface of a person with a keyboard and screen. Russian expertise in the use of computers to do cyber work was not limited to working for the State. As the Soviet Union broke apart and many people lost their jobs working for the State, there were those persons who took their talents to criminal ventures. And in the symbiotic nature of society in Russia, many of those who went into criminal ventures were former intelligence and security personnel who could maintain their connection to the official organizations that were successors to the KGB, the GRU, and others. Russia is the source of the most sophisticated cyber threats to the US. Senior Russian military officials, such as General Valery Gerasimov, Chief of the General Staff of the Russian Federation armed forces, equivalent to the US Chairman of the Joint Chiefs of Staff, have noted the growth of nonmilitary means of achieving strategic goals, and specifically in the information space. Gerasimov, in an article in 2013, has been widely quoted that all elements of national power have to be harnessed, including cyber capabilities. One Soviet and Russian military concept that relates to the information space is maskirovka, the use of camouflage, deception, and disinformation to confuse the enemy. Maskirovka is intimately connected with the Soviet/Russian concept of “active measures”. Active measures include actions taken generally by intelligence services to provide propaganda, false information, and otherwise sow discord and confusion among the enemy ranks at all levels of war as well as in the political, economic, and social spheres. In today’s time period, cyber, especially social media, offers the opportunity for the wide spread of aspects of maskirovka and active measures to all users, as well as targeted groups (Chart II-3). Reporting indicates a continued Russian emphasis on cyber as a means for active measures concealed by maskirovka. Chart II-3Social Media Offers Russia An Opportunity For The Spread Of Maskirovka August 2020 August 2020 Wikileaks has provided a platform for the dissemination of information normally hidden from the general public. It is noteworthy how much of the information on the Wikileaks platform relates to the US and the West, and relatively little on Russia. Possible factors that explain that characteristic include the disparity in penalties for disclosing information between the US and the West versus Russia; the greater number of journalists and other persons involved in the media, both for profit and personal reasons, in the West; and the language barriers involved in understanding Russian versus English. A final possible factor in Wikileaks greater dissemination of Western information might be an aspect of active measures undertaken by Russia. There are numerous actions attributed to Russian state actors in the cyber field in the recent past (Table II-1). They include a distributed denial of service attack on Estonia (2007); hacking the Ministry of Defense in the country of Georgia during a military conflict (2008); attacks on Ukrainian energy infrastructure (2015); and the hacking of the Democratic National Committee (2016). Chancellor Angela Merkel recently publicly named and shamed Russia for a cyber-attack on Germany circa 2015 (Appendix). Table II-1Russian State Actors Responsible For Many Of This Year’s Cyber Attacks August 2020 August 2020 Chart II-4Russian Use Of Cyber Is A Top Threat To The US August 2020 August 2020 Senior US officials have cited Russia as the source of the most sophisticated cyber threats to the US, both for espionage and state sponsored attacks against US national security capabilities such as energy, transportation, and telecommunications infrastructure; as well as for criminal activity such as ransom ware and identity theft. Russian use of cyber, both state sponsored and sponsoring criminal actors, has been the top threat to the US in each of the US intelligence community’s annual threat assessments for 2017, 2018, and 2019 (Chart II-4). Although the 2020 annual threat assessment was not made public in Congressional testimony, there’s little reason to suspect that Russian use of cyber would not continue to be cited as the top threat. Other nation states have state sponsored cyber capabilities which are of national security concern to the US, including China, Iran, and North Korea. These nation states are called out in the US intelligence community Annual Threat Assessments. Each of these nation states has been identified as committing intelligence and economic cyber attacks against the US and other Western nations. The recent speech by the Director of the Federal Bureau of Investigation designates China as the top threat. Given the nature of the internet, the pathway of a cyber attack will likely bounce around multiple countries before reaching its intended target. As the Director notes, forensic identification of the source of a cyber attack takes time and expertise. However, there is a clear record of specifically identifying the state sponsored entity that commits attacks on US or Western government information technology and infrastructure. More likely than confusing one state sponsored cyber actor from one country to another would be the potential blending of criminal elements across national boundaries. In this case, cyber criminal elements with Russian backgrounds or connections are clearly the most capable. Cyber-crime is rising despite deterrence. The stages of cyber conflict include reconnaissance, penetration, mapping, exfiltration, and operations. The US National Security Agency has an extensive technical cyber threat framework which goes into much detail. Cyber security professionals note the ongoing actions in cyber space and the attempts by elements suspected to be linked to Russia to gain and maintain access to US networks for potential military operations, or to exfiltrate data for criminal or other purposes. Part of the frustration of cyber security experts is the lack of transparency and timely reporting of those affected by malign cyber activities. Although some cyber activities may go on for multiple months, the exfiltration of data, or the emplacement of malware may only take a few seconds. Many networks lack the ability to detect penetration and mapping. Companies with large resources devoted to cyber security may have that investment negated if they have affiliations with other companies with lax cyber security which can allow for hostile intrusions into the connected network. Chart II-5Unlike Nuclear Doctrine, Cyber Lacks A Framework To Control Escalation August 2020 August 2020 Unfortunately, public and open attribution for cyber attacks has lagged. As an example, although the attack on the Democratic National Committee email servers was noted in 2016, it was not until 2018 that specific Russian individuals were charged with the crime. Factors that cause lags in public and open attribution include the difficulty of tracing specific computer code through cyberspace; the disjointed nature of the internet; the lack of an easy and accepted mechanism for involvement of US intelligence agencies in providing assistance to private sector parties; and the reticence of individuals and organizations negatively affected by cyber attacks to publicly disclose their injuries. Doctrine for the use of nuclear weapons developed over a period of years in the US and the West and in the Soviet bloc. The Soviets developed a coherent doctrine for the use of nuclear weapons that was understandable to the West. Arms control agreements between nuclear powers established mechanisms for controlling escalation of tensions (Chart II-5). The Soviet doctrine was adopted by the Russians after the breakup of the Soviet Union. Russia and Western nations continue to have a common understanding of the role of nuclear weapons in military affairs that allows for discussion of escalation and de-escalation. In contrast to nuclear doctrine, there is no commonly accepted framework for cyber warfare between Russia and other nations that provides understandable signals for escalation, de-escalation, appropriate targets, or goals. This is reflected in the Russian information security doctrine of 2016 which notes “The absence of international legal norms regulating inter-State relations in the information space…” The US Director of National Intelligence also noted this lack of agreement in his annual threat assessment testimony of 2017. Chart II-6Rapid Growth Of Internet Raises Vulnerability To Harmful Actions August 2020 August 2020 The rapid growth of the internet, and reliance on it by government and private sectors reflects its founding as an open system, vulnerable to negative actors and actions (Chart II-6). The intermingling of hardware and software, the information infrastructure used both by individuals and states, by the private sector and by government, makes separating doctrine and practice for cyberwar from legitimate use very difficult. Since non-cyber military capabilities, both conventional, and nuclear, rely upon the use of commercial information technology infrastructure, the use of offensive cyber is subject to the problem of blowback. As the NotPetya incident of 2018 indicated, damage from malware installed on one computer can rapidly spread across networks, industries, and international boundaries. The code for StuxNet and the code released by the more recent hack of CIA cyber tools have been noted in other cases of cyber attacks. The view of the international cyber environment by Russia is very similar to views in the US and the West. The Russian national security doctrine of 2015 notes “... An entire spectrum of political, financial-economic, and informational instruments have been set in motion in the struggle for influence in the international arena. Increasingly active use is being made of special services' potential … The intensifying confrontation in the global information arena caused by some countries' aspiration to utilize informational and communication technologies to achieve their geopolitical objectives, including by manipulating public awareness and falsifying history, is exerting an increasing influence on the nature of the international situation.” Although much of the Russian information security doctrine of 2016 is concerned with noting threats to Russia’s information space, what might be called counterintelligence in other documents, there are key comments that note the suitability of using attacks in the information space as an effective means of projecting Russian power, such as “… improving information support activities to implement the State policy of the Russian Federation …” As per usual Soviet and Russian state doctrinal documents, the 2016 doctrine notes all the negative activity of other actors in this field. This practice is consistent with historical Soviet and Russian open press documents which ascribe to other states the activities in which Russia engages or plans to engage. Chart II-7Cyber Attacks Are On The Rise August 2020 August 2020 Unlike other forms of national security alliances, such as for intelligence, there is little public literature on cyber alliances, especially for offensive action. For example, the US and Israel have never publicly acknowledged a government alliance to emplace the StuxNet virus into the Iranian nuclear development program. Should there be offensive cyber alliances in the West, it is likely they fall along traditional intelligence and defense lines. There is no public reporting on any sort of offensive cyber alliances that involve Russia. There are public efforts at common standards for information technology security, but these efforts are foundering on citizen and government concerns over privacy, as well as commercial  proprietary advantage. It is an open question as to whether cyber alliances among friendly nations would deter would-be cyber attackers or hackers. Certainly the growth of complaints to the FBI’s Internet Crime Complaint Center would indicate that statements of deterrence and even prosecutions are failing to reduce cyber attacks (Chart II-7). Both the US national intelligence community and private sector cybersecurity companies agree Russia has a sophisticated state sponsored effort to acquire intelligence via hacking and insert favorable themes into cyberspace via the use of social media. There is also agreement that Russia state elements have a close relationship with criminal elements which can provide a plausibly deniable means of engaging in cyber warfare activities favorable to Russia, as well as engaging in activities for illegal economic advantage. For example, see this quote from the CYBEREASON Intel team: “The crossing of official state sponsored hacking with cybercriminal outfits has created a specter of Russian state hacking that is far larger than their actual program. This hybridization of tools, actors, and missions has created one of the most potent and ill-defined advanced threats that the cybersecurity community faces. It has also created the most technically advanced and bold cybercriminal community in the world. When, as a criminal, your patronage is the internal security service that is charged with tracking and arresting cybercrime, your only concern becomes staying within their defined bounds of acceptable risk and not what global norms, laws, or even domestic Russian law states.” The US Department of Justice in June 2020 noted a Russian national was sentenced to prison for malicious cyber activities. Key points of his illegal activity were the operation of websites open only to Russian speakers, and the vetting or recommendation of other criminals before allowing entry to the websites. One analysis of this situation notes the ties to Russian state security organs and personnel which likely held up the Russian national’s extradition for trial in the US. Government leaders in the US have noted the potential for major cyber attacks in the US affecting physical infrastructure and causing significant economic and social damage, including further attacks on the political election process. However, they have been reticent to state any explicit sort of retaliation. The US Cyber Command notes it is actively combatting hostile cyber actors. Therefore, the question remains open as to what level of cyber attacks would be considered serious enough to be treated as an act of war by the US. There has been public speculation of both Russian and Chinese implants of malware into the US information technology infrastructure that might be activated in the case of open hostilities. US efforts to conduct military operations against Russia or China would likely be countered by Russian or Chinese cyber operations before any physical military operations could be initiated, especially since US based forces would have to transit oceans, taking many days, when cyber operations could happen in seconds. China, Russia, and Iran will also increasingly become victims of cyber attacks. Russian “gray zone” tactics, that is, actions short of large scale conventional war, many of which involve cyber attacks, active measures, and maskirovka, are the subject of much Department of Defense planning and action. To combat such gray zone activity analysis from the RAND Corporation notes the need for a spectrum of diplomatic, informational, military, and economic actions, which would involve commercial partners and allied nations. The difficulty of coordinating such counter action is one reason the Russians continue their gray zone efforts. Russia’s unique characteristics, some of which are weaknesses compared to the US and the West, are indicative of why Russia engages in state sponsored as well as criminal cyber activities (Chart II-8). Russian scientific history, the intertwining of state and criminal elements, and continent-spanning location are factors which promote the use of cyber. Russia’s economic position vis-à-vis the US, Russia’s relative lack of military power projection capability beyond the states on its borders (the Near Abroad), except for its nuclear forces, and Russia’s declining demographic situation are negative factors which push Russia to use cyber as a cost effective means of advancing national security and economic policy (Chart II-9). Despite US and Western imposed sanctions on Russia for past misdeeds, none of the factors noted above will be changed in the near future. Therefore, those factors, and published Russian doctrine should indicate to Western governments and businesses that Russia will continue to use cyber as a means to advance Russian national security objectives, as well as a means to siphoning off wealth from the West via criminal activities. Chart II-8Russia's Relative Weakness Drives Engagement In Cyber Activities Russia's Relative Weakness Drives Engagement In Cyber Activities Russia's Relative Weakness Drives Engagement In Cyber Activities Chart II-9Deteriorating Demographics Also Drive Russia’s Cyber Activities August 2020 August 2020   US preparedness for Russian cyber activity in the upcoming months should be greater given several factors. First, there is clearly awareness of a Russian cyber threat to US interests across government and in the private sector. Second, the US has established new organizations, shifted resources of money and people, and had practice defending against cyber attacks since the 2016 US election cycle. However, the US information technology infrastructure is vast and porous, making it hard to protect against every threat. Russian cyber actors, both state sponsored and criminal, are smart and persistent. Investment Takeaways Cyber security companies offer a way for investors to capitalize on major themes arising from the COVID-19 crisis and its aftermath. These themes include not only changes in worker behavior, e-commerce, corporate culture, and network security, but also our major geopolitical themes like nationalism and the retreat from globalization. Reports as we go to press that Russian hackers have targeted vaccine developers in the US, UK, and Canada underscore the point. The trend is not limited to Russia or COVID-19 vaccines. It is all too apparent from the actions of Russia and China – as well as the increasing efforts by the US and its allies to patrol their own cyber realms, IT systems, and ideological discourse – that governments view the Internet as a frontier to be conquered and fortified rather than as a free space of human exchange in which globalization can operate unfettered (Map II-1). Map II-1Governments View The Internet As A Frontier To Be Conquered August 2020 August 2020 Formal measures of country risk are inadequate but provide some perspective as to which countries and companies are least prepared. The International Telecommunication Union (ITU) is the United Nations body charged with monitoring information technology and communications. It ranks countries according to their commitment to cyber security and their exposure to cyber security risks (Chart II-10). Chart II-10Countries Have An Imperative To Strengthen Cyber Security August 2020 August 2020 We take these rankings with a grain of salt knowing that advanced countries like the US and UK rank near the top of the list, and yet are the prime targets of hackers and thus face enormous cyber security risks. What is clear is that no country is safe and every country has an economic and national security imperative to strengthen its cyber security. These indexes also suggest that several European countries are less well prepared than one would think and that emerging markets are grossly underprepared. China, Russia and Iran should not be thought of only as aggressors – they will increasingly become targets as the West seeks to counteract them. As Russia expands operations it becomes a target of cyber counter-strikes as well as economic sanctions. And as China accelerates its drive to become a high tech giant, it encourages economic decoupling from the West and retaliation for its use of cyber-theft and state-based hacking. There are two main cyber security equity indexes – the NASDAQ CTA Cybersecurity Index (NQCYBR) and NASDAQ ISE Cyber Security Index (HXR). These indexes trade in line with each other and have rallied extensively since the COVID-19 crisis (Chart II-11). Investors are aware that the surge in working from home and companies conducting operations off-site, as well as geopolitical great power struggle, have created extensive new vulnerabilities and capex requirements. On April 24, we recommended that investors go long the ISE index relative to the S&P 500 information technology sector. We are also going long the ISE index relative to the NASDAQ on a strategic horizon. Tech has been the prime beneficiary of the COVID-19 crisis while the necessary corollary of the tech companies’ continued success is the need for security of their information, property, and customers (Chart II-12). We also favor the ISE index because it has a slightly heavier cyclical component due to the fact that 13% of its companies are in the industrial sector, compared to 10% for the CTA index. The industrial side should benefit more as economies reopen and recover. Chart II-11Cyber Security Stocks Have Benefited From COVID-19 ... Cyber Security Stocks Have Benefited From COVID-19 ... Cyber Security Stocks Have Benefited From COVID-19 ... Chart II-12... But Not So Much Relative To Broad Tech Sector ... But Not So Much Relative To Broad Tech Sector ... But Not So Much Relative To Broad Tech Sector   These indexes are tracked by two ETFs. The First Trust NASDAQ Cybersecurity ETF (CIBR) tracks the NASDAQ CTA index with an emphasis on larger companies, while the ETFMG Prime Cyber Security ETF (HACK) tracks the ISE index, companies with market capitalization lower than $250 million, and a slightly lower exposure to the communications sector as opposed to IT and software. The HACK ETF has lagged the CIBR this year so far and offers an opportunity for investors to invest in data protection and up-and-coming firms. Over the past ten years cyber security has proven to be a volatile investment space with rapidly increasing competition for market share. But the secular tailwinds are powerful and a diversified exposure to the sector will be rewarding for investors positioning for the post-COVID-19 world. Elmo Wright Consulting Editor Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Appendix Table II-1Major Cyber-Attacks Over The Past Decade August 2020 August 2020 Works Cited Coats, Dan. “Statement For The Record Worldwide Threat Assessment Of The Us Intelligence Community,” May 23, 2017. Coats, Dan. “Statement For The Record Worldwide Threat Assessment Of The Us Intelligence Community,” March 6, 2018. Coats, Dan. “Annual Threat Assessment Opening Statement,” January 29, 2019. CyberReason Intel Team, “Russia And Nation-State Hacking Tactics: A Report From Cybereason Intelligence Group,” cybereason.com, June 5, 2017. Department of Justice, “Russian National Sentenced To Prison For Operating Websites Devoted To Fraud And Malicious Cyber Activities”, June 26, 2020. Department of Justice, “U.S. Charges Russian FSB Officers And Their Criminal Conspirators For Hacking Yahoo And Millions Of Email Accounts, Fsb Officers Protected, Directed, Facilitated And Paid Criminal Hackers”, March 15, 2017. Gerasimov, Vasily. “The Value Of Science In Prediction,” Military Industrial Courier, Feb 27, 2013. Federal Bureau of Investigation, “Internet Crime Complaint Center Marks 20 Years From Early Frauds to Sophisticated Schemes, IC3 Has Tracked the Evolution of Online Crime,” May 8, 2020. Fedorov, Yuriy Ye. “Arms Control In The Information Age” Symposium “Emerging Challenges In The Information Age,” 23 January 2002, Arlington, Virginia. Galeotti, Mark. “The ‘Gerasimov Doctrine’ And Russian Non-Linear War,” In Moscow’s Shadows, July 6, 2014. Greenberg, Andy. “The Untold Story Of Notpetya, The Most Devastating Cyberattack In History,” Wired Magazine, August 22, 2018. Krebs, Brian. “Why Were the Russians So Set Against This Hacker Being Extradited?,” Krebs on Security, Nov 18, 2019. Lusthaus, Jonathan.  “Cybercrime in Southeast Asia Combating a global threat locally,” May 20, 2020. Mattis, James. Department of Defense, “Summary Of The 2018 National Defense Strategy Of The United States Of America”. Meakins, Joss. “Living in (Digital) Denial: Russia’s Approach To Cyber Deterrence,” Russia Matters, July 2018. Ministry of Foreign Affairs of the Russian Federation. “Doctrine Of Information Security Of The Russian Federation,” Dec 5, 2016. Nakasone, Paul.  “Cybercom Commander Briefs Reporters At White House,” Department of Defense video briefing, Aug 2, 2018. National Security Agency, “NSA/CSS Technical Cyber Threat Framework V2”, a report from: Cybersecurity Operations The Cybersecurity Products And Sharing Division, 29 November 2018. Pettijohn and Wasser.  “Competing In The Gray Zone,” RAND Corporation, 2019.  Putin, Vladimir.  “Strategy of National Security of the Russian Federation,” Office of the President of the Russian Federation, Dec 31, 2015. Russian National Security Strategy 31 Dec 2015, Russia Matters. Snegovaya, Maria. “Putin’s Information Warfare In Ukraine: Soviet Origins Of Russia's Hybrid Warfare,” Institute for the Study of War, Sep 22, 2015. Tsygichko, V. N. “About Categories of “Correlation Of Forces” for Potential Military Conflicts in the New Era,” Symposium “Emerging Challenges In The Information Age,” 23 January 2002, Arlington, Virginia. Wiener, Norbert, Cybernetics: Or Control and Communication in the Animal and the Machine. Cambridge, Massachusetts: MIT Press, (1948). III. Indicators And Reference Charts We continue to favor stocks at the expense of bonds, but the risk of a tech-led correction has only grown. Moreover, the number of new COVID-19 cases in the US remains elevated and similarly disturbing trends are beginning to take shape in Europe. The recovery could hit a temporary pothole. Finally, as the November election approaches, political and geopolitical risks will come back on investors’ radar screens. Nonetheless, global monetary conditions remain highly accommodative and the risk of inflation in the short-term is minimal. Also, fiscal policy is extremely loose, and despite some procrastination, Congress will pass another large package by August 10, which will protect the economy against a violent relapse. Hence, the worst outcome over the coming three to five months is for the S&P 500 to retest of the 2800-2900 zone. On a cyclical basis, the same indicators that made us willing buyers of stocks since late March remain broadly in place. Stocks are expensive, but monetary conditions are extremely accommodative. Our Speculation Indicator continues to send a benign signal, which indicates that from a cyclical perspective, the market is not especially vulnerable. Finally, our Revealed Preference Indicator continues to flash a strong buy signal. Tactical indicators suggest that equities must digest the gains made since March 23. Both our Tactical Strength Indicator and the share of NYSE stocks trading above their 10-week moving average are elevated. Additionally, positioning in the derivatives market indicates some degree of vulnerability. Nonetheless, these risks must be put into perspective. Our Composite Sentiment Indicator is not flagging a top in the market and the AAII survey shows a predominance of bears over bulls. As a result, any correction should be limited to 10%. According to our Bond Valuation Index, Treasurys remain extremely expensive. Additionally, our Composite Technical Indicator continues to lose momentum. Guided by the FOMC’s communications, the market has decided that the recovery will lift inflation but that the Fed will stand pat. Consequently, yields are not moving up, but real rates are declining as inflation expectations inch higher. This trend is likely to be at a late stage, and the passage of additional fiscal support as well as a weak dollar will put a floor under real yields. In this context, Treasury yields should begin to rise in the closing months of 2020. The dollar breakdown has now fully taken shape. The greenback is expensive and its counter-cyclicality is a major handicap during a global economic recovery. Additionally, the US twin deficits are increasingly problematic. Fiscal deficits remain exceptionally wide and the household savings rate will not remain as elevated as it is today. The current account deficit is therefore bound to widen. The continued low level of real interest rates will complicate financing this deficit and to equilibrate the funding of US liabilities, the dollar will depreciate. Technically, our Composite Technical Indicator for the dollar has also broken down, which warns that a period of cyclical weakness has begun for the greenback. Nonetheless, our Dollar Capitulation Index is now in oversold territory, and a countertrend bounce is very likely in the coming weeks. Commodities are gaining traction. The Advance / Decline line for the Continuous Commodity Index has broken out to the upside, which suggests that the CCI could punch above its pre-COVID levels by yearend. A weak dollar, low real yields and a global industrial recovery are highly positive for natural resource prices. Within that asset class, gold has made new all-time highs. Gold is especially sensitive to lower real rates and a weak dollar. Sentiment and positioning for the yellow metal are stretched. Any rebound in economic sentiment could push real rates higher, which would cause gold to correct meaningfully in the near future, even if it remains in a cyclical uptrend. A dollar rebound is another tactical risk for gold. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see Emerging Markets Strategy Weekly Report "EM Equities: Concentration And Mania Risks," dated July 16, 2020, available at ems.bcaresearch.com 2 Please see US Equity Strategy Special Report "Revisiting Equity Sector Winners And Losers When Inflation Climbs," dated June 1, 2020, available at uses.bcaresearch.com 3 Please see US Equity Strategy Special Report “US Dollar Bear Market: What To Buy & What To Sell," dated June 22, 2020, available at uses.bcaresearch.com 4 Please see The Bank Credit Analyst Monthly Report “January 2020," dated December 20, 2019, available at bca.bcaresearch.com 5 Please see Geopolitical Strategy Special Report "What Is The Risk Of A Contested US Election?," dated July 27, 2020, available at gps.bcaresearch.com 6 Please see US Equity Strategy Insight Report "S&P 5 Versus S&P 495," dated July 23, 2020, available at uses.bcaresearch.com 7 Please see The Bank Credit Analyst Monthly Report "July 2020," dated June 25, 2020, available at bca.bcaresearch.com 8 Please see The Bank Credit Analyst Monthly Report "June 2019," dated May 30, 2019, available at bca.bcaresearch.com

Highlights China’s healthcare expenditure is projected to rise due to the increasing affluence and rapid aging of its population. The desire to access healthcare services beyond the basic coverage provided by the public health insurance will increasingly prompt people to purchase health insurance products from private insurers. We recommend going long Chinese insurance stocks in absolute terms. We also recommend accumulating and overweighting Chinese healthcare stocks on a 15% correction. Feature The aging population and the rapidly expanding middle class in China entail that healthcare expenditures will remain on a secular growth trajectory. The COVID-19 outbreak will function as a catalyst for the rapid transformation of China's healthcare system. In fact, many game changing trends in global healthcare systems will probably be attributed to the COVID-19 pandemic. Healthcare Expenditures: Still Low Health expenditures per capita in China grew substantially over the same period of time, but their level is still below those in most countries. Chart 1Chinese Healthcare Expenditure Will Grow 10% CAGR Chinese Healthcare Expenditure Will Grow 10% CAGR Chinese Healthcare Expenditure Will Grow 10% CAGR Health expenditures in China have grown considerably since the economic reforms started in 1978.  Between 1978 and 2018, total health expenditures in China grew at a compound annual growth rate (CAGR) of 17% in nominal terms, higher than the 15% growth in nominal GDP (Chart 1, top panel). Notwithstanding the rapid expansion of China’s healthcare market, expenditures remained at a modest 6.4% of China’s GDP in 2018 (Chart 1, bottom panel), far below the OECD average of 9%. Health expenditures per capita in China grew substantially over the same period of time, but their level is still below those in most countries. In 2017, health expenditures per capita in China were $841 in PPP (purchasing power parity) terms, ranking 92nd worldwide. Japan, by comparison, ranks 18th with $4,550, and Korea ranks 31th with $3,000, both in PPP terms (Chart 2). Chart 2China Ranks Low In Health Expenditure Per Capita Worldwide China: Healthcare Now And Beyond China: Healthcare Now And Beyond Healthcare Capacity And Healthy China 2030 Chart 3China Healthcare Capacities Are Rising Fast China Healthcare Capacities Are Rising Fast China Healthcare Capacities Are Rising Fast Access to adequate healthcare is crucial to social and economic development, as healthy human capital fosters productivity and economic growth. In China, healthcare capacity is still subdued. After the pandemic, authorities will divert resources to this sector to ensure it expands quickly. In 2018, the number of physicians and nurses per 1000 Chinese people was 2.6 and 2.9, respectively (Chart 3), far below the OECD average of 3.5 physicians and 8.8 nurses per 1,000 people. Hospital beds per 1000 people is 4.3 in China, compared to an average of 4.7 across OECD countries. In Japan and Korea, the measure is much higher, at 13.1 and 12.3 beds per 1,000 people, respectively (Chart 3, bottom panel). China released the Healthy China 2030 (HC 2030) blueprint in 2016, covering public health services, environmental management, the medical industry, and food and drug safety. The five specific goals of this blueprint are to improve the population’s health, control against major risks, increase the capacity of healthcare services, grow the scale of the healthcare industry, and improve the health service system generally. This program has set targets for health service capacity, including an increase in the number of doctors, nurses and beds per 1,000 people to 3, 4.7 and 6, respectively, by the year 2030. The blueprint also aims to further ease the financial burden imposed on the population by the cost of healthcare and medical treatments. Currently, in China, 29% of health costs are paid by individuals; HC 2030 recommends a reduction to 25%. We will discuss these objectives in the next section. Healthcare Financing: A Looming Funding Crunch The aging population, along with its rising income, will drive up health expenditures in the years to come. Chart 4China Elderly Population Will Rise Significantly China Elderly Population Will Rise Significantly China Elderly Population Will Rise Significantly There are currently more than 167 million people over the age of 65 in China. By this measure, China is already the largest eldercare market in the world in terms of the absolute number of elderly people. What is more, China’s elderly population is growing rapidly and is expected to reach almost 200 million by 2025 (Chart 4). The aging population, along with its rising income, will drive up health expenditures in the years to come. As health expenditures grow, so will investment opportunities. Global healthcare systems can generally be classified into the three categories shown in Table 1. China’s health insurance system more closely resembles Germany’s national social health insurance system than the US commercial health insurance model. China’s healthcare system and insurance scheme is illustrated in Table 2. Table 1Overview Of Major Healthcare Systems Worldwide China: Healthcare Now And Beyond China: Healthcare Now And Beyond Table 2Main Features Of China's Three Basis Social Health Insurance Schemes China: Healthcare Now And Beyond China: Healthcare Now And Beyond In 2000, just over 20% of Chinese citizens had healthcare coverage. The SARS outbreak in 2003 was a wake-up call for Chinese leaders. Thanks to heavy government subsidies and political commitments, China achieved universal health insurance coverage in 2011, when nearly 95% of its 1.4 billion people had health insurance. This represents the largest and fastest expansion of insurance coverage in human history. Chart 5Individuals Health Expenditures Remain High Individuals Health Expenditures Remain High Individuals Health Expenditures Remain High However, the government-sponsored health insurance plan provides for only basic coverage. Government budgetary spending accounted for 28% of total health expenditures in 2018 and the population’s out-of-pocket costs amounted to 29%, such that the remaining 43% was covered by the public social health insurance contributions (Chart 5). China’s health insurance is supervised at the national level and guided by the principle that all citizens are entitled to receive basic healthcare. Nevertheless, local governments are ultimately responsible for funding and offering these health services. This leads to unevenly distributed healthcare capacities across different provinces, as more resources are concentrated in wealthier jurisdictions. People can only receive a reimbursement for healthcare costs from their province of residence, as indicated on their hukou registration documents. Migrant urban professionals and laborers have to return to the place of their household registration to access healthcare. Chinese policy makers have been working on reforming the reimbursement system now for many years. As of the end of 2019, 3.95 million people have benefited from inter-provincial health insurance settlements. Relying heavily on local government contributions to healthcare expenditures is the primary reason why government spending on healthcare is relatively low, at only 1.7% of GDP and 7% of total general (central and local) government spending1 (Chart 6). Government expenditures on social security (which includes contributions to social health insurance, pension, unemployment and work injury insurance) make up 12% of overall government spending.1 The outbreak of COVID-19 sounded the alarm across Chinese society. Building a comprehensive and effective healthcare system with adequate capacity will become one of the most important priorities over the coming decade. The people’s well-being will be critical to social stability as its increasingly affluent population is asking for better healthcare services. Chart 6Government Spending In Healthcare Government Spending In Healthcare Government Spending In Healthcare Chart 7China: A Rapidly Aging Population China: A Rapidly Aging Population China: A Rapidly Aging Population However, the overall sustainability of the current healthcare financing scheme is questionable. Chart 7 shows the old age-dependency ratio, defined as the ratio of older dependents (people over the age of 64) to the working-age population (25 to 64-year old). The ratio is expected to increase from the current 19% to 30% in 2030. This means a decreasing contribution to social insurance budgets from the working population and an increase in healthcare spending on seniors. What makes the situation worse is the opacity of the National Social Security Fund (SSF). The SSF manages money reserved for pension and insurance disbursements related to medical, unemployment and injury needs for future use. Of the 2.6 trillion RMB under SSF management, at the end of 2019, over 90% are invested domestically. The fund’s average 10-year investment return is close to 6%, which is lower than the average nominal GDP growth rate of 11%, over the same period. With declining revenues from workforce contributions and rising healthcare costs, the ability of the social security system to finance proper healthcare service provisions  is endangered. Furthermore, the replenishing of the SSF, so far, has depended on central government contributions and asset transfers from state-owned enterprises to the SSF. Bottom Line: As demand for healthcare services increases, the current public scheme for financing healthcare is going to be increasingly unable to cover the costs. Private Health Insurance Private health insurance offers a more extensive level of protection than the state-based coverage. Currently, most private health insurance plans provide supplementary insurance products to complement public health insurance plans. Supplementary insurance and critical illness products are the most popular because the public insurance systems cannot fully cover the cost of catastrophic illnesses. The private health insurance industry has been thriving in recent years and is expected to continue growing  because of increased consumer awareness. The written premiums attributed to health insurance registered a compound annual growth rate of 36% between 2013 and 2019 (Chart 8). However, penetration into China’s health insurance market remains far behind that of more developed markets, signaling huge growth potential. One measure of insurance industry penetration is insurance depth. It is defined as the percentage of the GDP attributed to the total written premium for insurance. China’s insurance depth is currently 0.7% for health insurance and 4.2% for overall insurance (Chart 9), whereas the overall insurance depth is 11% in South Korea, 9% in Japan, and 7% in the US. Chart 8Health Insurance Premiums Are Skyrocketing Health Insurance Premiums Are Skyrocketing Health Insurance Premiums Are Skyrocketing Chart 9China: Health Insurance Penetration China: Health Insurance Penetration China: Health Insurance Penetration Faced with financial strains and a growing demand for healthcare services, the government is supporting private healthcare providers by relaxing regulatory restrictions and offering tax incentives to Chinese consumers when they buy health insurance. Private health insurance offers the growing middle-income class a more extensive level of protection than the state-based coverage. In regard to insurance companies’ asset management, the regulators raised the equity investment cap for all insurers earlier this month from 30% to 45% of total assets. In May of this year, regulators also allowed insurers to invest in the secondary capital bonds issued by banks, as well as in perpetual bonds. This expanded investment opportunity should help insurers diversify their investment portfolios and therefore increase the efficacy of their asset/liability management (ALM). Bottom Line:  Private health insurance offers the growing middle-income class a more extensive level of protection than the state-based coverage. This underdeveloped private insurance market presents substantial opportunities. Investment Conclusions As China’s population ages, incomes rise and private healthcare services expand, investment opportunities will also increase. In short, the growth trajectory of China’s healthcare sector warrants investors’ attention. To play on this healthcare theme in China, we are initiating two strategic investment positions: First, go long Chinese insurance companies in absolute terms. Chinese insurer stocks have rallied in absolute terms since March lows, but then lagged relative to the benchmark (Chart 10 & 11); Chart 10Chinese Insurance Stocks: Rising In Absolute Terms... Chinese Insurance Stocks: Rising In Absolute Terms... Chinese Insurance Stocks: Rising In Absolute Terms... Chart 11…But Underperforming The Benchmark ...But Underperforming The Benchmark ...But Underperforming The Benchmark Double-digit CAGR of insurance premiums entails a steady asset expansion (Chart 8 on page 8). High and steady growth at a time of a low discount factor warrants high equity multiples. The private insurance industry’s gross profit margin proxy, calculated as insurance premiums minus insurance payments, divided by insurance premiums, amount to a whopping of 67%, with health insurance at 65% and life insurance at 87% (Chart 12). The equity valuations are reasonable. Unlike the tech and media sectors of the new economy, that have sky-high multiples, the trailing price to earnings ratio for insurers is still 8.8, 45% lower than the 10-year average. (Chart 13). Chart 12Chinese Insurance Companies: Outstanding Gross Profit Margins Chinese Insurance Companies: Outstanding Gross Profit Margins Chinese Insurance Companies: Outstanding Gross Profit Margins Chart 13Attractive Valuations Attractive Valuations Attractive Valuations Insurance company assets will be better managed going forward due to the new asset/liability management (ALM) requirements imposed by the regulators. The ALM requirements were announced in March 2018 and then fully implemented in July 2019. The rules introduced quantitative risk-adjusted measurements to help insurers more accurately capture the risk of duration mismatch, negative spread and liquidity strain. The CBIRC regularly evaluates and ranks the competence of insurers’ ALM against peers. The key risk to shareholders of insurance companies is the credit risk of their portfolio. 39% of insurance sector portfolios are invested in other investments, which include long-term equity investments, project-based debt schemes, trust plans and asset management (Chart 14). Credit risks stemming from credit claims and asset management products warrant careful investor consideration. Chart 14Investment Portfolio Of The Insurance Industry China: Healthcare Now And Beyond China: Healthcare Now And Beyond Chart 15Healthcare Stocks Have Rallied Massively... Healthcare Stocks Have Rallied Massively... Healthcare Stocks Have Rallied Massively... Second, accumulate Chinese healthcare stocks on a 15% correction in absolute terms (Chart 15). While we believe that healthcare stocks are in a secular bull market, they have already rallied a lot since recent lows, and they are pricing in a lot of short-term good news. Chinese investable healthcare stocks registered 55% returns since the outbreak of COVID-19. The trailing P/E ratio reached 51, a decade high since 2010 (Chart 16). We are reluctant to buy and overweight this sector now and would wait for a better entry point. Chart 16...And Are Now Too Expensive ...And Are Now Too Expensive ...And Are Now Too Expensive   Lin Xiang, CFA Research Analyst LinX@bcaresearch.com   Footnotes 1Does not include quasi-fiscal (off-balance sheet) government spending.

Highlights The epicenter of the new Middle East crisis is the Shia Crescent, which threatens global oil supply. However, the escalation of conflict in the Mediterranean is also relevant to global investors. The crises in Libya and the Eastern Mediterranean are escalating as President Erdogan makes a last attempt to benefit from his relationship with Trump before US elections in November. A breakup between Turkey and NATO is not our base case, but European sanctions against Turkey are likely. Turkish risk will rise. A revival in Libyan oil production would not be a meaningful risk to the recovery in oil markets. Stay strategically long Brent crude oil. Libya could become a “Black Swan” for market participants exposed to southern Europe, Turkey, and North Africa. We remain short our EM Strongman Currency Basket versus other emerging market currencies. Feature Dear Clients, This week we present to you a special report on Turkey by my colleague Roukaya Ibrahim, Editor, Geopolitical Strategy. Roukaya argues that President Erdogan is at a crossroads in which he will confront major military and economic constraints to his foreign policy adventurism. On Monday, July 27 you will receive a special report that I co-wrote with Anastasios Avgeriou, chief strategist of our US Equity Strategy. In this report we continue our analysis of the equity sector implications of the upcoming US election. Anastasios also provides analysis of two cyclical sectors that you may find of interest. On Friday, July 31 we will send you our regular monthly GeoRisk Update, which surveys our proprietary, market-based geopolitical risk indicators and what they imply for your portfolio. We trust you will enjoy these reports and look forward to your feedback. All very best, Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Chart 1Shia Crescent' Flailing Under Maximum Pressure And COVID-19 Shia Crescent' Flailing Under Maximum Pressure And COVID-19 Shia Crescent' Flailing Under Maximum Pressure And COVID-19 The Middle East is suffering a wave of instability after the COVID-19 crisis just as it did in the years after the 2008 financial crisis. The crises in Libya, Syria, and Yemen were never resolved and now new crises are emerging from Egypt and Turkey to Iran and Iraq. By contrast with the “Arab Spring” of 2011, the epicenter of the political earthquake this time around is likely to be the “Shia Crescent,” i.e. Iran, Iraq, eastern Saudi Arabia, Syria, and Lebanon. The US policy of maximum pressure on Iran, which is intensifying in the lead-up to the US election, has weakened Iran and its sphere of influence (Chart 1). Chart 2Dominant Arab States Also Face Struggles Erdogan’s Neo-Ottoman Bid Hits Constraints Erdogan’s Neo-Ottoman Bid Hits Constraints Meanwhile the pandemic and collapse in oil prices have destabilized the predominantly Arab states (Chart 2). Authoritarian regimes like Egypt and Saudi Arabia that consolidated power after the Arab Spring are more stable than they were but still vulnerable to external and internal forces. These cyclical developments are occurring against the backdrop of structural changes like the US’s energy independence and strategic pivot to Asia, which have created a power vacuum in the Middle East. The pivot to Asia is rooted in US grand strategy and has proceeded across partisan administrations, so it will continue. Indeed US-China tensions are escalating rapidly in 2020 despite the financial market’s lack of interest. Turkey and Russia are scrambling to take advantage of the US’s withdrawal and gain greater influence through regional proxy wars. This year has seen a marked escalation of their involvement in Libya, where the war is re-escalating and drawing in Egypt, Europe, and Gulf Arabs. At minimum a Mediterranean conflict could affect oil prices as well as Turkish, Russian, and other regional financial assets. At maximum it could affect European assets, which are exposed to geopolitical risk in Turkey and North Africa. The Shia Crescent is the crisis’s epicenter, but Libya is also investment relevant. Bottom Line: The epicenter of the new Middle East crisis is the Shia Crescent, which threatens global oil supply. However, the escalation of conflict in the Mediterranean is also relevant to global investors, primarily through its potential to impact European assets. Re-Escalation In Libya The Libyan crisis has been escalating since the beginning of the year and is on the verge of turning into a major multilateral conflict. The risk now is that Egypt, another regional power, will intervene in Libya against Turkey in a battle for North African hegemony (Map 1). Map 1Libya Could Become A "Black Swan" Event Erdogan’s Neo-Ottoman Bid Hits Constraints Erdogan’s Neo-Ottoman Bid Hits Constraints Several incidents since we outlined Egypt’s red lines on the Libyan conflict suggest that Cairo and Ankara will clash in Libya (Table 1). Table 1Egypt And Turkey Up The Ante In Libya Erdogan’s Neo-Ottoman Bid Hits Constraints Erdogan’s Neo-Ottoman Bid Hits Constraints While Egypt has declared Sirte and al-Jufra as red lines, threatening military intervention if crossed, Turkey is calling for the Libyan National Army’s (LNA) withdrawal from these regions as a precondition for a ceasefire (Map 2). Egypt is allied with General Khalifa Haftar’s Libyan National Army, which is based in Benghazi and holds parliament in Tobruk. Map 2Libya’s Battlefront Is Closing In On The Oil Crescent Erdogan’s Neo-Ottoman Bid Hits Constraints Erdogan’s Neo-Ottoman Bid Hits Constraints The next move is now in Turkey’s hands. The escalation depends on whether it insists on moving forward toward Egypt’s red line. Turkey’s recent movements do not suggest it is backing down. True on July 21, and again on July 22, top officials from Turkey’s foreign ministry referred to a political solution as being the only solution in Libya. However, these statements were made while Turkey held diplomatic meetings with Niger and Malta that could be aimed at establishing airbases there.1 At its core, the conflict in Libya is a clash between the two dominant geopolitical forces in the Middle East. On the one hand, Turkey and Qatar are independent economic forces to Saudi Arabia and supporters of political Islam. On the other hand, Saudi Arabia, the UAE, and Egypt form an economic bloc and support Saudi religious authority and political authoritarianism. Bottom Line: The crisis in Libya is heading toward an Egypt-Turkey confrontation. Be ready for an escalation. Egypt Has More To Lose Than Turkey In Libya Both Egypt and Turkey are nearing a point of no return in Libya. A last-minute change of heart from either side would be increasingly more humiliating, both domestically and regionally. Chart 3Defeat In Libya Would Accelerate Erdogan’s Decline Erdogan’s Neo-Ottoman Bid Hits Constraints Erdogan’s Neo-Ottoman Bid Hits Constraints While Egypt’s geographic proximity to Libya makes it more interested in what goes on there and will give it a home advantage in any military confrontation, Egypt’s military may be overstretched as it is also at risk of conflict with Ethiopia over water resources.2 For Egypt, a victory would resuscitate its position as a regional power, bringing about a new era of greater Egyptian regional leadership. It would silence domestic skeptics who argue Egyptian President Abdel Fattah al-Sisi’s rule is based on the illegitimate ousting of Egypt’s only democratically elected leader. It would squash any prospect of a revival of the Muslim Brotherhood in Egypt and validate authoritarian rulers in the region. It could also annul the recent Libya-Turkey maritime demarcation agreement – a positive for Egypt’s natural gas ambitions. A loss would be a wake-up call for Egypt’s military, which has been spending scarce funds on costly equipment. It may also result in a change in leadership in Egypt or at the very least weaken al-Sisi’s domestic power and Egypt’s regional clout. The regime would persist over the short and medium term, but it would suffer a loss of legitimacy and the underground domestic opposition would intensify, creating a long-term threat. A complete defeat of LNA forces would pose a major security risk. Haftar’s LNA acts as a buffer between Egypt and unfriendly militias in Western Libya. Turkey does not have a vital national strategic interest in Libya and therefore the constraint pushing against on a protracted conflict is stronger than it is for Egypt. Given that Turkey is a democracy, President Recep Tayyip Erdogan has more to lose in the case of a military defeat. It would accelerate the decline in his popular support and that of his Justice and Development Party (AKP) (Chart 3). A conflict with Egypt is therefore a gratuitous gamble. However, victory would vindicate Erdogan’s efforts to create a strongman regime and revive memories of the great Ottoman empire.3 Such an accomplishment could mark a major turning point for Erdogan. His domestic blunders would be forgiven and he would be able to claim that he is one of the great leaders of Turkey. Given that Turkey lacks strategic necessity in Libya, and a defeat could dislodge Erdogan in 2023, one should expect Turkey not to cross Egypt’s red lines. However, Erdogan’s rule has been characterized by hubris, nationalism, and foreign assertiveness to distract from domestic economic mismanagement. Therefore we cannot have a high conviction that Turkey will bow to its political and military constraints. The risk of a large conflict is underrated. Bottom Line: Egypt has greater national interests at stake in Libya than Turkey. The implication is that Turkey should recognize Egyptian red lines. However, Turkey’s decision to intervene in Libya suggests that Erdogan could overreach. Libya could become a “Black Swan” for market participants exposed to southern Europe, Turkey, and North Africa. Will Turkey Break With NATO? Since signing the maritime and military cooperation agreements with Libya on November 27, Turkey has raised its stakes in Libya. Ankara has sent more armed drones, surface-to-air missile defense systems, naval frigates, a hundred officers, and up to 3,800 Syrian fighters. It has rolled back all of the strategic gains that the Libyan National Army made in 2019. The timing of the recent escalation is significant. The US election cycle offers Erdogan a chance to increase Turkey’s foreign assertiveness with minimal US retaliation. US-Turkish relations have been icy for years. Turkey is an ascendant regional power that is pursuing an increasingly independent national policy, while the US is no longer as dominant of a global hegemonic power capable of enforcing discipline among minor allies. The US alliance with the Kurds in Syria and Iraq has alienated Turkey. The 2016 Turkish coup attempt also increased the level of distrust between the two states. However, President Trump’s personal and political affinity for President Erdogan has resulted in a permissive policy toward Turkey. Trump seeks to distance the US from conflicts in Syria and Libya inherited from his predecessor. He has little commitment to the Kurds. More broadly he has embraced geopolitical multipolarity and avoided telling Erdogan what to do. The Trump administration has not retaliated against Turkey for purchasing Russia’s S400 missile defense system or for pursuing expansive maritime-territorial claims near Cyprus. Even though the Turkish arms purchase makes it eligible for sanctions under the Countering America’s Adversaries Through Sanctions Act (CAATSA), the Trump administration has yet to impose sanctions. Senator Lindsey Graham, who is close to the Trump administration, suggested in July 2019 that sanctions could be avoided if Turkey did not activate the system.4 Turkey, for its part, has yet to activate the system three months after the April target date for activation. Turkey blames the delay on COVID-19. With regard to Libya, the Trump administration has remained largely on the sidelines. It has promised to reduce American commitment to overseas conflicts and has criticized the Obama administration’s intervention in Libya in 2011 to bail out the European allies. Officially the US is aligned with Fayez al-Sarraj’s UN-backed Government of National Accord (GNA), but so far its role has been minimal, refraining from providing any military support. Moreover, Washington’s key allies in the region – Egypt, Saudi Arabia, the UAE, even France – support the Libyan National Army. Libya could become a “Black Swan” event. It is Haftar’s other main backer – Russia – that would present an incentive for greater American involvement. The US African Command reports that two thousand Russian mercenaries from the Kremlin-backed Wagner Group have fought in Libya. The US also reported in June that at least 14 MiG29 and Su-24 Russian warplanes were sent to Libya via Syria, believed to be located in the al-Jufra airbase. Moreover, the US State Department has accused Russia of printing billions of fake Libyan dinars to fund Haftar’s forces.5 The Trump administration has been permissive toward Russia as well as Turkey, letting them work out deals with each other, but US electoral politics could prompt Trump to make shows of strength against Russia to fend off criticism. Thus the months in the lead up to the US elections offer the Turkish leader what may be a closing opportunity to increase the country’s foreign assertiveness with minimal US retribution. If Trump loses, Erdogan may face a less sympathetic Washington. By contrast France, also a NATO ally, has taken a stronger position against Ankara over its involvement in Libya. Relations with other eastern Mediterranean countries have also been rocky due to Turkey’s exclusion from gas deals in the region and drilling in disputed waters near Cyprus and Greece. France has a commercial interest in Libya’s oil industry and backs Haftar’s Libyan National Army to some extent.6 Citing aggressive behavior by Turkish warships after an encounter in the Mediterranean, France suspended its involvement in NATO’s Operation Sea Guardian on July 1.7 France has also demanded EU sanctions against Turkey – both for its drilling activities around Cyprus as well as for its role in Libya.8 Still, Europeans have little appetite for direct intervention in Libya. The leaders of France, Italy and Germany have threatened sanctions against foreign states that violate the arms embargo in Libya. This warning comes after EU foreign ministers agreed to discuss the possibility of another set of sanctions against Turkey in their August meeting if Turkey persists in converting the Hagia Sophia from a museum to a mosque. Despite the fracturing within NATO, the alliance will not break up. Turkey’s geographic proximity to Russia, large number of troops, and military strength make it an essential member of the defense treaty (Chart 4). Chart 4NATO Will Not Break With Turkey Erdogan’s Neo-Ottoman Bid Hits Constraints Erdogan’s Neo-Ottoman Bid Hits Constraints Instead, the Europeans will retaliate against Erdogan’s foreign adventurism through sanctions, while maintaining the NATO alliance. This acts as a cyclical rebuke without damaging the secular relationship. Europe will use sanctions to retaliate against Turkey’s provocations. The Europeans will be particularly rattled if Turkey succeeds in its North African endeavor and amasses significant regional power as a result. Victory in Libya would make Turkey the gatekeeper to two major migrant entry points to the European continent, providing Ankara with leverage in its negotiations with Europe (Chart 5). It would also increase the likelihood that Turkey increases its assertive behavior in the Eastern Mediterranean, where Israel, Egypt, Greece, Cyprus, and Italy are seeking to develop a natural gas hub. Chart 5Turkish Victory In Libya Would Rattle Europe Erdogan’s Neo-Ottoman Bid Hits Constraints Erdogan’s Neo-Ottoman Bid Hits Constraints Although Erdogan shows no signs of backing down, constraints suggest that Erdogan may pull back from being perceived as overly provocative. The Turkish economy is highly dependent on Europe in trade and capital flows (Chart 6). Thus unlike American sanctions, which have little bearing on the Turkish economy short of radical financial measures, European sanctions suppress any chance of an economic recovery. Chart 6European Sanctions Would Reverse Turkey's Recovery European Sanctions Would Reverse Turkey's Recovery European Sanctions Would Reverse Turkey's Recovery Chart 7Erdogan Risks Popularity By Overstepping In Libya And East Med Erdogan’s Neo-Ottoman Bid Hits Constraints Erdogan’s Neo-Ottoman Bid Hits Constraints Turkey’s frail economy and crackdown on opposition parties could weigh on Erdogan’s approval, which is losing its COVID-induced bounce (Chart 7). Thus, as in the case of Egypt, Erdogan should recognize these constraints and reduce his foreign assertiveness. If he does not, then he will hit up against material constraints that will harm the Turkish economy. Bottom Line: The Libyan crisis is escalating as Erdogan makes a last attempt to benefit from his relationship with Trump before US elections in November. Washington’s detached stance in Libya highlights that its foreign policy priorities lie elsewhere – in Asia and Iran. Meanwhile, Europe is divided over Libya. A breakup between Turkey and NATO is not our base case, but new European sanctions against Turkey are not unlikely. A Turkish victory in Libya would lead to a significant escalation in tensions between Turkey and the West. Investment Implications Turkish geopolitical risk is set to rise in the lead up to the November US elections as Turkey becomes increasingly embroiled in foreign conflicts – in Libya, Syria, Iraq, and most recently in the Azerbaijan-Armenia conflict (Chart 8). Ankara’s more provocative stances raise the risk of sanctions from the US and more significantly from the EU. This would hurt Turkish risk assets at a time of already heightened vulnerability. If Turkey manages to secure a victory in Libya, it would benefit economically from construction and energy contracts there. However, it would also result in a significant uptick in geopolitical tensions in the Middle East as the West and the West’s regional allies will be disturbed by Ankara’s expanding influence. Stay short our EM Strongman Currency Basket composed of the Turkish lira, Philippine peso, and Brazilian real versus other emerging market currencies. Even though the lira is already cheap against the US dollar, it faces more downside due to the risks highlighted in this report and the massive growth in money supply in Turkey. Similarly, the prospect of a military confrontation will raise the equity risk premium priced in Egyptian stocks. Egypt will continue underperforming emerging markets as long as it remains invested in an unsettled conflict in Libya (Chart 9). Chart 8Turkish Risk Will Rise Turkish Risk Will Rise Turkish Risk Will Rise Libyan oil exports are unlikely to stage a major revival anytime soon (Chart 10). Although the Libyan National Oil Company lifted force majeure on July 10, Haftar’s Libyan National Army reintroduced the blockade a day later. Clashes are also occurring near oil facilities in the Brega region where Syrian, Sudanese, and Russian Wagner Group mercenaries currently have a presence. Chart 9Egyptian Risk Assets Will Underperform Egyptian Risk Assets Will Underperform Egyptian Risk Assets Will Underperform Chart 10Libyan Oil Handicapped By Haftar’s Blockade Erdogan’s Neo-Ottoman Bid Hits Constraints Erdogan’s Neo-Ottoman Bid Hits Constraints Chart 11Stay Bullish Euro Over The Long Run Stay Bullish Euro Over The Long Run Stay Bullish Euro Over The Long Run Even in the best-case scenario, in which force majeure is promptly lifted, the blockade damaged both the reservoirs and oil and gas infrastructure, preventing a resurgence of exports to pre-January levels. The Libyan National Oil Company warned that unless oil production restarts immediately, output will average 650,000 barrels per day in 2022. This is significantly less than the over 1 million barrels per day just prior to the blockade, and the 2.1 million barrels per day Libya had planned to produce by 2024. In any case these figures pale in comparison to the production curtailments currently in place by OPEC 2.0, which are set to decrease to 8.3 million barrels per day beginning in August from 9.6 million barrels per day now. Given OPEC 2.0’s demonstrated commitment to production discipline, a revival in Libyan oil production is not a meaningful risk to the recovery in oil markets. We remain strategically long Brent crude oil, which is up 78% since inception in March. This trade could experience near-term volatility due to any hiccups in global economic stimulus or risk-off events from geopolitical risks. But over a 12-month time frame we expect oil prices to rise higher. BCA Research’s Commodity & Energy strategists expect Brent prices to average $44/bbl in 2H2020, and $65/bbl in 2021. The recent rise in the euro is rooted in global macro and structural factors but a major Mediterranean crisis and/or other geopolitical risks we have highlighted surrounding the US election cycle could create headwinds in the short term. Over the long run we are bullish euro (Chart 11).   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com   Footnotes 1 In Niger, Turkish Foreign Minister Mevlut Cavusoglu met with his Nigerien counterpart and stated the two states’ willingness to boost bilateral relations in agriculture, mining, energy, industry, and trade. A day earlier, Turkey and Qatar’s defense ministers met with Libya’s minister of interior in Ankara to discuss the situation in Libya. And on July 20, a trilateral meeting was held between Turkey’s defense minister, Libya’s interior minister, and Malta’s minister of home affairs and national security. The inclusion of Malta – located just north of Libya in the Mediterranean – is perplexing. The three discussed defense cooperation and efforts toward regional stability and peace. These recent meetings could suggest that Turkey is negotiating agreements to fortify its strategic approaches to Libya. This could involve greenlighting airbases in Niger and Malta in exchange for economic support and Qatari funding. 2 The latest developments suggest that the Egypt-Ethiopia conflict is de-escalating. On July 21, Ethiopian Prime Minister Abiy Ahmed tweeted that Egypt, Ethiopia and Sudan had reached a “common understanding on continuing technical discussions on filling.” But Ethiopia will have an opportunity if Egypt becomes embroiled in Libya. 3 The Turks ruled Tripolitania from the mid-1500s until Italy’s 1912 victory in the Italo-Turkish War. Surveys conducted by Metropoll reveal that the share of Turks with a positive perception of Turkey’s active role in Libya shot up to 58% in June from 35% in January. 4 Senate Majority Whip John Thune has even proposed using the US Army’s missile procurement account to buy the Russian missiles from Turkey, thus reducing tensions between the two NATO allies. This is unlikely to occur because it would look politically weak in the US, while Turkey would face Russian pressure. The US suspended Turkey from the F35 Joint Strike Fighter program, banning it from purchasing F35s, and removing it from the aircraft’s production program. US Secretary of Defense Mark Esper stated that the US would only consider allowing Turkey back into the F35 Joint Strike Program if the Russian defense system were moved out of the country. The Turkish purchase of the Russian defense system was partly driven by the need to work with Russia and partly driven by Erdogan’s desire to reduce the risk of another coup attempt. Ankara was indefensible against the Turkish Air Force’s F-16s during the 2016 coup attempt since its military relies heavily on US built missile defense. 5 Moscow has denied all allegations of involvement in Libya. 6 US-made javelin missiles purchased by France were found at the pro-Haftar base in Gharyan in June last year, raising suspicion that France was backing Haftar’s offensives. 7 On June 10, French frigate Courbet approached a Tanzanian-flagged ship heading to Libya in suspicion that it was violating the UN arms embargo. France accused three Turkish vessels that were escorting the Tanzanian vessel of harassment by targeting the Courbet’s fire control radars. Turkey denied harassing the Courbet and maintains that the Tanzanian vessel was transporting humanitarian aid to Libya. A NATO investigation into the incident was inconclusive. 8 The EU agreed to impose sanctions on two Turkish oil company officials in February in protest against Turkish drilling activity in the Eastern Mediterranean. However these sanctions are mostly just political symbolism.

Highlights The EU’s €750 billion fiscal package, along with another round of US stimulus likely exceeding $1 trillion, will support global oil demand. On the supply side, OPEC 2.0’s production discipline likely holds, and US shale output will remain depressed. These fundamentals, along with a weakening USD, will continue to support Brent prices, which are up 129% from their lows in April. China’s record-setting crude-oil-import surge during the COVID-19 pandemic – averaging 12.7mm b/d in 1H20, up 28.5% y/y – is at risk of slowing in 2H20, as domestic storage fills. Supply-side risks are acute: Massive OPEC 2.0 spare capacity – which could exceed 6mm b/d into 2021 – will tempt producers eager to monetize these to boost revenue. On the demand side, COVID-19 infection rates are surging in the US. Progress on vaccines notwithstanding, politically intolerable public-health risks in big consuming markets could usher in demand-crushing lockdowns again. Economic policy uncertainty remains elevated globally, but the balance of risks continues to favor the upside: We expect 2H20 Brent prices to average $44/bbl, and 2021 prices to average $65/bbl, unchanged from last month’s forecast. Feature We are marginally lifting our forecast of average 2020 Brent prices to $43/bbl, with 2H20 expected to average $44/bbl, and $65/bbl next year, unchanged from June. Marginal improvements to preliminary supply and demand estimates earlier in the COVID-19 pandemic support the thesis that fundamentals will not derail the massive oil-price rally that lifted Brent 129% from its April 21 low of $19.30/bbl. A weakening US dollar, and the expectation this trend will continue, also is supportive to commodities in general, oil in particular. As a result, we are marginally lifting our forecast of average 2020 Brent prices to $43/bbl, with 2H20 expected to average $44/bbl, and $65/bbl next year, unchanged from June (Chart of the Week). The three principal oil-market data providers – the US EIA, IEA and OPEC – raised demand estimates at the margin for 1H20, particularly for 2Q20, the nadir for global oil consumption. The EIA’s estimate for 2Q20 demand shows an upward revision of 550k b/d from last month’s estimate. On the supply side, the EIA estimates global output fell -8.1mm b/d in 2Q20, a -300k b/d downward revision vs. its estimate from last month (Chart 2). Chart of the WeekOil Price Rally Remains Intact Oil Price Rally Remains Intact Oil Price Rally Remains Intact Chart 2OPEC 2.0, US Shale Production Cuts Deepen OPEC 2.0, US Shale Production Cuts Deepen OPEC 2.0, US Shale Production Cuts Deepen We continue to expect the drawdown in storage levels to flatten – and then backwardate – the forward curves for Brent and WTI. After accounting for this better-than-expected fundamental performance, we now expect global supply to fall 5.9mm b/d in 2020 and to increase 4.2mm b/d in 2021. On the demand side, we now expect 2020 demand to fall 8.1mm b/d vs. 8.9mm b/d last month, and for 2021 demand to rise 7.8mm b/d vs 8.5mm b/d in June (Chart 3). This will keep the physical deficit we’ve been forecasting for 2H20 and 2021 in place, allowing OECD storage to fall to 3,026mm barrels by year-end and to 2,766mm barrels by the end of next year (Chart 4). Chart 3Supply-Demand Balances Tighten ... Supply-Demand Balances Tighten ... Supply-Demand Balances Tighten ... Chart 4... Leading To Deeper Storage Draws ... ... Leading To Deeper Storage Draws ... ... Leading To Deeper Storage Draws ... We continue to expect the drawdown in storage levels to flatten – and then backwardate – the forward curves for Brent and WTI (Chart 5). One caveat, though: We are watching floating storage levels closely, particularly in Asia: The current structure of the Brent forwards does not support carrying floating inventory, but it’s been slow moving lower (Chart 6). This could reflect a slowing in China’s crude-oil import surge, which hit record levels in May and June. Chart 5... And More Backwardation In Brent And WTI Forwards ... ... And More Backwardation In Brent And WTI Forwards ... ... And More Backwardation In Brent And WTI Forwards ... Chart 6… Even As Floating Storage In Asia Remains Elevated Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside China’s Crude-Import Binge Ending? There is a non-trivial risk China’s crude-buying binge during the COVID-19 pandemic, which supported prices during the brief Saudi-Russian market-share war in March and the collapse in global demand in 2Q20, may have run its course (Chart 7).1 At the depths of the global pandemic in 2Q20, China’s year-on-year (y/y) crude imports surged 15%. According to Reuters, China’s crude oil imports totaled 12.9mm b/d in June, a record level for the second month in a row.2 Much of this was converted to refined products – chiefly gasoline and diesel fuel – as China’s demand recovered from the global pandemic (Chart 8). China’s 208 refineries can process 22.3mm b/d of crude, according to the Baker Institute at Rice University in Houston.3 Refinery runs in June were estimated at just over 14mm b/d by Reuters. Chart 7China's Crude Import Binge Stalls China's Crude Import Binge Stalls China's Crude Import Binge Stalls Chart 8China's Refiners Lift Runs As Imports Surge China's Refiners Lift Runs As Imports Surge China's Refiners Lift Runs As Imports Surge A reduction in China’s crude imports would force barrels to either remain on the water until refiners find a need for it, or demand for refined products increases in the region. China imports its oil into 59 port facilities, which can process ~ 16mm b/d. Storage is comprised of 74 crude oil facilities holding ~ 706mm barrels, and 213 refined-product facilities with capacity to hold ~ 357mm barrels of products (Map 1). By Reuters’s count, ~ 2mm b/d of crude went into storage in the January-May period, while close to 2.8mm b/d was stored in June. Official storage data is a state secret, so it is not possible to determine whether China’s crude and product storage is full. However, if crude oil imports remain subdued – and floating storage in Asia remains elevated – we would surmise the Chinese storage facilities are close to full. Additionally, any sharp and sustained increase in refined product exports would indicate storage is brimming. Map 1Baker Institute China Oil Map Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside A reduction in China’s crude imports would force barrels to either remain on the water until refiners find a need for it, or demand for refined products increases in the region. We expect the latter condition to obtain, in line with our expectation of a global recovery in demand, even though China remains out of sync with the rest of the world presently. China was the first state to confront the pandemic and first to emerge out of it; its trading partners still are in various stages of recovery (Chart 9). Chart 9China's Demand Recovery Likely Will Be Choppy China's Demand Recovery Likely Will Be Choppy China's Demand Recovery Likely Will Be Choppy OPEC 2.0’s Remains Sensitive To Demand Fluctuations OPEC 2.0’s leaders – the Kingdom of Saudi Arabia (KSA) and Russia – also managed to secure additional “compensation” cuts from members that have missed their targets in previous months. The asynchronous recovery in global oil demand poses a unique problem for OPEC 2.0 this year and next. OPEC 2.0 will be easing production curtailments to 7.7mm b/d beginning in August from 9.6mm b/d in July, on the advice of its Joint Ministerial Monitoring Committee (JMMC). This is a decision that will be closely monitored, amid rising concern over the speed of demand recovery in the US and EM economies, due to mounting COVID-19 cases (Chart 10). The surge in US infections relative to its trading partners is of particular concern, given the size of US oil demand (Chart 11). In 2H20, we expect US demand will account for close to 20% of global demand, much the same level it was prior to the pandemic (Table 1). Chart 10COVID-19 Infections Surge In The US Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside Chart 11US COVID-19 Infections Are A Risk To Global Commodity Demand Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside OPEC 2.0’s leaders – the Kingdom of Saudi Arabia (KSA) and Russia – also managed to secure additional “compensation” cuts from members that have missed their targets in previous months, bringing the actual increase in production closer to 1-1.5mm b/d. Together, Iraq, Nigeria, Kazakhstan, and Angola, over-produced versus their May and June targets by ~ 760k b/d. In our balances estimates, as is our normal practice, we haircut these estimates and use a lower compliance level that those stated in the official OPEC 2.0 agreement. In the case of these producers, we assume they will compensate for ~ 70% of their overproduction, bringing the adjusted cuts to ~ 8.3mm b/d. This should be sufficient to maintain the current supply deficit in oil markets that continues to support Brent prices above $40/bbl. However, the reliance on laggards’ extra cuts to balance markets adds instability. There is a lot of supply on the sidelines from the OPEC 2.0 cuts and the restart of the Neutral Zone shared by Saudi Arabia and Kuwait. The JMMC is continually assessing supply-demand balances and remains focused on making sure the totality of the cuts does not fall on a small group of countries. It reiterated its position that “achieving 100% conformity from all participating Countries is not only fair, but vital for the ongoing rebalancing efforts and to help deliver long term oil market stability.” In June, OPEC 2.0’s overall compliance was 107% – mostly reflecting over-compliance from KSA, the UAE, and Kuwait.4 There is a lot of supply on the sidelines from the OPEC 2.0 cuts and the restart of the Neutral Zone shared by Saudi Arabia and Kuwait. The US EIA estimates that within the original OPEC cartel spare capacity will average close to 6mm b/d this year, the first time since 2002 that it has exceeded 5mm b/d. On top of this, there’s the looming downside risk of a new Iran deal if Democrats win the White House and Congress in US elections in November, and a possible restart of Libyan exports this year. Watch The DUCs In The US With WTI prices averaging $41/bbl so far in July, we continue to expect part of previously shut-in US production to come back on line in July, August and September. Nonetheless, the negative effect of the multi-year low rig count will be felt heavily in 4Q20 and 1Q21 and will push production lower. The rig count appears to be bottoming but is not expected to increase meaningfully until WTI prices move closer to $45-50/bbl. On average it takes somewhere between 9-12 months for the signal from higher prices to result in new oil production flowing to market in the US. As the rig count moves back up in 2021, its effect on production will be apparent only in late-2021. However, the massive inventory of drilled-but-uncompleted (DUC) wells in the main US tight-oil basins will provide a source of cheaper new supply, if WTI prices remain above $40/bbl. DUCs are 30-40% cheaper to complete compared to drilling a new well from start. We expect DUCs completion will begin adding to US crude output in 1Q21, and that this will continue to be a source of supply beyond 2021. Bottom line: Global economic policy uncertainty remains elevated, albeit off its recent highs (Chart 12). We expect this uncertainty to continue to wane, which will allow the USD to continue to weaken. This will spur global oil demand, and will augment the fiscal and monetary stimulus to the COVID-19 pandemic undertaken globally. Chart 12Global Policy Uncertainty Remains High, Which Could Support USD Demand Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside Nonetheless, the global recovery remains out of sync, which complicates OPEC 2.0’s production management, and markets’ estimation of supply-demand balances. Uneven success in combating the pandemic keeps the risk of lockdowns on the radar in the US. Policy is driving oil production at present, and, given the temptation to monetize spare capacity, the supply side remains a risk to prices. We continue to see upside risk dominating the evolution of prices and are maintaining our expectation Brent prices will average $44/bbl in 2H20 – lifting the overall 2020 average to $43/bbl – and $65/bbl next year. Our expectation WTI will trade $2-$4/bbl below Brent also remains intact.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com     Commodities Round-Up Energy: Overweight Canadian oil production averaged 4.6mm b/d in 2Q20 vs. 5.5mm b/d in 2Q19, based on EIA estimates. The lack of demand from US refiners – crude imports from Canada fell by 420k b/d y/y during the quarter – and close to maxed-out local storage facilities pushed prices below cash costs, forcing the shut-ins of more than 1mm b/d of crude production. Canadian energy companies started releasing their 2Q20 earnings this week and analysts expect the results to be one of the worst ever recorded, reflecting the extent of the pain producers felt during the COVID-19 shock. Base Metals: Neutral High-grade iron ore prices (65% Fe) were trading above $120/MT this week, on the back of forward guidance from the commodity’s top exporter, Brazilian miner Vale, which suggested exports will be lower than had been previously estimated this year, according to Fastmarkets MB, a sister service of BCA Research. This is in line with an Australian Department of Industry, Science, Energy and Resources analysis in June, which noted, “The COVID-19 pandemic appears to have affected both sides of the iron ore market: demand disruptions have run up against supply problems localised in Brazil, where COVID-19-related lockdowns have derailed efforts to recover from shutdowns in the wake of the Brumadinho tailings dam collapse” (Chart 13). Precious Metals: Neutral Our long silver position is up 17.5% since it was recommended July 2. We are placing a stop-loss on the position at $21/oz, our earlier target, given the metal was trading ~ $22/oz as we went to press. The factors supporting gold prices – chiefly low real rates in the US, a weakening dollar and global monetary accommodation, also support silver prices. However, silver also will benefit from the recovery in industrial activity and incomes we anticipate in the wake of global fiscal and monetary stimulus, which will drive demand for consumer products (Chart 14). Ags/Softs:  Underweight Lumber prices have more than doubled since April lows. The uncertainty brought by the COVID-19 health emergency altered the perception of future housing demand and, by extension, lumber demand, to the point that mills responded by substantially decreasing capacity utilization rates. However, in the wake of global monetary and fiscal stimulus, housing weathered the storm better than expected. Furthermore, a surge in DIY projects from individuals working from home at a time of reduced supply contributed to the current state of market shortage. Chart 13Lower Supply Supports Iron Ore Prices Lower Supply Supports Iron Ore Prices Lower Supply Supports Iron Ore Prices Chart 14Silver Favored Over Gold Silver Favored Over Gold Silver Favored Over Gold         Footnotes 1     In our reckoning, a non-trivial risk is something greater than Russian roulette odds – i.e., a 1-in-6 chance of an event occuring. Re the ever-so-brief Saudi-Russian market-share war, please see KSA, Russia Will Be Forced To Quit Market-Share War, which we published March 19, 2020. It is available at ces.bcaresearch.com. 2     Please see COLUMN-China's record crude oil storage flies under the radar: Russell published by reuters.com July 20, 2020. 3    The Baker Institute’s Open-Source Mapping of China's Oil Infrastructure was last updated in March 2020. The map is “a beta version and is likely missing some pieces of existing infrastructure. The challenge of China’s geographic expanse — it is roughly the same area as the U.S. Lower 48 — is compounded by a lack of transparency on the part of China’s government,” according to the Baker Institute. 4    In our supply-side estimates, we used IEA estimates of cuts for June this month. This doesn’t change the overall estimate of cuts from our earlier analysis; however, it slightly changes how the 9.7mm b/d was split between OPEC 2.0 members. the official eased cuts are 7.7mm b/d from 9.7mm b/d in May-June-July, but it actually is closer to 8.3mm b/d accounting for the compensation from the countries mentioned above.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Balance Of Oil-Price Risk Remains To The Upside Balance Of Oil-Price Risk Remains To The Upside