Financial Markets

Executive Summary Investors Think The Fed Will Not Be Able To Raise Rates Much Above 2% Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? The neutral rate of interest is 3%-to-4% in the United States. This is substantially higher than the market estimate of around 2%. It is also higher than the central tendency range for the Fed’s terminal interest rate dot, which remained at 2.3%-to-2.5% following this week’s FOMC meeting. If the neutral rate turns out to be higher than expected, this is arguably good news for stocks over the short-to-medium term because it lowers the risk that the Fed will accidentally induce a recession this year by bringing rates into restrictive territory. Over a longer-term horizon of 2-to-5 years, however, a higher neutral rate is bad news for stocks because it means that investors will eventually need to value equities using a higher discount rate. It also means that the Fed could find itself woefully behind the curve in normalizing monetary policy. Bottom Line: Global equities will rise over the next 12 months as the situation in Ukraine stabilizes, commodity prices recede, and inflation temporarily declines. Stocks will peak in the second half of 2023 in advance of a second, and currently unexpected, round of Fed tightening beginning in late-2023 or 2024.   Dear Client, Instead of our regular report next week, we will be sending you a Special Report written by Matt Gertken, BCA Research’s Chief Geopolitical Strategist, discussing the geopolitical implications of the war in Ukraine. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. As always, I will hold a webcast discussing the outlook the week after, on Thursday, April 7th. Best regards, Peter Berezin Chief Global Strategist https://www.linkedin.com/in/peter-berezin-1289b87/ https://twitter.com/BerezinPeter A Two-Stage Fed Tightening Cycle The FOMC raised rates by 25 basis points this week, the first of seven rate hikes that the Federal Reserve has telegraphed in its Summary of Economic Projections for the remainder of 2022. We expect the Fed to follow through on its planned rate hikes this year, but then go on pause in early-2023, as inflation temporarily comes down. However, the Fed will resume raising rates in late-2023 or 2024 once inflation begins to reaccelerate and it becomes clear that monetary policy is still too easy. This second round of monetary tightening is currently not anticipated by market participants. If anything, investors think the Fed is more likely to cut rates than raise rates towards the end of next year (Chart 1). The Fed’s own views are not that different from the markets’: The central tendency range for the Fed’s terminal interest rate dot remained at 2.3%-to-2.5% following this week’s FOMC meeting, with the median dot actually ticking lower to 2.4% from 2.5% (Chart 2). Image Chart 2The Fed Is Still In The Secular Stagnation Camp The Fed Is Still In The Secular Stagnation Camp The Fed Is Still In The Secular Stagnation Camp A Higher Neutral Rate Image Our higher-than-consensus view of where US rates will eventually end up reflects our conviction that the neutral rate of interest is somewhere between 3% and 4%. One can think of the neutral rate as the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.1 Anything that reduces savings or increases investment would raise the neutral rate (Chart 3). As we discussed last month, a number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 4). Household wealth has soared since the start of the pandemic (Chart 5). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by nearly 4% of GDP. Image Chart 5Net Worth Has Soared Since The Pandemic Net Worth Has Soared Since The Pandemic Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 6). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. Banks are easing lending standards on consumer loans across the board. Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 7). As baby boomers transition from savers to dissavers, national savings will decline. Chart 6US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated Chart 7Baby Boomers Have Amassed A Lot Of Wealth Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 8). On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.2 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 9). Chart 8Fiscal Policy: Tighter But Not Tight Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? Chart 9Much Of The Deceleration In Potential Growth Has Already Happened Much Of The Deceleration In Potential Growth Has Already Happened Much Of The Deceleration In Potential Growth Has Already Happened After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 10). Capex intention surveys remain upbeat (Chart 11). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 12). Chart 10Positive Signs For Capex (I) Positive Signs For Capex (I) Positive Signs For Capex (I) Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 13). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 11Positive Signs For Capex (II) Positive Signs For Capex (II) Positive Signs For Capex (II) Chart 12An Aging Capital Stock An Aging Capital Stock An Aging Capital Stock Chart 13Housing Is In Short Supply Housing Is In Short Supply Housing Is In Short Supply The New ESG: Energy Security and Guns The war in Ukraine will put further pressure on the neutral rate, especially outside of the United States. Chart 14European Capex Should Recover European Capex Should Recover European Capex Should Recover After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 14). Capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Meanwhile, European governments are trying to ease the burden from rising energy costs. France has introduced a rebate on fuel starting on April 1st. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. Other countries are considering similar measures. European military spending will also rise. Germany has already announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate potentially several million Ukrainian refugees. A Smaller Chinese Current Account Surplus? Chart 15Will China Be A Source Of Excess Savings? Will China Be A Source Of Excess Savings? Will China Be A Source Of Excess Savings? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 15). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic investment on infrastructure and/or consumption. Notably, the IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. The Path to Neutral: The Role of Inflation If one accepts the premise that the neutral rate in the US is higher than widely believed, what will the path to this higher rate look like? Image The answer hinges critically on the trajectory of inflation. If inflation remains stubbornly high, the Fed will be forced to hike rates by more than expected over the next 12 months. In contrast, if inflation comes down rapidly, then the Fed will be able to raise rates at a more leisurely pace. As late as early February, one could have made a strong case that US inflation was set to fall. The demand for goods was beginning to moderate as spending shifted back towards services. On the supply side, the bottlenecks that had impaired goods production were starting to ease. Chart 16 shows that the number of ships anchored off the coast of Los Angeles and Long Beach has been trending lower while the supplier delivery components of both the ISM manufacturing and nonmanufacturing indices had come off their highs. Since then, the outlook for inflation has become a lot murkier. As we discussed last week, the war in Ukraine is putting upward pressure on commodity prices, ranging from energy, to metals, to agriculture. BCA’s geopolitical team, led by Matt Gertken, expects the war to worsen before a truce of sorts is reached in a month or two. Meanwhile, a new Covid wave is gaining momentum. New daily cases are rising across Europe and have exploded higher in parts of Asia (Chart 17). In China, the number of new cases has reached a two-year high. The government has already locked down parts of the country encompassing 37 million people, including Shenzhen, a major high-tech hub adjoining Hong Kong. Chart 17Covid Cases Are On The Rise Again In Some Countries Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? Most new cases in China and elsewhere stem from the BA.2 subvariant of Omicron, which appears to be at least 50% more contagious than Omicron Classic. Given its extreme contagiousness, China may be forced to rely on massive nationwide lockdowns in order to maintain its zero-Covid strategy. While such lockdowns may provide some relief in the form of lower oil prices, the overall effect will be to worsen supply-chain disruptions. Watch For Signs of a Wage-Price Spiral As the experience of the 1960s demonstrates, the relationship between inflation and unemployment is inherently non-linear: The labor market can tighten for a long time with little impact on prices and wages, only for a wage-price spiral to suddenly develop once unemployment falls below a certain threshold (Chart 18). Chart 18A Wage-Price Spiral Was Ignited By Very Low Unemployment Levels In The 1960s Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution For the time being, a wage-price spiral does not appear imminent. While wage growth has picked up, most of the increase in wages has occurred at the bottom end of the income distribution (Chart 19). Chart 20More Low-Wage Employees Should Return To Work More Low-Wage Employees Should Return To Work More Low-Wage Employees Should Return To Work Low-wage workers have not returned to the labor force to the same extent as higher-wage workers (Chart 20). However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. An influx of workers back into the labor market will cap wage growth, at least for this year. Long-Term Inflation Expectations Still Contained A sudden increase in long-term inflation expectations can be a precursor to a wage-price spiral because the expectation of higher prices can induce consumers to shop now before prices rise further, while also incentivizing workers to demand higher wages. Reassuringly, long-term inflation expectations have not risen that much. Expected inflation 5-to-10 years out in the University of Michigan survey registered 3.0% in March, down a notch from 3.1% in February (Chart 21). While the widely followed 5-year, 5-year forward TIPS inflation breakeven rate has climbed to 2.32%, it is still at the bottom of the Fed’s comfort zone of 2.3%-to-2.5% (Chart 22).3 Chart 21Long-Term Inflation Expectations Remain Contained (I) Long-Term Inflation Expectations Remain Contained (I) Long-Term Inflation Expectations Remain Contained (I) Chart 22Long-Term Inflation Expectations Remain Contained (II) Long-Term Inflation Expectations Remain Contained (II) Long-Term Inflation Expectations Remain Contained (II) Chart 23The Magnitude Of Damage Depends On How Long The Commodity Price Shock Lasts Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? Moreover, the jump in market-based inflation expectations since the start of the war in Ukraine has been fueled by rising oil prices. The forwards are pointing to a fairly pronounced decline in the price of crude and most other commodity prices over the next 12 months (Chart 23). If that happens, inflation expectations will dip anew. Investment Implications The neutral rate of interest is higher in the United States than widely believed. A higher neutral rate is arguably good for stocks over the short-to-medium term because it lowers the risk that the Fed will accidentally induce a recession this year by bringing rates into restrictive territory. Over a longer-term horizon of 2-to-5 years, however, a higher neutral rate is bad news for stocks because it means that investors will eventually need to value stocks using a higher discount rate. It also means that the Fed could find itself woefully behind the curve in normalizing monetary policy. While the war in Ukraine and yet another Covid wave could continue to unsettle markets for the next month or two, global equities will be higher in 12 months than they are now. With inflation in the US likely to temporarily come down in the second half of the year, bond yields probably will not rise much more this year. However, yields will start moving higher in the second half of next year as it becomes clear that policy rates still have further to rise. The bull market in stocks will end at that point.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  These savings can either by generated domestically or imported from abroad via a current account deficit. 2  Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. 3  The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. View Matrix Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks? Special Trade Recommendations Current MacroQuant Model Scores Is A Higher Neutral Rate Good Or Bad For Stocks? Is A Higher Neutral Rate Good Or Bad For Stocks?

Executive Summary Major EM’s Defense Spends Will Be Comparable To That Of Developed Countries Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​ Tectonic geopolitical trends are taking shape in Emerging Markets (EMs) today that will leave an indelible imprint on the next decade. First, EMs have gone on a relatively unnoticed public debt binge at a time when the economic prospects of the median EM citizen have deteriorated. This raises the spectre of sudden fiscal populism, aggressive foreign policy or social unrest in EMs. China, Brazil and Saudi Arabia appear most vulnerable to these risks. Second, the defense bill of major EMs could be comparable to that of the top developed countries of the world in a decade from now. Investors must brace for EMs to play a central role in the defense market and in wars, in the coming years. To profit from ascendant geopolitical risks in China, we reiterate shorting TWD-USD and the CNY against an equal-weighted basket of Euro and USD. To extract most from the theme of EM militarization, we suggest a Long on European Aerospace & Defense relative to European Tech stocks.   Trade Recommendation Inception Date Return LONG EUROPEAN AEROSPACE & DEFENSE / EUROPEAN TECH EQUITIES (STRATEGIC) 2022-03-18   Bottom Line: Even as EMs are set to emerge as protagonists on the world stage, investors must prepare for these countries to exhibit sudden fiscal expansions, bouts of social unrest or a newfound propensity to initiate wars. The only way to dodge these volatility-inducing events is to leverage geopolitics to foresee these shocks. Feature Only a few weeks before Russia’s war with Ukraine broke out, a client told us that he was having trouble seeing the importance of geopolitics in investing. “It seems like geopolitics was a lot more relevant a few years back, with the European debt crisis, Brexit, and Trump. Now it does not seem to drive markets at all”, said the client. To this we gave our frequent explanation which is, “Our strategic themes of Great Power Struggle, Hypo-Globalization, and Nationalism/Populism are now embedded in the international system and responsible for an observable rise in geopolitical risk that is reshaping markets”. In particular we highlighted our pessimistic view on both Russia and Iran, which have incidentally crystallized most clearly since we had this client conversation. Related Report  Geopolitical StrategyBrazil: The Road To Elections Won't Be Paved With Good Intentions Globally key geopolitical changes are afoot with Russia at war. In the coming weeks and months, we will write extensively about the dramatic changes we see taking shape in the realm of geopolitics and investing. We underscored the dramatic geopolitical realignment taking place as Russia severs ties with the West and throws itself into China’s arms in a report titled “From Nixon-Mao To Putin-Xi”. In this Special Report we highlight two key geopolitical themes that will affect emerging markets (EMs) over the coming decade. The aim is to help investors spot these trends early, so that they can profit from these tectonic changes that are sure to spawn a new generation of winners and losers in financial markets. (For BCA Research’s in-depth views on EMs, do refer to the Emerging Markets Strategy (EMS) webpage). Trend #1: Beware The Wrath Of EMs On A Debt Binge Chart 1The Pace Of Debt Accumulation Has Accelerated In Major EMs Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Investors are generally aware of the debt build-up that has taken place in the developed world since Covid-19. The gross public debt held by the six most developed countries of the world (spanning US, Japan, Germany, UK, France and Italy) now stands at an eye-watering $60 trillion or about 140% of GDP. This debt pile is enormous in both absolute and relative terms. But at the same time, the debt simultaneously being taken on by EMs has largely gone unnoticed. The cumulative public debt held by eight major EMs today (spanning China, Taiwan, Korea, India, Brazil, Russia, Saudi Arabia and Turkey) stands at $20tn i.e., about 70% of GDP. Whilst the absolute value of EM debt appears manageable, what is worrying is the pace of debt accumulation. The average public debt to GDP ratio of these EMs fell over the early 2000s but their public debt ratios have now doubled over the last decade (Chart 1). EMs have been accumulating public debt at such a rapid clip that the pace of debt expansion in EMs is substantially higher than that of the top six developed countries (Chart 1). These six DMs have a larger combined GDP than the eight EMs with which they are compared. Related Report  Geopolitical StrategyIndia's Politics: Know When To Hold 'Em, Know When To Fold 'Em (For in-depth views on China’s debt, do refer to China Investment Strategy (CIS) report here). Now developed countries taking on more debt makes logical sense for two reasons. Firstly, most developed countries are ageing, and their populations have stopped growing. So one way to prop up falling demand is to get governments to spend more using debt. Secondly, this practice seems manageable because developed country central banks have deep pockets (in the form of reserves) and their central banks are issuers of some of the safest currencies of the world. But EMs using the same formula and getting addicted to debt at an earlier stage of development is risky and could prove to be lethal in some cases. Also distinct from reasons of macroeconomics, the debt binge in EMs this time is problematic for geopolitical reasons. This Time Is Different EMs getting reliant on debt is problematic this time because their median citizen’s economic prospects have deteriorated. Growth is slowing, inflation is high, and job creation is stalling; thereby creating a problematic socio-political backdrop to the EM debt build-up. Growth Is Slowing: In the 2000s EMs could hope to grow out of their social or economic problems. The cumulative nominal GDP of eight major EMs more than quadrupled over the early 2000s but a decade later, these EMs haven not been able to grow their nominal GDP even at half the rate (Chart 2). Inflation Remains High: Despite poorer growth prospects, inflation is accelerating. Inflation was high in most major EMs in 2021 (Chart 3) i.e., even before the surge seen in 2022. Chart 2Major EM’s Growth Engine Is No Longer Humming Like A Well-Tuned Machine Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ Chart 3Despite Slower Growth, Inflation In Major EMs Remains High Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ Rising Unemployment: Employment levels have improved globally from the precipice they had fallen into in 2020. But unemployment today is a far bigger problem for major EMs as compared to developed markets (Chart 4). If the economic miseries of the median EM citizen are not addressed, then they can produce disruptive sociopolitical effects that will fan market volatility. This problem of rising economic misery alongside a rapid debt build-up, can also be seen for the next tier of EMs i.e. Mexico, Indonesia, Iran, Poland, Thailand, Nigeria, Argentina, Egypt, South Africa and Vietnam. While the average public debt to GDP ratios of these EMs fell over the early 2000s, the pace of debt accumulation has almost doubled over the last decade (Chart 5). Furthermore, the growth engine in these smaller EMs is no longer humming like a well-tuned machine and inflation remains at large (Chart 5). Chart 4Unemployment - A Bigger Problem In Major EMs Today Unemployment - A Bigger Problem In Major EMs Today Unemployment - A Bigger Problem In Major EMs Today ​​​​​ Chart 5Smaller EMs Must Also Deal With Rising Debt, Alongside Slowing Growth Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ Chart 6The Debt Surge In EMs This Time, Poses Unique Challenges Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War History suggests that periods of economic tumult are frequently followed by social unrest. The eruption of the so-called Arab Spring after the Great Recession illustrated the power of this dynamic. Then following the outbreak of Covid-19 in 2020 we had highlighted that Turkey, Brazil, and South Africa are at the greatest risk of significant social unrest. We also showed that even EMs that looked stable on paper faced unrest in the post-Covid world, including China and Russia. In this report we take a decadal perspective which reveals that growth is slowing, and debt is growing in EMs. Given that EMs suffer from rising economic miseries alongside growing debt and lower political freedoms (Chart 6), it appears that some of these markets could be socio-political tinderboxes in the making. Policy Implications Of The EM Debt Surge “As it turns out, we don't 'all' have to pay our debts. Only some of us do.” – David Graeber, Debt: The First 5,000 Years (Melville House Publishing, 2011) The trifecta of fast-growing debt, slowing growth and/or low political freedoms in EMs can add to the volatility engendered by EMs as an asset class. Given the growing economic misery in EMs today, politicians will be wary of outbreaks of social unrest. To quell this unrest, they may resort broadly to fiscal expansion and/or aggressive foreign policy. Both of these policy choices can dampen market returns in EMs. Chart 7India's Performance Had Flatlined Post Mild Populist Tilt India's Performance Had Flatlined Post Mild Populist Tilt India's Performance Had Flatlined Post Mild Populist Tilt Policy Choice #1: More Fiscal Spending Despite High Debt Policymakers in some EMs may respond by de-prioritizing contentious structural reforms and prioritizing fiscal expansion. The Indian government’s decision to repeal progressive changes to farm laws in late 2021, launch a $7 billion home-building program in early 2022 and withholding hikes in retail prices of fuel, illustrates how policymakers are resorting to populism despite high public debt levels. As a result, it is no surprise that MSCI India had been underperforming MSCI EM even before the war in Ukraine broke out (Chart 7). Brazil is another EM which falls into this category, while China’s attempts to run tighter budgets have failed in the face of slowing growth. Policy Choice #2: Foreign Policy Aggression EMs may also adopt an aggressive foreign policy stance. Russia’s decision to invade Ukraine, Turkey’s interventions in several countries, and China’s increasing assertiveness in its neighboring seas and the Taiwan Strait provide examples. Wars by EMs are known to dampen returns as the experience of the Russian stock market shows. Russian stocks fell by 14% during its invasion of Georgia in 2008 and are down 40% from 24 February 2022 until March 9, 2022, i.e. when MSCI halted trading. If politicians fail to pursue either of these policies, then they run the risk of social unrest erupting due to tight fiscal policy or domestic political disputes. In fact, early signs of social discontent are already evident from large protests seen in major EMs over the last year (see Table 1). Table 1Social Unrest In Major EMs Is Already Ascendant Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Bottom Line: The last decade has seen major EMs go on a relatively unnoticed public debt binge. This is problematic because this debt surge has come at a time when economic prospects of the median EM citizen have deteriorated. Politicians will be keen to quell the resultant discontent. This raises the specter of excessive fiscal expansion, aggressive foreign policy, and/or social unrest. All three outcomes are negative from an EM volatility perspective. Trend #2: The Rise And Rise Of EM Defense Spends Great Power Rivalry is an outgrowth of the multipolar structure of international relations. This theme will drive higher defense spending globally. In this report we highlight that even after accounting for a historic rearmament in developed countries following Russia’s invasion of Ukraine, a decade from now EMs will play a key role in driving global military spends. The defense bill of the six richest developed countries of the world (the US, Japan, Germany, UK, France and Italy) will increasingly be rivaled by that of the top eight EMs (China, Taiwan, Korea, India, Brazil, Russia, Saudi Arabia and Turkey). While key developed markets like Japan and Germany in specific (and Europe more broadly) are now embarking on increasing defense spends, the unstable global backdrop will force EMs to increase their military budgets as well. The combination of these forces could mean that the top eight EM’s defense spends could be comparable to that of the top six developed markets in a decade from now i.e., by 2032 (Chart 8). This is true even though the six DMs have a larger GDP. The assumptions made while arriving at the 2032 defense spend projections include: Substantially Higher Pace Of Defense Spends For Developed Countries: To reflect the fact that Russia’s invasion of Ukraine will trigger a historical wave of armament in developed markets we assume that: (a) NATO members France, Germany and Italy (who spent about 1.5% of GDP on an average on defense spends in 2019) will ramp up defense spending to 2% of GDP by 2032, (b) US and UK i.e. NATO members who already spend substantially more than 2% of GDP on defense spends will still ‘increase’ defense spends by another 0.4% of GDP each by 2032 and finally (c) Japan which spends less than 1% of GDP on defense spends today, in a structural break from the past will increase its spending which will rise to 1.5% of GDP by 2032. China And Hence Taiwan As Well As India Will Boost Spends: To capture China’s increasingly aggressive foreign policy stance and the fact that India as well as Taiwan will be forced to respond to the Chinese threat; we assume that China increases its stated defense spends from 1.7% of GDP in 2019 to 3% by 2032. Taiwan follows in lockstep and increases its defense spends from 1.8% of GDP in 2019 to 3% by 2032. India which is experiencing a pincer movement from China to its east and Pakistan to its west will have no choice but to respond to the high and rising geopolitical risks in South Asia. The coming decade is in fact likely to see India’s focus on its naval firepower increase meaningfully as it feels the need to fend off threats in the Indo-Pacific. India currently maintains high defense spends at 2.5% of GDP and will boost this by at least 100bps to 3.5% of GDP by 2032. Defense Spending Trends For Five EMs: For the rest of the EMs (namely Russia, Saudi Arabia, South Korea and Brazil), the pace of growth in defense spending seen over 2009-19 is extrapolated to 2032. For Turkey, we assume that defense spends as a share of GDP increases to 3% of GDP by 2032. Extrapolation Of Past GDP Growth For All Countries: For all 14 countries, we extrapolate the nominal GDP growth calculated by the IMF for 2022-26 as per its last full data update, to 2032. This tectonic change in defense spending patterns has important historical roots. Back in 1900, UK and Japan i.e., the two seafaring powers were top defense spenders (Chart 9). Developed countries of the world continued to lead defense spending league tables through the twentieth century as they fought expensive world wars. Chart 8Major EM’s Defense Spends Will Be Comparable To That Of Developed Countries Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​​ Chart 9Back In 1900, Developed Countries Like UK And Japan Were Top Military Spenders Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​​ Chart 10By 2000, EMs Had Begun Spending Generously On Armament Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War But things began changing after WWII. Jaded by the world wars, developed countries began lowering their defense spending. By the early 2000s EMs had now begun spending generously on armament (Chart 10). The turn of the century saw growth in developed markets fade while EMs like China and India’s geopolitical power began rising (Chart 11). Then a commodities boom ensued, resulting in petro-states like Saudi Arabia establishing their position as a high military spender. The confluence of these factors meant that by 2020 EMs had becomes major defense spenders in both relative and absolute terms too (Chart 12). Going forward, we expect the coming renaissance in DM defense spending in the face of Russian aggression, alongside rising geopolitical aspirations of China, to exacerbate this trend of rising EM militarization. Chart 11The 21st Century Saw Developed Countries’ Geopolitical Power Ebb Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Chart 12EMs Today Are Top Military Spenders, Even In Absolute Terms Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Why Does EM Weaponizing Matter? History suggests that wars are often preceded by an increase in defense spends: Well before WWI, a perceptible increase in defense spending could be seen in Austria-Hungary, Germany, and Italy (Chart 13). These three countries would go on to be known as the Triple Alliance in WWI. Correspondingly France, Britain and Russia (i.e., countries that would constitute the Triple Entente) also ramped up military spending before WWI (Chart 14). Chart 13Well Before WWI; Austria-Hungary, Germany, And Italy Had Begun Ramping Up Defense Spends Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​​ Chart 14The ‘Triple Entente’ Too Had Increased Defense Spends In The Run Up To WWI Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​​ History tragically repeated itself a few decades later. Besides Japan (which invaded China in 1937); Germany and Italy too ramped up defense spending well before WWII broke out (Chart 15). These three countries would come to be known as the Axis Powers and initiated WWII. Notably, Britain and Russia (who would go on to counter the Axis Powers) had also been weaponizing since the mid-1930s (Chart 16). Chart 15Axis Powers Had Been Increasing Defense Spends Well Before WWII Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ Chart 16Allied Powers Too Had Been Increasing Defense Spends In The Run Up To WWII Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ Chart 17Militarily Active States Have Been Ramping Up Defense Spends Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Russia, Ukraine, Turkey and Gulf Arab states like Iraq have been involved in wars in the recent past and noticeably increased their defense budgets in the lead-up to military activity (Chart 17). Given that a rise in military spending is often a leading indicator of war and given that EMs are set to spend more on defense, it appears that significant wars are becoming more rather than less likely, which Russia’s invasion of Ukraine obviously implies. A large number of “Black Swan Risks” are clustered in the spheres of influence of Russia, China, and Iran, which are the key powers attempting to revise the US-led global order today (Map 1). Map 1Black Swan Risks Are Clustered Around China, Russia & Iran Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Distinct from major EMs, eight small countries pose meaningful risks of being involved in wars over the next. These countries are small (in terms of their nominal GDPs) but spend large sums on defense both in absolute terms (>$4 billion) and in relative terms (>4% of GDP). Incidentally all these countries are located around the Eurasian rimland and include Israel, Pakistan, Algeria, Iran, Kuwait, Oman, Ukraine and Morocco (Map 2). In fact, the combined sum of spending undertaken by these countries is so meaningful that it exceeds the defense budgets of countries like Russia and UK (Chart 18). Map 2Eight Small Countries That Spend Generously On Defense Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Chart 188 Countries Located Near The Eurasian Rimland, Spend Large Sums On Defense Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​ Bottom Line: As EM geopolitical power and aspirations rise, the defense bill of top developed countries will be challenged by the defense spending undertaken by major EMs. On one hand this change will mean that certain EMs may be at the epicenter of wars and concomitant market volatility. On the other hand, this change could spawn a new generation of winners amongst defense suppliers. Investment Conclusions In this section we highlight strategic trades that can be launched to play the two trends highlighted above. Trend #1: Beware The Wrath Of EMs On A Debt Binge Investors must prepare for EMs to witness sudden fiscal expansions, unusually aggressive foreign policy stances, and/or bouts of social unrest over the next few years. The only way to dodge these volatility-inducing events in EMs is to leverage geopolitics to foresee socio-political shocks. Using a simple method called the “Tinderbox Framework” (Table 2), we highlight that: Table 2Tinderbox Framework: Identifying Countries Most Exposed To Socio-Political Risks Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Within the eight major EMs; China, Brazil, Russia and Saudi Arabia face elevated socio-political risks. Amongst the smaller ten EMs, these risks appear most elevated for Egypt, South Africa and Argentina. It is worth noting that Brazil, South Africa and Turkey appeared most vulnerable as per our Covid-19 Social Unrest Index that we launched in 2020. We used the tinderbox framework in the current context to fade out effects of Covid-19 and to add weight to the debt problem that is brewing in EMs. Client portfolios that are overweight on most countries that fare poorly on our “Tinderbox Framework” should consider actively hedging for volatility at the stock-specific level. To profit from ascendant geopolitical risks in China, we reiterate shorting TWD-USD and the CNY against an equal-weighted basket of Euro and USD. China’s public debt ratio is high and social pressures may be building with limited valves in place to release these pressures (Table 2). The renminbi has performed well amid the Russian war, which has weighed down the euro, but China faces a confluence of domestic and international risks that will ultimately drag on the currency, while the euro will benefit from the European Union’s awakening as a geopolitical entity in the face of the Russian military threat. Trend #2: EM’s Will Drive Wars In The 21st Century Wars are detrimental to market returns.1 Furthermore, as the history of world wars proves, even the aftermath of a war often yields poor investment outcomes as wars can be followed by recessions. It is in this context that investors must prepare for the rise of EMs as protagonists in the defense market, by leveraging geopolitics to identify EMs that are most likely to be engaged in wars. While we are not arguing that WWIII will erupt, investors must brace for proxy wars as an added source of volatility that could affect EMs as an asset class. To profit from these structural changes underway we highlight two strategic trades namely: 1.  Long Global Aerospace & Defense / Broad Market Thanks to the higher spending on defense being undertaken by major EMs, global defense spends will grow at a faster rate over the next decade as compared to the last. We hence reiterate our Buy on Global Aerospace & Defense relative to the broader market. 2.  Long European Aerospace & Defense / European Tech Up until Russia invaded Ukraine and was hit with economic sanctions, Russia was the second largest exporter of arms globally accounting for 20% global arms exports. With Russia’s ability to sell goods in the global market now impaired, the two other major suppliers of defense goods that appear best placed to tap into EM’s demand for defense goods are the US (37% share in the global defense exports market) and Europe (+25% share in the global defense exports market). Chart 19American Defense Stocks Have Outperformed, European Defense Stocks Have Underperformed Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​​ Chart 20Defense Market: Russia’s Loss Could Be Europe’s Gain Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ But given that (a) American aerospace & defense stocks have rallied (Chart 19) and given that (b) France, Germany, and Italy are major suppliers of defense equipment to countries that Russia used to supply defense goods to (Chart 20), we suggest a Buy on European Aerospace & Defense relative to European Tech stocks to extract more from this theme. In fact, this trade also stands to benefit from the pursuance of rearmament by major European democracies which so far have maintained lower defense spends as compared to America and UK. This view from a geopolitical perspective is echoed by our European Investment Strategy (EIS) team too who also recommend a Long on European defense stocks and a short on European tech stocks. Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1      Please see: Andrew Leigh et al, “What do financial markets think of war in Iraq?”, NBER Working Paper No. 9587, March 2003, nber.org.  David Le Bris, “Wars, Inflation and Stock Market Returns in France, 1870-1945”, Financial History Review 19.3 pp. 337-361, December 2012, ssrn.com. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary Profit Margins Are Headed Lower; So Are Equity Multiples Profit Margins Are Headed Lower; So Are Equity Multiples Profit Margins Are Headed Lower; So Are Equity Multiples The post pandemic profit recovery in India was driven by a one-off revival of demand from very depressed levels, which led to a spike in profit margins as companies’ sales outpaced their costs (hiring costs and financing cost). The glacial pace of job creation since the pandemic and the muted wage growth is to blame for weak household income, which in turn is hurting consumption. Indian growth is wobbling as household consumption is losing steam, and capital investments are decelerating. The Ukraine crisis and the resulting oil / commodity price surge will hurt Indian firms’ margins and profits even more in the months to come. Indian stocks are still expensive, and future profit expectations are elevated – especially relative to their EM and emerging Asian counterparts. This has set the stage for profit disappointment. Bottom Line: Indian growth is decelerating amid high stock valuations. Higher for longer commodity prices will hurt as well. Equity investors should downgrade Indian stocks tactically from neutral to underweight in EM and emerging Asian portfolios. Domestic bond investors should book profits on their Indian exposure, and downgrade to neutral in EM and emerging Asian baskets. Feature Chart 1Indian Stocks Are Headed For A Turbulent Time Indian Stocks Are Headed For A Turbulent Time Indian Stocks Are Headed For A Turbulent Time ​​​​​​ Long COVID is a condition that manifests itself after a person recovers from the acute phase of the disease. The Indian economy is showing similar signs: after an initial post-COVID recovery, household consumption and investment have begun to disappoint. This is happening at a time when Indian equity valuations and investors’ profit expectations are much higher than those of the rest of the EM. As such, Indian share prices are set for a turbulent time ahead. Equity investors should tactically downgrade this bourse to underweight in EM and emerging Asian portfolios (Chart 1). Domestic bond investors should book profits on their Indian exposure, and downgrade it to neutral in EM and emerging Asian baskets. Consumer Spending During and in the immediate aftermath of the pandemic, the Indian government did not supplement lost household income caused by the lockdowns and the layoffs by any good measure. Tangible fiscal stimulus (i.e., excluding government guarantees etc.) amounted to less than 2% of GDP. Post-pandemic, jobs have been growing at a glacial pace. In fact, India’s total employment is estimated to be still 8% lower as of the end of 2021 compared to the first quarter of 2020, as per Oxford Economics data. Consistently, wage growth has been very poor as well – in both urban and rural areas (Chart 2). Wages in real terms (deflated by CPI) have been contracting. Household income has therefore remained severely impaired. The consequences of meagre household incomes can now be seen in persistently weak consumer durable sales. Chart 3 shows that passenger cars and 2-wheeler sales are languishing at much lower levels than they were in the pre-pandemic period. Chart 2Subdued Employment And Poor Wage Growth Sapped Household Income … Subdued Employment And Poor Wage Growth Sapped Household Income ... Subdued Employment And Poor Wage Growth Sapped Household Income ... Chart 3… Leading To Impaired Household Consumption ... Leading To Impaired Household Consumtion ... Leading To Impaired Household Consumtion Chart 4Signs Of Softening Business Activity Signs Of Softening Business Activity Signs Of Softening Business Activity The overall growth in India was seen to be softening even before the Ukraine crisis. The economy grew at a 5.4% YoY rate in the last quarter of 2021, down from 8.5% in the previous quarter. The trend appears to be continuing into this year. Corroborating evidence comes in the form of the number of E-way bills1 issued – which is a barometer of business activity. The number peaked in October last year and has been struggling since (Chart 4). Persistently weak consumer demand is a crucial reason why manufacturing production is also struggling to get back to the pre-pandemic trend – which would be a good 10% higher than the current level (Chart 4, bottom panel). Industrial production will face difficulty gaining traction should weakness in consumer demand linger. On the whole, the post-pandemic economic recovery in India was a rapid one initially; but is now gradually losing steam as joblessness remains high and wages remain low. Looming Energy Tax Ominously, odds have risen that core (non-oil) consumer demand could be even weaker in the months ahead. The sharp rise in crude prices will soon mean that Indian consumers and businesses will have to shell out more for their energy-related purchases. Chart 5 shows that retail gasoline and diesel prices in India did not keep pace with the global crude prices in recent months. Hence, if some or all of the rise is passed on to the consumers, domestic fuel prices could go up by about 10 - 20%. If so, that would be a major tax on the economy. Higher expenses on fuel and transportation – which make up about 15% of consumer spending – will force households to curtail their non-oil spending elsewhere. That means non-energy firms would see lower sales. Those firms would also see their own operating and raw material costs going up given the higher oil and other commodity prices. Together, these will have a pronounced negative impact on these firms’ profit margins. Lower margins are a harbinger of lower stock multiples (Chart 6). Chart 5Retail Gasoline And Diesel Prices Could Rise Materially Reatil Gasoline And Diesel Prices Could Rise Materially Reatil Gasoline And Diesel Prices Could Rise Materially Chart 6Profit Margins Are Headed Lower; So Are Equity Multiples Profit Margins Are Headed Lower; So Are Equity Multiples Profit Margins Are Headed Lower; So Are Equity Multiples Notably, Indian corporate profit margins had surged to decade high levels last year thanks mainly to cost cutting. Wage bills had gone down as businesses slashed employees; and were slow to re-hire them. Interest expenses had also gone down – both relative to sales and profits – as the central bank cut interest rates aggressively. When sales revived after the lockdowns, the higher/rising margins led to surging profits. But now, both sales and margins are in jeopardy as weak consumer demand is hurting the former, while rising raw materials cost will hurt the latter. Profits are set to disappoint as a result. Related Report  Emerging Markets StrategyEquity Capitulation, A Commodity Shock And Geopolitics What’s more, faltering profits could also lead to a premature slowdown in India’s capital investments. Firms’ capex plans are highly contingent on profit growth; and therefore, the former may see a dip in the coming months with dwindling profits (Chart 7). This potential development could be a major negative for India’s sustainable growth story, and its ill-effects may linger. What makes this episode of oil/commodity shock particularly negative for India is that it is taking place when consumer demand is already sluggish. Previous oil shocks in 2007-08 and 2011-12 took place when the underlying growth was quite robust. Stronger underlying growth allows for the absorption of negative exogenous shocks like higher oil & energy prices. Overall, rising oil prices have historically been bearish for Indian stocks’ relative performance. That correlation had broken down since the onset of the pandemic two years ago (Chart 8). However, now with the crude price hovering around $100 a barrel, India’s relative equity outperformance versus the EM benchmark will give up some of its gains of the past two years. Chart 7Dwindling Profits Could Lead To A Slowdown In Caital Expenditure Dwindling Profits Could Lead To A Slowdown In Caital Expenditure Dwindling Profits Could Lead To A Slowdown In Caital Expenditure Chart 8India’s Relative Equity Outperformance Cannot Continue With $100 Oil India' Relative Equity Outperformance Cannot Continue With $100 Oil India' Relative Equity Outperformance Cannot Continue With $100 Oil How About Inflation? Chart 9Global Commodity Prices Dictate Indian PPI, But Not So Much CPI Global Commodity Prices Dictate Indian PPI, But Not So Much CPI Global Commodity Prices Dictate Indian PPI, But Not So Much CPI India’s producer price inflation (PPI) is highly geared to global commodity prices. As such, one can expect PPI to re-accelerate in the months ahead. That said, commodity prices are not a major driver of India’s consumer price inflation (CPI). The latter will therefore likely remain more well behaved than PPI would (Chart 9). Historically, the two primary drivers of India’s CPI have been the economy’s productivity growth rate and broad money (M3) growth rate. Since productivity trends do not change much in the near term, it’s money supply that determines the short-term trajectory of CPI (Chart 10). Chart 10Money Supply Determines India’s CPI Over Cyclical Horizon Money Supply Determines India's CPI Over Cyclical Horizon Money Supply Determines India's CPI Over Cyclical Horizon Chart 11Drivers Of India’s Money Supply Will See Only A Mediocre Growth Drivers Of India's Money Supply Will See Only A Mediocre Growth Drivers Of India's Money Supply Will See Only A Mediocre Growth Money growth has been quite mediocre recently; and will likely stay that way. This is because neither of the two main drivers of money supply, bank credit and fiscal expenditure, are set to rise very strongly. In the proposed fiscal budget for April 2022 – March 2023, the government is planning to raise current expenditure2 by just 1% in nominal terms; and the total expenditure by 5%. Meanwhile, non-interest government spending growth has already come back to normal levels following the one-off surge during the pandemic (Chart 11, top panel). Bank credit has also slowed on the margin this year. That it has barely grown in real terms in the past couple of years is also dampening inflationary pressures (Chart 11, bottom panel). All this means that any rise in consumer price inflation will be limited. Notably, a marginal rise in consumer price inflation is unlikely to lead to policy tightening by the central bank. This is because the source of inflation would be supply driven, rather than demand driven. The central bank would recognize that higher commodity prices will exacerbate the already weak consumer demand; and therefore, any further policy tightening could decimate growth. On the whole, very sluggish wage growth and contained core CPI support the fact that there are no genuine demand-driven inflationary pressures in the country (Chart 12). A rise in global food prices should also not impact India much as the country is not a big importer of food grains and most of its food is domestically grown. All in all, the RBI is likely to ignore the slight pickup in CPI, and will refrain from raising rates. How Much Downside In Stocks? Indian stocks have been in a trading range relative to their EM counterparts since we downgraded them to neutral in October last year. In absolute terms also they have not fallen much so far – even though foreign investors have exited this market en masse over the past several months. The missing piece of the puzzle for this apparent dichotomy is the massive purchases by domestic mutual funds in recent months. This local demand is what prevented this bourse from tanking (Chart 13). Chart 12India’s Consumer Inflation Will Not Rise By Too Much India's Consumer Inflation Will Not Rise By Too Much India's Consumer Inflation Will Not Rise By Too Much Chart 13The Massive Purchases Of Mutual Funds Will Wane With Profit Disappointment The Massive Purchases Of Mutual Funds Will Wane With Profit Disappointment The Massive Purchases Of Mutual Funds Will Wane With Profit Disappointment Chart 14Indian Stock Multiples Are Still Very High Relative To Their Counterparts Indian Stock Multiples Are Still Very High Relative To Their Counterparts Indian Stock Multiples Are Still Very High Relative To Their Counterparts Going forward, however, those domestic purchases are likely to wane as growth and profits slow, and local investors become wary of their equity exposures. That would lead to a sell-off in stock prices. Notably, Indian stocks are still quite pricey when compared to both their EM and emerging Asian counterparts based on the cyclically adjusted P/E ratio (Chart 14). As explained above, Indian stock multiples are set to fall materially as firms’ profit margins are squeezed in the months to come. Investors have paid high equity multiples as they have extrapolated the strong profit recovery post-pandemic into the future. However, the profit recovery post-pandemic was driven by a one-off revival of demand from very depressed levels and a one-off spike in profit margins as companies’ sales outpaced their costs (hiring costs and financing cost). As and when investors realize that a sustainable profit growth rate is much lower than the initial post-pandemic trajectory, multiples will shrink somewhat. At the same time, firms’ topline will also wobble as non-oil consumer spending sees forced retrenchment. Weakish topline, multiplied by lower margins, entails weak earnings growth. That would be another drag (besides shrinking multiples) on Indian share prices. Notably, a sell-off in Indian stocks usually comes with a depreciating rupee – thereby compounding woes for foreign investors in Indian stocks. All in all, this bourse could witness a major down leg in absolute USD terms in the months to come. Relative to other EM and emerging Asian markets also they will trade on the weaker side. Book Profits On Domestic Bonds We have been overweight India in EM local currency bond portfolios given Indian bonds’ rather high yields, and the country’s prudent fiscal policy, benign inflation outlook, and a cheap currency. The call has worked out well (Chart 15, top panel). However, following the sharp rise in EM bond yields, Indian bond yields are no longer attractive in relative terms (Chart 15, bottom panel). A less sanguine rupee outlook over the short term is another cause for concern. Besides, rising US bond yields would make Indian bonds look less attractive. Considering all, we recommend EM local currency bond investors take profits on their overweight India exposure and reduce the allocation to neutral in EM and emerging Asian baskets. Investment Recommendations Equities: Indian firms’ profit outlook has deteriorated significantly given odds of disappointing margins and still high equity valuations. Investors should tactically downgrade this market from neutral to underweight in EM and emerging Asian equity portfolios. Absolute return investors should avoid this market outright. Currency and Bonds: The Indian rupee is at a risk of mild depreciation along with a sell-off in the Indian stock markets. However, given that the currency is cheap, its relapse will not be large (Chart 16). Chart 15Indian Domestic Bonds Are Not As Attractive Any More; Book Profits Indian Domestic Bonds Are Not As Attractive Any More; Book Profits Indian Domestic Bonds Are Not As Attractive Any More; Book Profits Chart 16Indian Rupee Is Cheap, And Hence Has Only A Limited Downside Indian Rupee Is Cheap, And Hence Has Only A Limited Downside Indian Rupee Is Cheap, And Hence Has Only A Limited Downside Indian government bonds have outperformed their EM counterparts over the past four years; but are no longer as attractive as the yield advantage has disappeared and the rupee has a weaker near-term outlook. Investors should book profits on their overweight allocations, and downgrade them to neutral relative to EM and emerging Asian baskets. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1     E-way bills are issued as part of Goods & Services Tax (GST) collection mechanism. 2     The rest is capital expenditure – which the government is planning to raise by 24%, albeit from a much smaller base (2.6% of GDP) compared to current expenditure (13.6% of GDP).

Executive Summary Global Oil Price Pushes Up Inflation Expectations Global Oil Price Pushes Up Inflation Expectations Global Oil Price Pushes Up Inflation Expectations The US cut off of Russian energy exports has limited immediate impact because EU trade with Russia continues. Russia is unlikely to embargo the EU as it needs revenues to wage war. However, the EU will diversify away from Russia over time, which means that Russia will intensify its efforts to replace the government in Ukraine. The Biden administration began with an adversarial posture toward the energy sector, both US producers and Gulf Arab petro-states. Now it is adjusting its stance as prices surge. The OPEC states do not favor Biden but have an interest in calibrating production to avoid global recession and prolong their profit windfall. Even if the US restores the 2015 nuclear deal with Iran, which we doubt, investors should fade the oil price implications and stay focused on OPEC. Recommendation (Tactical) Inception Level Inception Date Return Long DXY (Dollar Index) 96.19 Feb 23, 2022 2.9% Bottom Line: Stagflation is the likeliest economic outcome of today’s global supply constraints. Feature Biden’s Oil Policy: Implications Will the Ukraine crisis lead to a US recession? The probability of a recession is 7.7% today, according to the bond market, but the oil price shock suggests that the probability will only increase from here. Stagflation, at least, is now highly likely. Short-term interest rates are rising faster than long-term rates, causing the 2-year/10-year Treasury slope to slide toward inversion, though it is not there yet. That would be a telltale sign of a looming recession (Chart 1). The 3-mo/10-year Treasury yield slope is nowhere near inverting and has a better record of predicting recessions than the 2-year/10-year. The Federal Reserve’s interest rate hikes are expected to cause the 10-year yield to rise and the yield curve to steepen. But exogenous shocks may push short rates even higher. When the oil price doubles, a recession often ensues. Out of the past seven recessions, five of them witnessed an oil spike beforehand. True, not every spike causes a recession. But the causality is clear. Today’s spike is large enough to be recessionary (Chart 2). The critical question is where will the price settle? If it settles above $90-$100 per barrel then it will erode global demand. Chart 1An End-Of-Cycle Crisis? An End-Of-Cycle Crisis? An End-Of-Cycle Crisis? Chart 2Oil Price Often Doubles Before Recessions Oil Price Often Doubles Before Recessions Oil Price Often Doubles Before Recessions Most likely the price will settle at around $85 per barrel by the end of 2022, and average $85 in 2023, according to our Commodity & Energy Strategy. High prices will discourage consumption and incentivize new production, leading to a price drop and new equilibrium. The OPEC cartel will increase production because they want to prolong the business cycle. Non-OPEC producers like US shale oil companies will also increase production. It is not likely that the US will significantly lift sanctions on Iran and Venezuela, though that would free up 1.3 million barrels per day and 700,000 barrels per day respectively. More on this below. Even so, this year’s energy spike will feed into a larger bout of inflation that is eroding real incomes. Headline consumer price inflation is running at 7.9% as of February, the highest in four decades. Core inflation is running at 6.4%. The Ukraine war did not prevent the European Central Bank from delivering a hawkish surprise in its fight against inflation on March 10, so it is even less likely to prevent the Fed from delivering a hawkish surprise on March 16. The Fed has a history of hiking rates even during geopolitical crises (as during the Arab oil embargo of 1973), which implies that the war in Ukraine will not prevent the Fed from hiking rates four times or more this year. There is a close relationship between the global oil price and the financial market’s long-term inflation expectations (Chart 3). When the costs of production and transportation go up, investors start to expect higher prices. Expectations are already rising because of the global pandemic, stimulus, supply constraints, wage pressure, and tardy policy normalization. Gasoline prices at the pump will shape consumer expectations (Chart 4). Chart 3Global Oil Price Pushes Up Inflation Expectations Global Oil Price Pushes Up Inflation Expectations Global Oil Price Pushes Up Inflation Expectations Chart 4Geopolitics Compound Inflation Geopolitics Compound Inflation Geopolitics Compound Inflation Yet high commodity prices are not coinciding with strong global growth and a weak dollar, as one might suspect. Global growth is falling and the dollar is strengthening. The energy shock from Russia will rattle importing countries like Europe, China, and India and thus enhance the dollar’s rise (Chart 5). Investor sentiment will suffer as the war in Ukraine reinforces the secular rise in geopolitical risk. Global policy uncertainty is also rising sharply, which will reinforce the dollar, weighing on global economic activity. Chart 5Dollar Strengthens on Weak Global Growth Dollar Strengthens on Weak Global Growth Dollar Strengthens on Weak Global Growth Bottom Line: A stagflationary dynamic is taking shape. Moreover the risk of recession is underrated by the bond market’s measure of recession probability. Investors should maintain tactically bearish trades and cut losses on cyclically bullish trades that suffer from higher rates and persistent inflation. US Boycotts Russia And Begs OPEC The Biden administration’s decision to ban Russian oil exports – and to encourage private sector boycotts of the Russian energy trade – raises the potential for the Russian conflict to escalate beyond Ukraine’s borders. While a total boycott of Russian oil exports is unlikely, it would be one of the larger oil shocks in modern history (Chart 6). Unlike the Iranian attack on the Saudi oil refinery in 2019, the Russian shock would come amid an existing energy shortage. Chart 6Worst Case Oil Risk in Historical Context Biden's Oil Shock Biden's Oil Shock There are two critical questions about US policy at this stage: Will the US foist its energy boycott on Europe, triggering a Russian retaliation? This could plunge Europe into recession and further upset the global economy. Will the US convince the OPEC cartel to increase oil production? A production boost would reduce prices and help to rebalance the economy, salvaging the business cycle. The next two sections discuss these options. US Boycotts Russia The first question is how Russia will respond to the US boycott and whether the Biden administration will try to force Europe to adopt the boycott. The US is comfortable boycotting Russian energy because oil and gas imports only account for 0.6% of GDP and those from Russia only 0.04%. Europe cannot make the same decision. While O&G imports are only 2.21% of GDP, and Russian O&G imports at 0.4%, these numbers will spike to near 2008 levels as a result of the price shock (Charts 7A & 7B). Major European countries, notably Germany, have already rejected the US boycott, and any EU direct sanctions require unanimity. The EU is instead outlining a plan to diversify away from Russia more gradually. This is a medium-term threat to Russia and hence a major concern for global stability but it is not an instant cutoff, which would cause an immediate recession in Europe. Chart 7AThe US Is Energy Independent... Biden's Oil Shock Biden's Oil Shock Chart 7B...The EU Is Not Biden's Oil Shock Biden's Oil Shock The EU’s plan would theoretically reduce its dependency on Russian energy by 66% by the end of the year. But that is easier said than done. Also, Europe cannot simply swap the US for Russia. American exports to the rest of the world could be redirected to Europe, but the switch requires an overhaul of supply chains. A total switch of US exports to Europe is impracticable in the short run and would leave other US allies dependent on Russian exports (Charts 8A & 8B). Chart 8AUS Will Not Replace Russian Energy Anytime Soon Biden's Oil Shock Biden's Oil Shock Chart 8BUS Will Not Replace Russian Energy Anytime Soon Biden's Oil Shock Biden's Oil Shock US shale producers are only starting to increase production. With WTI crude oil at $100, and Henry Hub natural gas spot price at $4.6 per million BTU, American production will speed up. But US companies are more focused on profitability and returns to shareholders than they were at the beginning of the shale boom, which has restrained oil production (Charts 9A & (9B). Chart 9AUS Production And Exports Increase After Pandemic Lull US Production And Exports Increase After Pandemic Lull US Production And Exports Increase After Pandemic Lull Chart 9BUS Production And Exports Increase After Pandemic Lull US Production And Exports Increase After Pandemic Lull US Production And Exports Increase After Pandemic Lull   The Biden administration has not yet fully adopted the tactics necessary: promoting the domestic fossil fuel industry and coordinating it for purposes of national strategy. American oil executives complain that while the Biden administration courts foreign energy producers and contemplates arbitrarily lifting sanctions on Iran and Venezuela, it has not approached domestic producers about facilitating production.1 Meanwhile there is a risk that Russia will retaliate against western sanctions by cutting off natural gas to the EU, for instance via the Nord Stream I pipeline. This is a risk, rather than a base case, because Moscow would prefer to sell energy as long as Europe is buying – and even increase the amount it produces at today’s high prices. Russian energy exports to the EU account for 5% of Russian GDP and thus provide an important lifeline at a time when the country is suffering heavily under banking, technology, and trade sanctions (Chart 10). Russian natural resource exports on average provide 43% of government revenue, which is essential for Moscow to carry on its war effort (Chart 11). Chart 10Russia Will Not Punish EU For US Boycott Biden's Oil Shock Biden's Oil Shock Chart 11Russia Needs EU Energy Imports Biden's Oil Shock Biden's Oil Shock And yet Russians are now slapping an embargo on agricultural exports, constricting global food supply and pushing up food prices. The implication is that a reduction in energy exports to the EU is not out of the question, especially an incremental reduction aimed at increasing Russian diplomatic pressure on Europe. If the Russians cut off Europe, it will fall into a severe recession and the energy shock will risk a global recession. While US direct trade exposure to Europe is limited, at about 3.8% of GDP (Chart 12A), nevertheless the US would suffer from price pressures. The US is already seeing import prices rise toward 2008 levels (Chart 12B). Chart 12AUS Exposure To The EU Is Limited... US Exposure To The EU Is Limited... US Exposure To The EU Is Limited... Chart 12B...But Its Import Prices Will Rise ...But Its Import Prices Will Rise ...But Its Import Prices Will Rise Bottom Line: The US is boycotting Russian oil but not forcing the EU to join the boycott. Europe is pursuing gradual diversification but Russia is unlikely to cut off Europe’s supply. However, this dynamic is showing signs of faltering, which means investors are justified in taking further risk off the table. US Begs OPEC The Biden administration started off on the wrong foot with the Gulf Arab states by criticizing them for autocratic government and human rights abuses, threatening to withhold arms sales, and trying to restore the 2015 nuclear deal and détente with Iran. Now, with a global energy shock unfolding, Biden is going back to Saudi Arabia and the UAE and imploring them to increase oil production and ease the supply pressure. The Arab states are reportedly giving him the cold shoulder, ignoring his phone calls while answering Russian President Vladimir Putin’s calls.2 These states never have an interest in producing oil at any US president’s beck and call. The US and Iran have also reached a critical stage in nuclear negotiations. So it is only fitting that the Arab states play hard to get. While the UAE ambassador to the US suggested that his country supporting increasing production on March 9, the country’s energy minister said the opposite. However, the core OPEC states are even less likely to do Russia’s bidding. Moscow propped up the Syrian regime, arms and subsidizes Iran, and aspires to gain ever greater control over Middle East exports to Europe. The Gulf states also know that the Russians will produce as much energy as they can since they need the revenues to sustain their war (Chart 13). Chart 13Core OPEC Countries Have An Interest In Increasing Oil Supply Core OPEC Countries Have An Interest In Increasing Oil Supply Core OPEC Countries Have An Interest In Increasing Oil Supply The Gulf states rely on the US military for national security, they fear that US-Iran détente will lead to US abandonment and Iranian regional ascendancy, and they seek to sustain their centrality to the global oil market. They want to prolong their export revenues in the context of a growing global economy for the sake of their own delicate internal stability and reforms. They do not aim to incentivize non-OPEC oil production and renewable energy transition with excessive prices, or to trigger a global recession (Chart 14). Hence the Saudi and UAE strategy will be to lower the oil price closer to their fiscal breakeven rate of $82.3 and $62.8 (oil price consistent with a balanced budget) and prolong the business cycle (Chart 15). Chart 14Core OPEC Does Not Want To Threaten Their Fiscal Future Biden's Oil Shock Biden's Oil Shock Chart 15Current Oil Price Comfortably Supports Fiscal Spending In OPEC Biden's Oil Shock Biden's Oil Shock The critical factor in the negotiation with the Biden administration will be Iran, their chief rival. Biden is trying to rejoin the 2015 nuclear deal, which would require removing sanctions in exchange for Iran’s halting its nuclear progress. A deal would bring 1.3 million barrels per day online, at least for the next two years or so. It could also prompt the Saudis or others to increase production to prevent Iran from stealing market share, as occurred in 2014 (Chart 16). Any deal would reduce the risk of military conflict in the short term and as such would remove some risk premium from oil prices. If Biden agrees to walk away from the Iran deal, then perhaps the Saudis and UAE will oblige him with a larger and quicker production boost. They know the Democratic Party is doomed in this year’s midterm elections anyway. Sanctions are not preventing the Iranians from exporting oil today and there is very little chance that they will truly abandon their quest for nuclear weapons (Chart 17). Chart 16Production Ramped Up Ahead Of The Iran Deal In 2015 Production Ramped Up Ahead Of The Iran Deal In 2015 Production Ramped Up Ahead Of The Iran Deal In 2015 Chart 17Production May Ramp Up Again As Iran Managed To Evade Sanction Production May Ramp Up Again As Iran Managed To Evade Sanction Production May Ramp Up Again As Iran Managed To Evade Sanction Either way the core OPEC members need to adjust the oil supply to maintain market share and prolong the business cycle. Taking it all together, investors should expect oil prices to remain volatile and for oil supply risks to remain elevated, meaning that oil prices will likely resume their rise after the expected OPEC intervention. Biden is also tinkering with the idea of easing sanctions on Venezuela. This would take a long time and require regime change to come to fruition. Venezuela produces about 700,000 barrels per day at present, down from about 2 million bpd in 2017.Given the lack of capital, investment, and engineering expertise, the Venezuelans probably cannot increase production beyond 1 million bpd over the next year or so. Of that, maybe 600,000 barrels could be sent to export markets, according to our Commodity & Energy Strategist Bob Ryan. The US cannot remove all sanctions from Venezuela as it does not recognize the legitimacy of President Nicolas Maduro’s regime. The Department of Justice indicted Maduro in 2020. Accommodating Maduro will create even more bad blood between the Democrats and the Cuban-American voters in electorally critical Florida. US companies will be reluctant to get involved in oil production in Venezuela on such a flimsy basis, as they will fear future sanctions if Republicans win in 2024. So investment in Venezuela, and hence oil production, will remain limited even if Biden waives some sanctions. Bottom Line: Biden’s attempts to ease sanctions on Iran and Venezuela are unlikely to have a lasting impact on oil prices. But it is possible that he will convince the OPEC states to increase production, as their own interests support such a move. Investment Takeaways Comparing Russia’s 2022 invasion of Ukraine to the original invasion in 2014, the major trends are parallel: stocks are falling relative to bonds, cyclical sectors are underperforming defensives, and small caps are outperforming large caps (Chart 18A). Chart 18AMarket Response 2022 Versus 2014 Market Response 2022 Versus 2014 Market Response 2022 Versus 2014 Chart 18BMarket Response 2022 Versus 2014 Market Response 2022 Versus 2014 Market Response 2022 Versus 2014 If Russia imposes an energy embargo or OPEC refuses to increase production, then there will be an even larger global energy shock and a European recession that will weigh on global growth. The dollar will stay well bid in the near term. Value stocks are far outpacing growth stocks in the 2022 crisis, in keeping with high inflation and rising bond yields (Chart 18B). While we favor value over growth on a structural basis, we took the opposite stance as a tactical trade at the beginning of this year in expectation of falling bond yields, which has backfired. We are closing this trade for a loss of 7.7%.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com     Footnotes 1     See Shannon Pettypiece, “White House, oil industry spar anew over drilling as gas prices surge”, NBC News, March 12, nbcnews.com. 2     See Holman Jenkins, “The Putin Endgame,” The Wall Street Journal, March 1, 2022, wsj.com   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Biden's Oil Shock Biden's Oil Shock Table A3US Political Capital Index Biden's Oil Shock Biden's Oil Shock Chart A1Presidential Election Model Biden's Oil Shock Biden's Oil Shock Chart A2Senate Election Model Biden's Oil Shock Biden's Oil Shock Table A4APolitical Capital: White House And Congress Biden's Oil Shock Biden's Oil Shock Table A4BPolitical Capital: Household And Business Sentiment Biden's Oil Shock Biden's Oil Shock Table A4CPolitical Capital: The Economy And Markets Biden's Oil Shock Biden's Oil Shock

Executive Summary Winners And Losers The Impact Of The Ukraine War On The US Economy And Equity Sectors The Impact Of The Ukraine War On The US Economy And Equity Sectors Combining Russia and Ukraine: Taken together, Russia and Ukraine account for a small fraction of global trade. However, Russia is a key player in the global energy and metals markets, providing rare materials like palladium. Ukraine is a sizable agricultural producer, as well as an exporter of specialized products such as neon. Effects on global trade: Shortages of metals and agricultural goods will reverberate across the global economy, exacerbating shortages and supply disruptions. Manufacturer anxiety about the availability of raw input materials catalyzed an explosive rally in the commodity universe.  Effect on the US companies: Most US equity sectors have limited direct sales exposure to Russia. However, self-sanctioning will have an adverse immediate effect on many multinationals, while indirect effects of the war will be even more impactful. Winners and losers: At the margin, the escalation in Ukraine is a net positive for Energy, Big Tech, and Metals & Mining, while Travel, Consumer Staples, Semiconductors Manufacturers, and Automakers will be hit by shortages and surging input costs. Bottom Line:The war in Ukraine has wreaked havoc in the US equity market, even though US trade with Russia and Ukraine is insignificant and is mostly limited to energy, palladium, and other rare metals. However, US companies are affected by the scarcity of selected metals and materials, soaring prices, and supply chain disruptions. Feature Introduction The war in Ukraine has become the proverbial black swan that has blindsided even the most cautious investors. The world simply did not expect Russia to wage such a bloody, and all-out war. As such, tragically, small Ukraine has come out of obscurity, and became a focal point of the world’s attention, mostly for humanitarian reasons. While our heart goes out to the people living under fire, it is our job as investment strategists to conduct a detailed economic analysis of the effect of the war in Ukraine and sanctions on Russia’s goods and services on US equities. To do so, we will first investigate trade links between Ukraine, Russia, and the US. And then look at the indirect effects of the war on US equity sectors. Russia And Ukraine Effect On Global Trade Taken together, Russia and Ukraine account for about 3.5% of global GDP in PPP terms and only 1.9% in dollar terms. Even a deep recession in each of these economies is unlikely to cause a dent in global growth, at least not directly. Unfortunately, the indirect effects of this war are substantial. What Is Russia Producing? In 2019, Russia exported $407B in goods, which made it the 13th largest exporter in the world. It is the second-largest commodities exporter (after the US) and the second-largest oil producer, accounting for 12% of annual global output. Energy: Russia’s crude oil exports account for 8.4% of global crude consumption, while natural gas exports account for 5.9% of global consumption, and 3.4% for coal (Table 1). These energy products constitute roughly 60% of Russia’s exports. Its exports of natural gas represent close to half of all European gas imports. Table 1Russia’s Global Share In Various Commodities The Impact Of The Ukraine War On The US Economy And Equity Sectors The Impact Of The Ukraine War On The US Economy And Equity Sectors Nickel: Russia is also one of the top metal producers. It is the third largest producer of nickel, accounting for 4.4.% of global output. The recent surge in nickel prices reflects manufacturers’ anxiety about the potential shortages of this metal.1 Elon Musk has said that a shortage of nickel is the “biggest challenge” in “producing high-volume, long-range batteries”. Palladium: In addition, to nickel, Russia accounts for 35.6% of global palladium output. Palladium is widely used in catalytic converters, electrodes, and other types of electronics.2 Palladium prices are up 46% since the start of the year. Chart 1War Wreaked Havoc In Commodities Market The Impact Of The Ukraine War On The US Economy And Equity Sectors The Impact Of The Ukraine War On The US Economy And Equity Sectors Fertilizers: Together, Russia and Belarus account for about 40% of global potash production, a key ingredient in potassium-based fertilizers. Russia also produces two-thirds of all ammonium nitrate, the main source of nitrogen-rich fertilizers. Wheat and lumber: Russia produces 10% of the global supply of wheat and lumber. While Russia’s trading network is wide, the most common destinations for its exports are China (14%), Netherlands (10%), Belarus (5%), and Germany (4.6%), making its direct effect on global trade limited. What Is Ukraine Producing? Ukraine’s effect on global trade is less significant: In 2019 it exported only $49.5B, with exports dominated by agricultural products and metals (Chart 2). Food: Ukraine’s production is dominated by foodstuffs such as corn, wheat, and seed oils. Russia and Ukraine together account for 25% of global wheat exports, much of which is going to the developing nations of Africa and Asia (Chart 3). Russia and Ukraine are also significant producers of potatoes, sunflowers, and sugar beets. Chart 2Ukraine Exports Metals And Food The Impact Of The Ukraine War On The US Economy And Equity Sectors The Impact Of The Ukraine War On The US Economy And Equity Sectors Chart 3Wheat Is Exported To North Africa And Asia The Impact Of The Ukraine War On The US Economy And Equity Sectors The Impact Of The Ukraine War On The US Economy And Equity Sectors With war and sanctions, most of this output will be lost or kept for domestic consumption, accelerating food inflation, which is already rampant. Of course, the rest of the world could try to compensate for lost agricultural output, but there is a major snag: Russia, Ukraine, and Belarus are significant producers of fertilizer. Metals: Ukraine produces significant amounts of steel. ArcelorMittal and Metinvest suspended production at their Ukrainian plants last week. Auto Components: In addition, Ukraine is a major producer of automotive wire harnesses. Volkswagen, BMW, and Porsche have all had to curtail auto production due to war-related shortages. Neon: Then there are the more esoteric commodities. The bulk of semiconductor-grade neon, used in high-precision lasers, comes from Ukraine. A dearth of this critical gas could exacerbate the semiconductor shortage. While Ukraine trades predominately with its European neighbors, such as Russia, Germany, Poland, and Italy, shortages of agricultural products, semiconductors, and automotive components are likely to reverberate across the globe. The US Is An Island… Almost According to the OEC,3 in 2019 the US was the number two economy in terms of total exports ($1.51T), and the number one economy in total imports ($2.38T). Russia barely registers as the US trading partner, with only $14.B or 0.61% of total imports coming from Russia. Ukraine is even less significant for the US: Its exports constitute only $1.23B. US exports to Ukraine and Russia constitute less than 1% of its total exports. However, to uncover the potential effects of the possible halting of Russian trade on the US economy, let’s look at what goods the US is buying. The reality on the ground may be complex. Petrochemicals Refined and crude petroleum constitute about half of all Russian imports to the US and account for roughly $7 billion (Chart 4). The US sanctioning of Russian oil is unlikely to have a significant effect on the US economy: It constitutes only about 5.7% of all the US oil imports, both crude and refined, which in 2019 were about $123B. As a result, the recent US embargo of Russian oil is unlikely to have much impact. Platinum, Titanium, And Other Rare and Precious Metals US imports roughly $7B worth of platinum, over one-fifth of which is sourced from Russia. Russia also provides about 21.5% of all titanium and 23% of radioactive chemicals that the US imports. Chart 4US Imports Fuels And Rare Metals From Russia The Impact Of The Ukraine War On The US Economy And Equity Sectors The Impact Of The Ukraine War On The US Economy And Equity Sectors Palladium The situation with palladium is even more strained: Russia produces 42% of the palladium imported by the US while South Africa supplies another 30%. All other exports of palladium are fragmented, and producers are unlikely to be able to ramp up production fast enough. Nickel US imports only $1.4B worth of nickel per year, 11% of which is coming from Russia. Australia and Canada are the only other large producers of this metal, and it is not clear if they will be able to step in and fill in the void left by Russia. How Much Production From Russia Will Be Curtailed? The West’s official sanctions affect Russian exports of certain commodities but there is also a reluctance on the part of private companies to buy or ship Russian exports. This latter factor makes it nearly impossible to gauge just how much supply of each individual commodity will be curtailed. In addition, Putin has announced his decision to suspend some commodity exports at least until 2023. Assuming in the near term that a considerable share of Russia’s commodity exports will be blocked from global markets, the largest impact will be on oil, palladium, copper, nickel, fertilizer, and grains. The Stock Market Is Not The Economy US Companies Most Exposed To Russian Trade Most US multinational companies have limited direct sales exposure to Russia. Among those that do have some exposure (Table 2), Philip Morris comes on top of the list at 8% of sales, PepsiCo 4.3%, Mondelez 3.1%, and McDonald’s 4.5%. Apple has generated only 1.3% of its sales in Russia. Overall, the Consumer Staples sector has the highest exposure to Russia. Exodus The majority of US multinationals have announced their exit from the Russian market in protest at the war. The exodus affects wide swaths of the Russian economy, including joint ventures in energy, auto manufacturing, finance, retail, entertainment, and fast food (See Appendix for the list). The war affects US sectors in many different way, and there are winners and losers (Chart 5). Table 2US Multinationals With The Highest Exposure To Russia The Impact Of The Ukraine War On The US Economy And Equity Sectors The Impact Of The Ukraine War On The US Economy And Equity Sectors Chart 5Winners And Losers The Impact Of The Ukraine War On The US Economy And Equity Sectors The Impact Of The Ukraine War On The US Economy And Equity Sectors Investment Implications Energy Sector – Positive The US embargo of Russian oil does not have a pronounced immediate and direct effect on the US energy sector as US imports from Russia are minor. Exxon’s exit from Russia is not going to have any noticeable short-term effect on the US energy sector. On the contrary, elevated oil and gas prices create an impetus for the US shale producers to ramp up output. Oil Equipment and Services companies will be the key beneficiaries of the new energy Capex cycle. While we closed our overweight in E&P companies with a view that OPEC will open oil spigots and cure high prices, locking in a gain of 60%, we remain overweight E&S Energy industry. Consumer Staples – Negative Companies such as Mondelez, Philip Morris, and PepsiCo are most exposed to the Russian market. All three have announced that they are discontinuing or curtailing Russian operations, taking a direct hit on earnings. However, disruptions in agricultural exports from Russia and Ukraine, and accompanying soaring food prices (Chart 6), are likely to have a broad negative effect on the sector, increasing input prices while sector margins are already razor-thin. So far, the sector had been able to pass on costs to customers, but its pricing power may be limited going forward (Chart 7). Chart 6Food Price Surge Is Parabolic Food Price Surge Is Parabolic Food Price Surge Is Parabolic Chart 7Consumer Staples Have Been Able To Pass Costs On To Customers Consumer Staples Have Been Able To Pass Costs On To Customers Consumer Staples Have Been Able To Pass Costs On To Customers We are overweight Consumer Staples thanks to its defensive attributes in the face of overall market volatility. However, we will be monitoring this position closely. Semiconductors - Neutral Disruptions in supplies of neon, palladium, and nickel, which are essential components of the manufacturing of semiconductors, will exacerbate global chip shortages, and hit profits of semiconductor manufacturers, mostly in Asia. However, the majority of the large US semiconductor companies are chip designers and are unlikely to be affected. The only exception is Intel, which is an integrated semiconductor company. Intel has also announced that it is exiting Russia, which may have an adverse effect on its profitability. Auto Manufacturers - Negative Overall, US car manufacturers have limited direct exposure to Russia. Ford has recently closed its joint venture with a Russian car manufacturer. GM does not have a significant presence in Russia, selling only 3,000 cars a year there, of the six million it sells worldwide. Tesla’s presence in Russia is also insignificant – there are only 700 Teslas registered there. However, there are supply problems. Shortages of metals, such as palladium and nickel, widely used in catalytic converters and electrodes, will compound shortages in tight auto component markets. Travel Complex: Hotels, Restaurants, and Airlines Hilton, Marriott, and Hyatt have announced that they are halting development and new investments in Russia. While these actions on the margin will have a long-lasting negative effect on their business, a more immediate concern is that a war in Europe will suppress travel, which only recently started rebounding after COVID-19 country closures. US airlines will suffer from a double whammy of rising fuel costs, and consumer reluctance for international travel in the light of hostilities in the heart of Europe. International and business travel are the most lucrative segments of their business, the rebound of which is needed for these companies to restore profitability. We were positive on airlines in light of the reopening of international travel as the Omicron wave was receding, but now have to reconsider our optimistic stance if oil prices don’t normalize soon. Fast-food restaurant closures in Russia (Burger King, McDonald’s, Starbucks, etc.) will result in a significant hit to their bottom line. To put these actions in perspective, McDonald’s announced that temporary closures of its 750 restaurants in Russia and 180 in Ukraine will make it lose $50 million a month, resulting in a 9% hit to its revenue. In addition, these businesses are already reeling from rising food prices and consumers shifting their goods and services away from discretionary spending to necessities because of negative wage growth. We are overweight the Travel complex but are likely to downgrade it in the coming days. Big Tech – Positive According to a recent report by the IDC, the global impact of a steep decline in Information and Communications Technology (ICT) spending in Russia and Ukraine will be somewhat limited. Combined, the two countries only account for 5.5% of all ICT spending in Europe and 1% worldwide.4 Meanwhile, tech spending among Western European countries may increase in part due to expanded defense and security allocations. We believe that dislocation also creates an opportunity for US technology companies, especially in the software and cybersecurity space. Exiting the Russian market is likely to have a limited negative effect on US technology companies’ revenue, as most of them derive only a very small proportion of it from Russia. We are overweight the Software and Cybersecurity industries. Metals and Mining - Positive Disruption of the supply of metals from Russia and Ukraine creates an opportunity for US metals and mining companies, with soaring pricing promising a profits windfall. Unlike with oil and gas, an increase of supply in metals not only takes substantial investment but also takes years to bring to production. As a result, there is no respite in sight. As such, we will consider adding to our existing position, bringing allocation to an overweight. Stay tuned. Bottom Line The war in Ukraine has wreaked havoc in the US equity market, even though US trade with Russia and Ukraine is insignificant and is mostly limited to energy, palladium, and other rare metals. However, the US economy is affected by the scarcity of selected metals and materials, soaring prices, and supply chain disruptions. As is often the case, there are winners and losers: Energy, and Metals & Mining are mostly immune to the crisis and are likely to benefit by picking up slack in supply. The Technology sector, especially Software and Cybersecurity, will benefit from the disruption of the war. Consumer Staples, Travel, Auto Manufacturers, and Semiconductor Manufacturers are likely to take a hit because of shortages and soaring input prices.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Appendix: Companies’ Self-Sanctions In Russia5 Airlines American Airlines, Delta, and United cut ticket sales partnerships with Russian airlines. All three have stopped flying over Russia. Banks Goldman Sachs became the first American bank to announce that it is exiting Russia. Citigroup also indicated that it is curtailing operations in Russia. Technology Accenture is discontinuing its operations in Russia. Airbnb (ABNB) announced that the company is suspending all operations in Russia and Belarus. Amazon (AMZN)’s cloud division, Amazon Web Services (AWS), said it would halt new sign-ups for the service in Russia and Belarus. AWS indicated that it has no data centers in Russia and, as a matter of policy, it does not do business with the Russian government. It stated that while it had Russian customers, they are all headquartered outside of Russia. Apple (AAPL) has stopped selling its products in Russia, and limited access to digital services, such as Apple Pay, inside Russia. Google confirmed that it is no longer accepting new Google Cloud customers in Russia. It has also halted its advertisement operations in the country. IBM (IBM) has suspended all business in Russia. Intel (INTC) has stopped all shipments to Russia and Belarus, the company announced. Microsoft (MSFT) is suspending all new sales of its products and services in Russia. Microsoft (MSFT) also said it will continue aiding in Ukrainian cybersecurity. Netflix (NFLX) said it will be suspending its streaming service in Russia. Spotify (SPOT) said it has closed its office in Russia “indefinitely” and restricted shows “owned and operated by Russian state-affiliated media.” Adobe stopped all new sales in Russia Uber is divesting from internet company Yandex Paypal suspended all services in Russia Big Four Accounting Firms Ernst & Young, Deloitte, KPMG, and PwC are pulling out of the country. Energy Exxon pledged to leave its last remaining oil and gas project in Russia and not to invest in new developments in the country. Credit Card Providers All three American credit card giants, Mastercard (MA), Visa (V), and American Express (Amex), have suspended all their network operations in Russia. Credit cards issued by Russian banks will not work in other countries, and cards issued elsewhere will not work for purchases in Russia. Hotels Hyatt (H), Hilton (HLT), and Marriott (MAR) are halting development and new investments in Russia. Hilton and Marriott are closing their corporate offices. Hilton is keeping its existing 26 hotels open (a fraction of the company’s 6,800 properties worldwide). Marriott hotels are franchised and the company is evaluating the ability to keep these hotels open. Industrials 3 has halted operations in Russia. Dow (DOW) has suspended all purchases of feedstocks and energy from Russia. It has also stopped all investments in the region and is supplying only limited essential goods in Russia. General Electric (GE) suspended most of its operations in Russia, with the exception of “providing essential medical equipment and supporting existing power services.” John Deere (DE) has halted shipments of its products to Russia. Caterpillar (CAT) is suspending operations at its Russian manufacturing facilities. Boeing (BA) said it would suspend support for Russian airlines. Automakers Ford (F) announced it was suspending its operations in Russia. The American automaker has a 50% stake in Ford (F) Sollers, a joint venture that employs at least 4,000 workers. GM does not have much of a presence in Russia. Entertainment Disney (DIS) is also suspending the release of its theatrical films in Russia, citing “the unprovoked invasion of Ukraine.” WarnerMedia said on February 28 that it would pause the release of “The Batman” in Russia. The company is also pausing all new business in Russia, ceasing broadcast of its channels, halting all new content licensing with Russian entities, and pausing planned theatrical and games releases. Retail Estée Lauder Companies will suspend all commercial activity in Russia, including closing every store and brand site and halting shipments to any of our retailers in Russia. The company had also already suspended business investments and initiatives in Russia. TJX has promised to divest its equity ownership in Familia, an off-price retailer with more than 400 stores in Russia. Consumer Staples Mondelez (MDLZ) said it would scale back all non-essential activities in Russia “while helping maintain continuity of the food supply.” The company said it would focus on “basic offerings,” and discontinue all new capital investments and suspend advertising spending in the country. Procter & Gamble (PG) has discontinued all new capital investments in Russia and is suspending all media, advertising, and promotional activity. The company will continue to provide basic health, hygiene, and personal care items. Philip Morris suspended planned investments and will reduce manufacturing in Russia. PepsiCo will stop selling soda in Russia but will continue to produce dairy and baby food. Restaurants Yum Brands (YUM) is closing 70 company-owned KFC restaurants and 50 Pizza Hut franchises in Russia. It will also suspend all investment and restaurant development in the country. McDonald’s (MCD) is closing some 750 restaurants in Russia. Russia’s restaurants along with another 108 in Ukraine, accounted for 9% of the company’s revenue in 2021. The company said that halting Russian operations will cost it $50 million a month. Restaurant Brands International (owner of Burger King) will end corporate support for 800 locations in Russia and will not approve any additional investment or expansion. Starbucks is closing all of its locations in Russia. Transportation UPS, DHL, and FedEx have suspended operations in Russia and Belarus.       Footnotes 1     The nickel price increase was compounded by a margin call on a major Chinese nickel producer that had accumulated a large short position through forward contracts in order to lock in a price for future delivery. 2     Palladium - Wikipedia 3    United States (USA) Exports, Imports, and Trade Partners | OEC - The Observatory of Economic Complexity 4    A New Report from IDC Looks at the Initial Impact of the Russia-Ukraine War on Global ICT Markets. 5    Which Companies Have Pulled Out of Russia? Here’s a List. - The New York Times (nytimes.com) and https://www.cnn.com/2022/03/02/business/companies-pulling-back-russia-ukraine-war-intl-hnk/index.html Recommended Allocation

Executive Summary The conflict in Ukraine will grind on until Kiev and the coastal cities fall and Russia is able to seat a government that will keep the country firmly within its sphere of influence. Rallies on slight hopes for an end to hostilities suggest that equities have more downside as they have yet to face up to the reality that the active military campaign has only begun. Surging energy prices imperil Europe’s expansion, but the net impact on the US economy will likely be modest, as increased employment and investment in the oil patch and better performance from high-yield borrowers offset higher gasoline prices. The US economy has enough momentum that it will be able to grow well above trend despite intensified inflation pressures from the Ukraine conflict. As US growth holds up, so too should S&P 500 earnings. Equities’ downside will be determined by how much P/E multiples contract. Though we expect additional near-term de-rating, we expect the market’s forward multiple will be resilient given the lack of positive-real-return alternatives. War Headwind Trumps Discount Rate Tailwind (For Now) War Headwind Trumps Discount Rate Tailwind (For Now) War Headwind Trumps Discount Rate Tailwind (For Now) Bottom Line: We do not think equities have bottomed, but we expect that they will generate a positive real return between now and the rest of the year. Feature All Ukraine, all the time has been the story since Russia invaded on February 24th. The headlines on the front page, the gyrations in financial markets and the internet’s perpetual loop of images from embattled cities and villages have kept the conflict front and center. Our daily meeting has revolved around updates from the ground, discussions of diplomatic moves and countermoves and the evolution of market and economic impacts. An investor could be forgiven for feeling nostalgic about the halcyon pre-invasion days when equity markets fixated on the pace of rate hikes and what they might mean for stocks with high P/E multiples. Until those days return, investors will have to figure out how to manage their way through the multiple issues raised by the conflict. We devote this week’s report to the most pressing questions that have emerged in our discussions with colleagues and other investment professionals. We don’t know how the various issues will turn out, but we offer our current thinking on the way events may impact the economy and financial markets. Conditions are evolving rapidly and we’ll change our minds as the flow of events changes but we hold tight to the central idea that markets are hoping in vain that a ceasefire might be reached before Kiev is overrun. The Military Campaign Q: How do you see the military campaign progressing? Ukrainian forces seem to be holding their own; has that changed your view of the end game? Our Geopolitical Strategy team cautions against reading too much into the plodding pace of the Russian advance. The Ukrainian military has acquitted itself well against a better endowed opponent, but the Russians still have an overwhelming advantage and show no sign of abandoning their goal. BCA continues to expect that Russia’s offensive will proceed until Kiev is captured and a pro-Russian government is installed. Russian leadership wants a buffer between NATO and its border, and it will sacrifice its own economy and inflict unlimited devastation on Ukraine to get it. Our base-case scenario is that the full fury of the fighting will continue until Russia controls the eastern half of Ukraine and its southern coast, effectively partitioning the country into a Russian east and south and a Ukrainian west. It is possible that Russia may move to take the entire country, though it seems that would be more trouble than it’s worth. Given the commitment Ukrainians have already shown to their country, stifling the resistance in the territory Russia must have (east of the Dnieper and along the coast) looks like it will be a tall order (Map 1). In our base case, the war will end once redrawn political borders allow for a new Cold War equilibrium, but the road to that new steady state may contain several twists and turns. Map 1Redrawing The Borders Q&A On Ukraine, Financial Markets And The Economy Q&A On Ukraine, Financial Markets And The Economy Q: How long do you think it will take to get to that steady state? Our Geopolitical Strategy team judges that Russian forces ought to be able to complete their mission of capturing Kiev in a matter of weeks or months and Ukraine’s coastal territory within half a year. While it appears that the victors face a determined ongoing insurgency, the clash between official forces will likely conclude by the end of the summer. We expect that Russia will move for a ceasefire once its objectives are met and a de facto partitioning of Ukraine could be accomplished by this time next year. Global investors will not wait for a full resolution before turning their attention elsewhere, but they will remain highly sensitive to any sign that the war will encompass more than Ukraine. Until Kiev falls, the risk of a broader conflict will remain high as Russia will attempt to cow all interested parties to hasten the inevitable. Conquering all of Ukraine would imply an extension of the war beyond our base-case scenario and our hypothetical timeline assumes that Russia does not attempt it because it doesn’t yet have enough boots on the ground to pull it off. The Russians will have their hands full with policing the rest of the country and the existence of a buffer zone between occupied territory east of Kiev and NATO territory on the Poland-Ukraine border may suit everyone’s interests. It will help reduce the probability of an accident that could turn into a battlefield face-off between Russia and NATO. A wider and potentially open-ended conflict would appear to be especially unwelcome from Russia’s perspective, given the way its economy is already buckling under sanctions. Involvement in a shooting war with the country holding the world’s second-largest nuclear arsenal is not in the West’s interests, either. The US and NATO have scrupulously avoided crossing the red line of direct involvement in Ukraine. Despite Ukrainian pleas, the American-European coalition will not impose a no-fly zone which could lead to head-to-head aerial combat, and no one would touch last week’s hot potato of providing Poland’s fleet of Soviet-era fighter planes to Ukraine. As heart-rending as it may be, the West is clearly willing to allow a partial conquest of Ukraine. We find it telling that Russia hasn’t extended the fight beyond the existing theater – hackers have yet to cut off access to our US-based team member’s checking and brokerage accounts or play havoc with the electric grid – and both sides’ revealed desire to limit the conflict supports our base case that they ultimately will. European anxiety will linger at Cold War-era levels, but the immediate risk of a larger conventional war on the continent should be limited once Russia neutralizes Ukraine. US Economic Impacts Q: How likely is the oil shock to tip the US economy into a recession? Chart 1Previous Shocks Have Heralded Recessions ... Previous Shocks Have Heralded Recessions ... Previous Shocks Have Heralded Recessions ... It took seven years for prices to grow tenfold in the decade marked by the Arab state oil embargo and the Iranian revolution, but only ten months for prices to surge 500% from the pandemic bottom in the spring of 2020. On an annual-change basis, the current move is twice as large as any past oil shocks. Sudden surges in oil prices have historically been precursors of recessions (Chart 1). The EU, Japan and oil-importing emerging countries may face dire economic consequences, but the US is relatively better positioned. The production of one unit of US GDP today requires a third of the amount of oil it did in the 1970s (Chart 2). All developed economies have benefitted from the technological progress and the shift away from manufacturing to services that has enabled a more efficient use of oil, but its status as the world’s largest oil producer separates the US from its peers in terms of its vulnerability to rising energy prices. For the first time since the EIA started reporting petroleum import and export data, the US became a net exporter of oil in 2020 and 2021 (Chart 3). Increased prices incentivize higher oil production and lift export revenues (curbs on Russian imports have the potential to increase global demand for US oil). These dynamics, in turn, lead to increased CAPEX and higher employment (Chart 4) when oil prices rise, along with marginally better credit performance, given that the energy sector is heavily represented in high-yield bond indices. Chart 2... But Oil Intensity Has Fallen ... ... But Oil Intensity Has Fallen ... ... But Oil Intensity Has Fallen ... Chart 3... Along With Import Dependency ... Along With Import Dependency ... Along With Import Dependency   There is a risk, however, that rising energy prices will push long-term inflation expectations higher and force the Fed to become more hawkish. They could also weigh on future consumption, as the dismal University of Michigan Consumer Sentiment Survey suggests. US households are well positioned to navigate higher inflation and higher interest rates nonetheless. A tight labor market is lifting income, particularly at the lower end of the wage distribution, while stimulus checks have allowed households to significantly reduce their level of indebtedness and amass large savings cushions. Rising wealth from financial market and home price advances will further support consumption. Chart 4Capex And Jobs Move With Prices ... Along With Import Dependency ... Along With Import Dependency Q: How worried are you about a growth shortfall this year? The Ukrainian conflict will unleash a spate of indirect economic effects by interfering with the supply of commodities in markets that were already quite tight. In additional to persistently high energy prices, we can expect higher prices for base metals, aluminum, steel, wheat, corn and perhaps semiconductors, as Ukraine is an important source for neon that is essential to one aspect of the chip manufacturing process. Widespread increases in input prices could give inflation an additional spur and therefore have the potential to dent consumer confidence while encouraging the Fed to tighten monetary policy more than it otherwise might. Although today’s macro backdrop has more stagflationary elements than it has had in decades, we think the US will escape its grip. Regarding consumers, we reiterate our view that they are unusually well positioned to overcome higher prices at the pump. They have built up an enormous pandemic savings cushion (largely concentrated among the bottom 70% of taxpayers who qualified for the full share of economic impact payments and the lower-income service workers who bore the brunt of job losses), seen the value of their homes rise at a rapid clip (nearly two-thirds of households own their own homes) and benefitted from robust advances in financial markets (largely reserved to households at the top of the wealth scale). Voluntary debt paydowns and rock-bottom interest rates have combined to make their debt servicing burden as light as it’s ever been in the four decades that it’s been tracked (Chart 5). Higher gasoline prices are not going to unleash a paradox-of-thrift vicious circle. Chart 5A Light Yoke A Light Yoke A Light Yoke The labor market is also poised to support consumption. Nonfarm payrolls are not likely to continue to expand at their 560 thousand a month clip since the start of 2021 (Chart 6), but the NFIB survey (Chart 7, top panel) and the record-high job-openings-to-unemployed ratio (Chart 7, bottom panel) indicate that businesses are still hunting for workers. The good times won’t last forever, but we maintain our view that the US economy will grow well above its 2% (inflation-adjusted) trend level this year. It has a lot of momentum, consumers have a lot of dry powder and COVID infections are dwindling by the day (Chart 8). Chart 6Job Gains Will Slow ... Job Gains Will Slow ... Job Gains Will Slow ... Chart 7... But They Won't Stop ... But They Won't Stop ... But They Won't Stop Chart 8Omigone Omigone Omigone Tighter monetary policy could cool things off, but it works with a lag and rate hikes will take a while to take effect. We endorse our US Bond Strategy colleagues’ projection of a 25-basis-point hike in the target fed funds rate at each of this year’s seven remaining FOMC meetings. That would get fed funds up to 1⅞% by year end, but the hikes would not fully filter through the economy until the second half of 2023, after a lag of six to twelve months. BCA estimates that the fed funds rate will have to exceed 3% before monetary policy begins to restrain activity. US Market Impacts Q: How much more can equities decline? Following on from the discussion of the previous growth question, we think the S&P 500 can live up to less-than-demanding consensus 2022 earnings per share (EPS) expectations. 4Q21 index EPS were $54.14 but are projected to be just $51.55 this quarter, a nearly 5% sequential decline. For the full year, 2022 S&P 500 EPS are projected to be $225.68, 4% above 4Q21’s annualized run rate ($54.14 x 4 = $216.56). Sequential declines outside of recessions are extremely unusual and a 4% four-quarter run-rate increase sets the expectations bar quite low (Chart 9). Chart 9A Low Bar A Low Bar A Low Bar Chart 10Multiple Compression Has Squeezed Stocks Multiple Compression Has Squeezed Stocks Multiple Compression Has Squeezed Stocks Most investors focus on year-over-year changes, and full-year 2022 earnings per share are expected to grow 8% versus 2021. That’s hardly a slam dunk in a decelerating economy, but the deceleration is coming from an extremely high level and it’s important to remember that earnings are measured in nominal dollars. With consensus 2022 real GDP growth and PCE price index estimates of 3.6% and 5%, respectively, nominal GDP is expected to grow 8.6%. If S&P 500 revenues grow in line with nominal GDP and buybacks shrink the index’s share count by 2-3%, 8% EPS growth is doable despite downward pressure on profit margins from rising wages and other input costs. The decline in the S&P 500 so far this year (Chart 10, top panel) has entirely been a function of multiple contraction. Forward four-quarter earnings expectations are 1% higher than they were at the start of the year (Chart 10, middle panel) but the multiple investors are willing to pay for them has dropped by 13%, from 21.7 to 18.8 (Chart 10, bottom panel). While we expect continued de-rating in the near term, we don’t foresee a decline of more than another 10% (below 17) unless the Ukraine conflict sparks a broader European war. There simply are no public market alternatives that offer investors a better chance of achieving positive real returns and historically low real interest rates would support a return to the 20s (Chart 11), where the forward multiple has lingered for most of the pandemic. Summing Up Chart 11Divergence Divergence Divergence The ideas that underpinned our pre-Ukraine view of financial markets and the US economy still apply, even though the distribution of potential outcomes has widened. We still believe that a recession is very unlikely over the next twelve months. We continue to hold that monetary policy will remain stimulative into 2023, as the fed funds rate will end this year well shy of its neutral level. We continue to flag inflation as the greatest risk to our constructive twelve-month views. Against that backdrop, we expect that equities and credit will rally once the outlines of our base-case Ukraine scenario take shape: Russia seeks peace once it topples the elected Ukrainian government, NATO and Russia exchange heated words but do not engage on the battlefield, and a rump state in western Ukraine provides a buffer against potential NATO-Russia accidents. As those events occur, COVID disruptions abate, commodity prices stop exploding higher and base effects rein in CPI prints beginning in April, inflation will start to decelerate. That should help financial markets and consumers breathe a sigh of relief and help earnings multiples to recover enough to allow the S&P 500 to generate positive real returns over the rest of the year. We remain constructive on markets and the US economy over the next twelve months. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Associate Editor jenniferl@bcaresearch.com

Executive Summary On a tactical (3-month) horizon, the inflationary impulse from soaring energy and food prices combined with the choke on growth from sanctions will weigh on both the global economy and the global stock market. As such, bond yields could nudge higher, the global stock market has yet to reach its crisis bottom, and the US dollar will rally. But on a cyclical (12-month) horizon, the short-term inflationary impulse combined with sanctions will be massively demand-destructive, at which point the cavalry of lower bond yields will charge to the rescue. Therefore: Overweight the 30-year T-bond and the 30-year Chinese bond, both in absolute terms and relative to other 30-year sovereign bonds. Overweight equities. Overweight long-duration US equities versus short-duration non-US equities. Fractal trading watchlist: Brent crude oil, and oil equities versus banks equities. The DAX Has Sold Off ##br##Because It Expects Profits To Plunge… The DAX Has Sold Off Because It Expects Profits To Plunge... The DAX Has Sold Off Because It Expects Profits To Plunge... …But The S&P 500 Has Sold Off ##br##Because The Long Bond Has Sold Off ...But The S&P 500 Has Sold Off Because The Long Bond Has Sold Off ...But The S&P 500 Has Sold Off Because The Long Bond Has Sold Off   Bottom Line: In the Ukraine crisis, the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. If anything, the fixation on inflation and sanctions may increase short-term pain for both the economy and the stock market, before the cavalry of lower bond yields ultimately charges to the rescue. Feature Given the onset of the largest military conflict in Europe since the Second World War, with the potential to escalate to nuclear conflict, you would have thought that the global stock market would have crashed. Yet since Russia’s full-scale invasion of Ukraine on February 24 to the time of writing, the world stock market is down a modest 4 percent, while the US stock market is barely down at all. Is this the stock market’s ‘Wile E Coyote’ moment, in which it pedals hopelessly in thin air before plunging down the chasm? Is this the stock market’s ‘Wile E Coyote’ moment, in which it pedals hopelessly in thin air before plunging down the chasm? Admittedly, since the invasion, European bourses have fallen – for example, Germany’s DAX by 10 percent. And stock markets were already falling before the invasion, meaning that this year the DAX is down 20 percent while the S&P 500 is down 12 percent. But there is a crucial difference. While the DAX year-to-date plunge is due to an expected full-blooded profits recession that the Ukraine crisis will unleash, the S&P 500 year-to-date decline is due to the sell-off in the long-duration bond (Chart I-1 and Chart I-2). This difference in drivers will also explain the fate of these markets as the crisis evolves, just as in the pandemic.   Chart I-1The DAX Has Sold Off Because It Expects Profits To Plunge... The DAX Has Sold Off Because It Expects Profits To Plunge... The DAX Has Sold Off Because It Expects Profits To Plunge...   Chart I-2...But The S&P 500 Has Sold Off Because The Long Bond Has Sold Off ...But The S&P 500 Has Sold Off Because The Long Bond Has Sold Off ...But The S&P 500 Has Sold Off Because The Long Bond Has Sold Off During The Pandemic, Central Banks And Governments Saved The Day… We can think of a stock market as a real-time calculator of the profits ‘run-rate.’ In this regard, the real-time stock market is several weeks ahead of analysts, whose profits estimates take time to collect, collate, and record. For example, during the pandemic, the stock market had already discounted a collapse in profits six weeks before analysts’ official estimates (Chart I-3 and Chart I-4). Chart I-3The German Stock Market Is Several Weeks Ahead Of Analysts The German Stock Market Is Several Weeks Ahead Of Analysts The German Stock Market Is Several Weeks Ahead Of Analysts Chart I-4The US Stock Market Is Several Weeks Ahead ##br##Of Analysts The US Stock Market Is Several Weeks Ahead Of Analysts The US Stock Market Is Several Weeks Ahead Of Analysts We can also think of a stock market as a bond with a variable rather than a fixed income. Just as with a bond, every stock market has a ‘duration’ which establishes which bond it most behaves like when bond yields change. It turns out that the long-duration US stock market has the same duration as a 30-year bond, while the shorter-duration German stock market has the same duration as a 7-year bond. Pulling this together, and assuming no change to the very long-term structural growth story, we can say that: The US stock market = US profits multiplied by the 30-year bond price (Chart I-5 and Chart I-6). The German stock market = German profits multiplied by the 7-year bond price (Chart I-7 and Chart I-8). Chart I-5US Profits Multiplied By The 30-Year Bond Price... US Profits Multiplied By The 30-Year Bond Price... US Profits Multiplied By The 30-Year Bond Price... Chart I-6...Equals The US Stock Market ...Equals The US Stock Market ...Equals The US Stock Market Chart I-7German Profits Multiplied By The 7-Year Bond Price... German Profits Multiplied By The 7-Year Bond Price... German Profits Multiplied By The 7-Year Bond Price... Chart I-8...Equals The German Stock Market ...Equals The German Stock Market ...Equals The German Stock Market When bond yields rise – as happened through December and January – the greater scope for a price decline in the long-duration 30-year bond will hurt the US stock market both absolutely and relatively. But when bond yields decline – as happened at the start of the pandemic – this same high leverage to the 30-year bond price can protect the US stock market. When bond yields decline, the high leverage to the 30-year bond price can protect the US stock market. During the pandemic, the 30-year T-bond price surged by 35 percent, which more than neutralised the decline in US profits. Supported by this surge in the 30-year bond price combined with massive fiscal stimulus that underpinned demand, the pandemic bear market lasted barely a month. What’s more, the US stock market was back at an all-time high just four months later, much quicker than the German stock market. …But This Time The Cavalry May Take Longer To Arrive Unfortunately, this time the rescue act may take longer. One important difference is that during the pandemic, governments quickly unleashed tax cuts and stimulus payments to shore up demand. Whereas now, they are unleashing sanctions on Russia. This will choke Russia, but will also choke demand in the sanctioning economy. Another crucial difference is that as the pandemic took hold in March 2020, the Federal Reserve slashed the Fed funds rate by 1.5 percent. But at its March 2022 meeting, the Fed will almost certainly raise the interest rate (Chart I-9). Chart I-9As The Pandemic Took Hold, The Fed Could Slash Rates. Not Now. As The Pandemic Took Hold, The Fed Could Slash Rates. Not Now. As The Pandemic Took Hold, The Fed Could Slash Rates. Not Now. As the pandemic was unequivocally a deflationary shock at its outset, it was countered with a massive stimulatory response from both central banks and governments. In contrast, the Ukraine crisis has unleashed a new inflationary shock from soaring energy and food prices. And this on top of the pandemic’s second-round inflationary effects which have already dislocated inflation into uncomfortable territory. Our high conviction view is that this inflationary impulse combined with sanctions will be massively demand-destructive, and thereby ultimately morph into a deflationary shock. Yet the danger is that myopic policymakers and markets are not chess players who think several moves ahead. Instead, by fixating on the immediate inflationary impulse from soaring energy and food prices, they will make the wrong move. In the Ukraine crisis, the big risk is that the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. If anything, the fixation on inflation and sanctions may increase short-term pain for both the economy and the stock market. Compared with the pandemic, both the sell-off and the recovery will take longer to play out. In the Ukraine crisis, the big risk is that the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. One further thought. The Ukraine crisis has ‘cancelled’ Covid from the news and our fears, as if it were just a bad dream. Yet the virus has not disappeared and will continue to replicate and mutate freely. Probably even more so, now that we have dismissed it, and Europe’s largest refugee crisis in decades has given it a happy hunting ground. Hence, do not dismiss another wave of infections later this year. The Investment Conclusions Continuing our chess metaphor, a tactical investment should consider only the next one or two moves, a cyclical investment should be based on the next five moves, while a long-term structural investment (which we will not cover in this report) should visualise the board after twenty moves. All of which leads to several investment conclusions: On a tactical (3-month) horizon, the inflationary impulse from soaring energy and food prices combined with the choke on growth from sanctions will weigh on both the global economy and the global stock market. As such, bond yields could nudge higher, the global stock market has yet to reach its crisis bottom, and the US dollar will rally (Chart I-10). Chart I-10When Stock Markets Sell Off, The Dollar Rallies When Stock Markets Sell Off, The Dollar Rallies When Stock Markets Sell Off, The Dollar Rallies But on a cyclical (12-month) horizon, the short-term inflationary impulse combined with sanctions will be massively demand-destructive, at which point the cavalry of lower bond yields will charge to the rescue. Therefore: Overweight the 30-year T-bond and the 30-year Chinese bond, both in absolute terms and relative to other 30-year sovereign bonds. Overweight equities. Overweight long-duration US equities versus short-duration non-US equities. How Can Fractal Analysis Help In A Crisis? When prices are being driven by fundamentals, events and catalysts, as they are now, how can fractal analysis help investors? The answer is that it can identify when a small event or catalyst can have a massive effect in reversing a trend. In this regard, the extreme rally in crude oil has reached fragility on both its 65-day and 130-day fractal structures. Meaning that any event or catalyst that reduces fears of a supply constraint will cause an outsized reversal (Chart I-11). Chart I-11The Extreme Rally In Crude Oil Is Fractally Fragile The Extreme Rally In Crude Oil Is Fractally Fragile The Extreme Rally In Crude Oil Is Fractally Fragile Equally interesting, the huge outperformance of oil equities versus bank equities is reaching the point of fragility on its 260-day fractal structure that has reliably signalled major switching points between the sectors (Chart I-12). Given the fast-moving developments in the crisis, we are not initiating any new trades this week, but stay tuned. Chart I-12The Huge Outperformance Of Oil Equities Versus Banks Equities Is Approaching A Reversal The Huge Outperformance Of Oil Equities Versus Banks Equities Is Approaching A Reversal The Huge Outperformance Of Oil Equities Versus Banks Equities Is Approaching A Reversal Fractal Trading Watchlist Biotech To Rebound Biotech Is Starting To Reverse Biotech Is Starting To Reverse US Healthcare Vs. Software Approaching A Reversal US Healthcare Vs. Software Approaching A Reversal US Healthcare Vs. Software Approaching A Reversal Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Greece’s Brief Outperformance To End Greece Is Snapping Back Greece Is Snapping Back Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades Are We In A Slow-Motion Crash? Are We In A Slow-Motion Crash? Are We In A Slow-Motion Crash? Are We In A Slow-Motion Crash? 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary US Equity Drawdowns During Geopolitical Crises/Commodity Shocks US Equity Drawdowns During Geopolitical Crises/Commodity Shocks US Equity Drawdowns During Geopolitical Crises/Commodity Shocks ​​​​​​ The most recent examples of geopolitical and commodity price shocks similar the current one include the Cuban missile crisis in 1962, the oil embargo of 1973 in response to the Yom Kippur War as well as the Gulf War of 1990. The magnitude of the S&P 500 selloff was 28% in 1962, 23% in 1973 and 20% in 1990 (Chart of the week). Neither of our capitulation indicators for the S&P 500 or for EM stocks have reached their previous lows. As for commodity prices, the only thing that is certain in the next couple of months is that volatility will remain very elevated. Having incurred considerable costs, Russia will push to maximize its gains and secure a new, more favorable agreement with NATO. This will keep geopolitical tension elevated.   Bottom Line: The drawdown in global and EM stocks in not over yet. The US dollar has more upside in the near term. This is consistent with the S&P500 outperforming and EM stocks underperforming. A rising US dollar bodes ill for EM fixed-income markets. Feature Chart 1US Equity Drawdowns During Geopolitical Crises/Commodity Shocks US Equity Drawdowns During Geopolitical Crises/Commodity Shocks US Equity Drawdowns During Geopolitical Crises/Commodity Shocks The world is experiencing geopolitical and commodity price shocks that have not been seen in over a generation. The most recent examples of this kind of shock include the Cuban missile crisis in 1962, the oil embargo of 1973 in response to the Yom Kippur War as well as the Gulf War of 1990. Chart 1 illustrates the current trajectory of the S&P 500 with selloffs that occurred during those three episodes. The magnitude of the S&P 500 selloff was 28% in 1962, 23% in 1973 and 20% in 1990. The S&P 500 is down only 11% from its peak. Based on the above three profiles, the current selloff in US stocks has further to go. This also means that non-US equities, including EM, will continue to suffer. What are the conditions needed for global stocks to bottom? In our opinion, a durable bottom in share prices will occur when measures of capitulation in equity markets reach their previous lows, commodity prices (particularly crude prices) decline and geopolitical tensions peak. We elaborate on each below. Equity Capitulation Neither of our capitulation indicators for the S&P 500 or for EM stocks have reached their previous lows. Chart 2 displays our capitulation indicator for US equities. Its construction is based on four equal-weighted components: the composite momentum indicator, the US equity sentiment indicator, industry group breadth and the advance-decline line (shown individually in Chart 7-8 below). Chart 2US Stocks Have Not Reached Their Selling Climax US Stocks Have Not Reached Their Selling Climax US Stocks Have Not Reached Their Selling Climax This indicator has not reached its lows of 2010, 2011, 2018 and 2020. In 2011 and 2018, the S&P500 selloffs were 19.5% and 19.8%, respectively. Hence, our best guess for the magnitude of an equity drawdown in this selloff is about 20%. This puts the potential S&P500 low at 3600-3700. The latter is consistent with the technical support (3-year moving average) that held up in 2011, 2016 and 2018 (Chart 2, top panel).  Chart 3 illustrates our EM equity capitulation indicator. Its four equal-weighted components are the composite momentum indicator, EM equity sentiment, industry group breadth and net EPS revisions (shown individually in Chart 9-10 below). We believe that EM share prices will drop until this capitulation indicator comes to the levels reached in the 2011, 2013 and 2018 selloffs. Chart 3The EM Equity Capitulation Has Further To Run The EM Equity Capitulation Has Further To Run The EM Equity Capitulation Has Further To Run Concerning the magnitude of further EM equity selloff, the next technical defense line for the MSCI EM stock index in USD is 10%, or in the worst-case scenario, 25% below current levels (Chart 3, top panel). The Commodity Shock Global share prices have become negatively correlated with commodity (primarily oil) prices and such an inverse relationship will likely persist for now. In fact, an important signal of the bottom in the S&P 500 during the 1990 oil spike was the peak in crude prices (the latter is shown inverted in Chart 4). In the case of the oil embargo of 1973-74, the oil market was not developed, and US share prices were negatively correlated with US 10-year Treasury yields (Chart 5). Chart 4The 1990 Oil Shock The 1990 Oil Shock The 1990 Oil Shock Chart 5The 1973 Oil Shock The 1973 Oil Shock The 1973 Oil Shock   Presently, given that US stocks were reacting negatively to rising US bond yields prior to the Ukraine crisis, it is reasonable to expect American share prices to bottom only when two conditions are satisfied: (1) oil prices start falling on a sustainable basis and (2) US bond yields do not rise much. How much will oil and other commodity prices rise? It is hard to know because multiple forces are in play. First, Russia is the second largest commodity exporter in the world (after the US). Russia’s crude oil exports account for 8.4% of global crude consumption, natural gas exports for 5.9% of global consumption and 3.4% for coal (Table 1). Across metals, Russia is a large producer too – 35.6% for palladium, 4.4% for nickel and 4.2% for copper (Table 1).  In turn, Russia and Ukraine production together accounts for 14% of global wheat consumption. Table 1Russia’s Global Share In Various Commodities Equity Capitulation, A Commodity Shock And Geopolitics Equity Capitulation, A Commodity Shock And Geopolitics The West’s official sanctions affect Russian exports of certain commodities but there is also a reluctance on the part of private companies to buy or ship Russian exports. This latter factor makes it nearly impossible to gauge just how much supply of each individual commodity will be curtailed. Assuming in the near term that a considerable share of Russia’s commodity exports will be blocked from global markets, the largest impact will be on oil, palladium, copper, nickel and fertilizer. While ratcheting sales of resources to China is a saving grace for Russia, it might take some time until shipments can be rerouted and reorganized. Second, the US is pressuring allied nations in the Gulf as well as other countries like Venezuela to produce and bring more oil to the market. Finally, the surge in commodity prices is probably already destroying demand. Oil and wheat prices have risen to record highs in many EM currencies (Chart 36 and 37 below). This will push inflation higher and herald more rate hikes from central banks. High interest rates along with tight fiscal policy and eroding discretionary spending (due to high energy and food prices) entail weak demand in developing economies. Bottom Line: In the very short run, risks to many commodity prices are skewed to the upside due to supply constraints. Yet, enormous uncertainty over factors driving their demand and supply makes prices over the next three months impossible to forecast. During this period, individual commodity prices might be driven by idiosyncratic factors. The only thing that is certain in the next couple of months is that volatility in commodity prices will remain very elevated. Price surges might be followed by large drawdowns and vice versa. Geopolitical Tensions The Kremlin will continue its military assault until it establishes firm control over Kyiv and the Black Sea coast, including the city of Odessa. As we wrote in our March 2 report, Putin’s objective is to install a very loyal government in Kyiv and to control the territory east of the Dniepr river. It is not clear to us whether the Kremlin has the appetite to control the Ukraine territory west of the Dniepr river. Western Ukraine has always been very anti-Russian and Putin might realize that it will be too costly to capture and control it. We do not think Putin has ambitions to go beyond Ukraine (Moldova being an exception). That said, there is no doubt that the Kremlin will be presenting more demands to NATO and threatening if those demands are not met. Having incurred considerable costs, Russia will push to maximize its gains and secure a new, more favorable agreement with NATO. It is not clear how many geopolitical concessions or what security guarantees the US is willing to provide to Russia. On the whole, geopolitical tensions between Russia and NATO/the US will continue until there is a new deal between the parties. Investment Strategy Chart 6No Trend Change In EM And US Relative Equity Performance No Trend Change In EM And US Relative Equity Performance No Trend Change In EM And US Relative Equity Performance The drawdown in global and EM stocks in not over yet. Within a global equity portfolio, we continue to recommend underweighting EM and Europe and overweighting the US. Interestingly, the EM relative equity performance versus the global stock index has rolled over at its 200-day moving average, while the US’s relative performance has found a support at its 200-day moving average (Chart 6). Such a technical configuration suggests that EM stocks will continue underperforming for now while US equities will have another upleg in relative terms. The US dollar has more upside in the near term. This is consistent with the S&P500 outperforming and EM stocks underperforming. A rising US dollar bodes ill for EM fixed-income markets. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Components Of Our US Equity Capitulation Indicator Not all components of our US Equity Capitulation Indicator have reached their previous lows. Given the backdrop of still expensive US equity valuations, heightened geopolitical risks, very elevated inflation and high inflation expectations as well as the little maneuvering room that the Fed has, odds are that US share prices will drop further. Chart 7Components Of Our US Equity Capitulation Indicator Components Of Our US Equity Capitulation Indicator Components Of Our US Equity Capitulation Indicator Chart 8Components Of Our US Equity Capitulation Indicator Components Of Our US Equity Capitulation Indicator Components Of Our US Equity Capitulation Indicator Components Of Our EM Equity Capitulation Indicator Not all components of our EM Equity Capitulation Indicator have reached their previous lows either. The share of industry groups above their 200-day moving average, analysts’ net EPS revisions as well as the momentum and equity sentiment indicators remain above their lows. Further downside in EM share prices is likely. Chart 9Components Of Our EM Equity Capitulation Indicator Components Of Our EM Equity Capitulation Indicator Components Of Our EM Equity Capitulation Indicator Chart 10Components Of Our EM Equity Capitulation Indicator Components Of Our EM Equity Capitulation Indicator Components Of Our EM Equity Capitulation Indicator US Stocks Have Not Yet Reached Their Selling Climax The NYSE’s advance/decline line has broken down and is dropping, signifying a broadening equity rout. Yet, we doubt the US equity indexes will bottom when 35% of NYSE listed stocks are above their 200-day moving average. Finally, the US median stock has broken below its 200-day moving average. Given the fundamental backdrop, all of these technical signposts point to a larger than 10% correction in the S&P 500. Chart 11US Stocks Have Not Yet Reached Their Selling Climax US Stocks Have Not Yet Reached Their Selling Climax US Stocks Have Not Yet Reached Their Selling Climax Chart 12US Stocks Have Not Yet Reached Their Selling Climax US Stocks Have Not Yet Reached Their Selling Climax US Stocks Have Not Yet Reached Their Selling Climax Chart 13US Stocks Have Not Yet Reached Their Selling Climax US Stocks Have Not Yet Reached Their Selling Climax US Stocks Have Not Yet Reached Their Selling Climax Chart 14US Stocks Have Not Yet Reached Their Selling Climax US Stocks Have Not Yet Reached Their Selling Climax US Stocks Have Not Yet Reached Their Selling Climax Global Overall And Global ex-US Equities Although Global ex-US stocks are much more oversold than US stocks, their growth and profit backdrops are worse. As we argued in the front section of this report (Chart 6 above), odds are that US stocks will continue outperforming non-US stocks in the near term. Despite crashing, European stocks might not have found a support yet. Chart 15Global Overall And Global ex-US Equities Global Overall And Global ex-US Equities Global Overall And Global ex-US Equities Chart 16Global Overall And Global ex-US Equities Global Overall And Global ex-US Equities Global Overall And Global ex-US Equities Chart 17Global Overall And Global ex-US Equities Global Overall And Global ex-US Equities Global Overall And Global ex-US Equities Chart 18Global Overall And Global ex-US Equities Global Overall And Global ex-US Equities Global Overall And Global ex-US Equities European Stocks: Is A Support At Hand? Investor sentiment on European stocks has become depressed. Yet, European economies will decelerate due to the energy shock (natural gas prices have shot up two-fold since October 1) as well as falling consumer and business confidence. A bottom for euro area stocks might be lower than current prices. Chart 19European Stocks: Is A Support At Hand? European Stocks: Is A Support At Hand? European Stocks: Is A Support At Hand? Chart 20European Stocks: Is A Support At Hand? European Stocks: Is A Support At Hand? European Stocks: Is A Support At Hand? Chart 21European Stocks: Is A Support At Hand? European Stocks: Is A Support At Hand? European Stocks: Is A Support At Hand? EM Equities: Cheap But Mind The Profit Outlook According to our cyclically adjusted P/E ratio, EM stocks are slightly cheap in absolute terms and are very attractive versus US equities. However, this valuation indicator should be used by long-term investors. In the short run and even from a cyclical perspective, this valuation indicator is not very useful. Besides, investor sentiment on EM equities was neutral in the middle of February. It might take more weakness before bad news get priced in EM share prices. Chart 22EM Equities: Cheap But Mind The Profit Outlook EM Equities: Cheap But Mind The Profit Outlook EM Equities: Cheap But Mind The Profit Outlook Chart 23EM Equities: Cheap But Mind The Profit Outlook EM Equities: Cheap But Mind The Profit Outlook EM Equities: Cheap But Mind The Profit Outlook Chart 24EM Equities: Cheap But Mind The Profit Outlook EM Equities: Cheap But Mind The Profit Outlook EM Equities: Cheap But Mind The Profit Outlook EM Profits In A Soft Spot As projected by our EM narrow money (M1) aggregate, EM corporate earnings will continue to disappoint. This is the key risk to EM share prices. In fact, EM EPS has been broadly flat over the past 15 years. That is why EM stocks appear cheap. Plus, EM ex-TMT stocks have not yet fallen much and downside risks remain. Chart 25EM Profits In A Soft Spot EM Profits In A Soft Spot EM Profits In A Soft Spot Chart 26EM Profits In A Soft Spot EM Profits In A Soft Spot EM Profits In A Soft Spot Chart 27EM Profits In A Soft Spot EM Profits In A Soft Spot EM Profits In A Soft Spot Chinese Investable Stocks Are At Their March 2020 Lows Offshore and onshore Chinese shares prices have been falling hard. Not only have Chinese corporate profit expectations been downshifting but also Chinese Investable stocks have been derating (their multiples have been compressing). This has been due to foreign investors projecting/extrapolating the US-Russia confrontation to a possible future US-China geopolitical standoff, and therefore possible sanctions the West can impose on China. Chart 28Chinese Investable Stocks Are At Their March 2020 Lows Chinese Investable Stocks Are At Their March 2020 Lows Chinese Investable Stocks Are At Their March 2020 Lows Chart 29Chinese Investable Stocks Are At Their March 2020 Lows Chinese Investable Stocks Are At Their March 2020 Lows Chinese Investable Stocks Are At Their March 2020 Lows Chart 30Chinese Investable Stocks Are At Their March 2020 Lows Chinese Investable Stocks Are At Their March 2020 Lows Chinese Investable Stocks Are At Their March 2020 Lows Chart 31Chinese Investable Stocks Are At Their March 2020 Lows Chinese Investable Stocks Are At Their March 2020 Lows Chinese Investable Stocks Are At Their March 2020 Lows China: No "All-In" Stimulus Yet The improvement in China’s total social financing has been entirely due to local government bond issuance. Corporate and household credit have not improved at all. Consistently, traditional infrastructure investment has probably bottomed. Yet, outside this sector the outlook is uninspiring. Property construction remains at risk, consumer spending is very sluggish and private business sentiment is downbeat. Chart 32China: No "All-In" Stimulus Yet China: No "All-In" Stimulus Yet China: No "All-In" Stimulus Yet Chart 33China: No "All-In" Stimulus Yet China: No "All-In" Stimulus Yet China: No "All-In" Stimulus Yet Chart 34China: No "All-In" Stimulus Yet China: No "All-In" Stimulus Yet China: No "All-In" Stimulus Yet Chart 35China: No "All-In" Stimulus Yet China: No "All-In" Stimulus Yet China: No "All-In" Stimulus Yet EM Woes: Energy And Food Prices Many low-income developing countries will be suffering from elevated food and energy prices. Oil and wheat prices in EM currencies have surged to all-time highs. This will lift headline inflation in many emerging economies, lead to monetary tightening and reduce household income available for discretionary spending. All of these and the lack of fiscal easing in many developing countries entail growth disappointments this year. Chart 36EM Woes: Energy And Food Prices EM Woes: Energy And Food Prices EM Woes: Energy And Food Prices Chart 37EM Woes: Energy And Food Prices EM Woes: Energy And Food Prices EM Woes: Energy And Food Prices Chart 38EM Woes: Energy And Food Prices EM Woes: Energy And Food Prices EM Woes: Energy And Food Prices Chart 39EM Woes: Energy And Food Prices EM Woes: Energy And Food Prices EM Woes: Energy And Food Prices EM Credit Spreads Are Widening Rapidly EM sovereign and corporate spreads have broken out. Such spread widening is not simply due to Russian credit. The pace of spread widening differs among countries. However, directionally, credit spreads seem to have embarked on a widening path. In a nutshell, Chinese USD corporate in general and property bond prices in particular are tanking (see below). This foreshadows the poor outlook for Chinese housing. Chart 40EM Credit Spreads Are Widening Rapidly EM Credit Spreads Are Widening Rapidly EM Credit Spreads Are Widening Rapidly Chart 41EM Credit Spreads Are Widening Rapidly EM Credit Spreads Are Widening Rapidly EM Credit Spreads Are Widening Rapidly Chart 42EM Credit Spreads Are Widening Rapidly EM Credit Spreads Are Widening Rapidly EM Credit Spreads Are Widening Rapidly Chart 43EM Credit Spreads Are Widening Rapidly EM Credit Spreads Are Widening Rapidly EM Credit Spreads Are Widening Rapidly EM Credit Markets And EM Equities Historically, rising EM corporate USD bond yields led to a selloff in EM share prices. This is the cost of capital that matters for EM equities. Unless EM sovereign and corporate bonds yields start falling on a sustainable basis, EM equities will continue to struggle. Chart 44EM Credit Markets And EM Equities EM Credit Markets And EM Equities EM Credit Markets And EM Equities Chart 45EM Credit Markets And EM Equities EM Credit Markets And EM Equities EM Credit Markets And EM Equities Chart 46EM Credit Markets And EM Equities EM Credit Markets And EM Equities EM Credit Markets And EM Equities Global Resource Stocks The relative performance of global energy and basic materials versus the global equity index has bottomed. In the medium term, odds are that TMT stocks will underperform while resource companies outperform. Yet, the outlook for energy stocks and basic materials in absolute terms is complicated (in line with the elevated volatility in commodity prices we discussed in the front section). Notably, even though commodity prices have skyrocketed, basic materials and energy share prices have not yet broken out. It seems the market is doubting the sustainability of high commodity prices. Chart 47Global Resource Stocks Global Resource Stocks Global Resource Stocks Equity Capitulation, A Commodity Shock And Geopolitics Equity Capitulation, A Commodity Shock And Geopolitics Equity Capitulation, A Commodity Shock And Geopolitics Equity Capitulation, A Commodity Shock And Geopolitics Footnotes

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

Executive Summary Chinese Onshore Stocks Are Less Impacted By External Factors Upgrading Chinese Onshore Stocks To Neutral Upgrading Chinese Onshore Stocks To Neutral We are upgrading Chinese onshore stocks from underweight to neutral relative to global stocks. At the same time, we are closing our tactical trade of long Chinese investable stocks/short global stocks. In the near term, Russia’s armed invasion of Ukraine will spark a further selloff in global risk assets. Volatility in Chinese onshore stock prices will remain high; A-share prices in absolute terms may also drop but should fall by less than their peers in European and emerging markets. On the other hand, Chinese offshore stocks are more vulnerable to geopolitical risks compared with their onshore counterparts. There are tentative signs that home prices may be stabilizing, although demand for housing remains in deep contraction. Chinese policymakers remain vigilant in preventing the property market from overheating and credit creation from overshooting. However, the ongoing Russia/Ukraine incursion has the potential to catalyze a larger stimulus package in China. If the escalating geopolitical crisis threatens the global economy, China’s authorities will likely strengthen policy supports at home to buttress the country’s domestic political, economic and financial conditions. Bottom Line: Chinese onshore stocks will weather the ongoing geopolitical storm better than their offshore and global peers. China’s economy is also less negatively impacted by the Russia/Ukraine hostilities. If the crisis deepens, China’s leadership will likely step up measures to support its economy and ensure stable domestic financial and political dynamics. Feature The conflict between Russia and Ukraine unnerved global financial markets in the past few weeks. Chinese offshore stocks were not insulated from the geopolitical event; the MSCI China Index declined by about 4% in February, in-line with the selloff in global stocks. Chart 1Chinese Onshore Financial Markets Held Up Relatively Well Last Month Chinese Onshore Financial Markets Held Up Relatively Well Last Month Chinese Onshore Financial Markets Held Up Relatively Well Last Month The current global geopolitical environment, however, has turned us a bit more positive on Chinese onshore stocks in relative terms. In the near term, the onshore market should hold up better than its offshore and European counterparts. China’s closed capital market prevents panic capital outflows and its large current account surplus as well as favorable real interest rate differentials help to maintain strength in the RMB (Chart 1). On a cyclical basis, China’s domestic economic fundamentals will continue to drive prices in the A-share market. China’s aggregate economy is less affected by the Russia/Ukraine conflict than Europe. Energy supplies from Russia to China will likely continue and may even accelerate, mitigating the risks of energy shock-induced inflation spikes. As such, we are upgrading Chinese onshore stocks from underweight to neutral in a global portfolio, both in tactical and cyclical time horizons. We remain cautious about the size of Chinese stimulus for the year and, therefore, are neutral in our cyclical view on Chinese onshore stocks relative to global equities. Despite some nascent signs of reflation and an easing of housing policy in a few Chinese cities, aggregate property demand remains weak and overall policy easing in the sector has been marginal. Nonetheless, the situation surrounding Ukraine and the global sanctions against Russia are highly fluid and may provide some ground for Chinese policymakers to ramp up stimulus at home. If the conflict intensifies and derails the European/global economy, Beijing will be more inclined to adopt measures to ensure the stability of its domestic economy, financial markets and political dynamics. Meanwhile, we are closing our long MSCI China/short MSCI global tactical trade. Chinese offshore stocks are more vulnerable to geopolitical tensions and risk-off sentiment among global investors. The Russia Incursion Has Limited Direct Impact On China’s Economy Chinese stocks were not immune last week to the global financial market’s gyrations triggered by Russia’s invasion of Ukraine. While Russia’s attack on its neighbor will create short-term disruptions on the prices of global commodities and China’s A-shares, the cyclical performance of Chinese onshore stocks is tied to the country’s domestic economic fundamentals. The military conflict between Russia and Ukraine should have a limited knock-on effect on China’s business cycle dynamics for the following reasons: Russia and Ukraine together account for less than 3% of Chinese total exports as of 2021, limiting the negative impact from reduced demand in the region on China’s current account balance.  Chart 2Ukraine: China’s Major Source Of Agricultural Commodity Supplies Upgrading Chinese Onshore Stocks To Neutral Upgrading Chinese Onshore Stocks To Neutral Russia’s incursion of Ukraine may have consequences on China’s food prices. Ukraine is a major agricultural commodity exporter to China, hence a prolonged military conflict may disrupt agricultural supplies and push up imported food prices in China (Chart 2). In this scenario, we expect that Beijing will provide subsidies to ease pressures on domestic food prices due to supply shocks, rather than tighten monetary policy to reduce demand. China is unlikely to experience shocks linked to possible energy disruptions. Russia is a core exporter of energy to China and supplies of crude oil, natural gas and coal have increased in recent years (Chart 3). We do not expect that Russia’s energy supply to China will be disrupted. Indeed, following the 2014 Russia’s invasion of Crimea, Russia’s crude oil exports to China increased by 40% (Chart 3, top panel). We anticipate that oil prices will fall from the current level in the second half of the year, limiting the upshot from higher oil prices on Chinese inflation. So far, the US and EU have announced tough sanctions on Russia’s non-energy sectors, but they have avoided halting Russia’s energy exports. ​​​​​​​In the unlikely scenario that energy flows from Russia to Europe are disrupted in any meaningful and long-lasting way, either through European sanctions or a Russian embargo, Russia would probably turn to China to absorb its energy exports. Given that Russia cannot easily replace Europe with any other alternative market, particularly natural gas, China would gain an upper hand in price negotiations with the Russians (Chart 4). Thus, a steady supply of cheap natural gas and other forms of energy would be a net positive for China’s economy. Chart 4Russia Cannot Easily Replace Europe With Any Alternative Consumer Other Than China Upgrading Chinese Onshore Stocks To Neutral Upgrading Chinese Onshore Stocks To Neutral Chart 3Russia's Ties With China On Energy Supplies Will Likely Strengthen Russia's Ties With China On Energy Supplies Will Likely Strengthen Russia's Ties With China On Energy Supplies Will Likely Strengthen Meanwhile, oil’s current price spike may widen the gap in profits between China’s upstream and downstream industrial enterprises (Chart 5). However, the effect from higher oil prices on Chinese downstream manufacturers should be temporary. Our Commodity and Energy Strategists believe that the Russian invasion will prompt increased production from core OPEC producers. These production increases would reduce prices from last week’s $105 per barrel level to $85 per barrel by the second half of 2022 and keep it at that level throughout 2023 (Chart 6). Chart 6Crude Oil Price Risk Premium Will Abate But Not Disappear Crude Oil Price Risk Premium Will Abate But Not Disappear Crude Oil Price Risk Premium Will Abate But Not Disappear Chart 5Rising Oil Prices May Temporarily Widen Profit Gaps Between China's Up- And Downstream Industries Rising Oil Prices May Temporarily Widen Profit Gaps Between China's Up- And Downstream Industries Rising Oil Prices May Temporarily Widen Profit Gaps Between China's Up- And Downstream Industries Bottom Line: Russia’s invasion of Ukraine should have a limited direct impact on China’s domestic economy, inflation and monetary policy. Tentative Signs Of Home Price Stabilization Although the property market is showing some signs of improvement, the aggregate demand for homes remains very sluggish. Recently released housing data in China show some slight progress, as fewer cities reported a month-on-month drop in new home prices in January (Chart 7). The monthly average new home prices among China’s 70 cities were broadly flat last month following four consecutive months of falling prices. Tier 1 and Tier 2 cities had the largest increases in home prices, whereas prices in other regions continued to contract through January, albeit to a lesser degree (Chart 7, bottom panel). The minor improvement in home prices reflects recently implemented measures to help shore up the flagging market. Last month, the PBoC cut the policy rate by 10 bps and reduced the one- and five-year loan prime rates by 10 bps and 5 bps, respectively. Moreover, last week several regional banks lowered the down payments on mortgages for homebuyers. Chart 8...Demand For Housing Remains In Deep Contraction ...Demand For Housing Remains In Deep Contraction ...Demand For Housing Remains In Deep Contraction Chart 7Although There Are Some Early Signs Of Stabilization In Home Prices... Although There Are Some Early Signs Of Stabilization In Home Prices... Although There Are Some Early Signs Of Stabilization In Home Prices... Nonetheless, the aggregate demand for housing remains weak. China’s 100 largest developers experienced a roughly 40% year-on-year plunge in total sales in January, indicating that recent easing measures failed to revive the downbeat sentiment among homebuyers (Chart 8). Bottom Line: Policymakers will remain vigilant in not inducing another surge in house prices and will continue to target steady home prices. As such, it is too early to upgrade our cyclical view on China’s property market, stimulus and economic recovery. Investment Conclusions We are upgrading Chinese onshore stocks to neutral relative to global equities (both tactically and in the next 6 to 12 months), while closing our tactical trade of long MSCI China/short MSCI global index. Chart 9Chinese Onshore Stock Prices Are Largely Driven By Domestic Rather Than External Factors... Chinese Onshore Stock Prices Are Largely Driven By Domestic Rather Than External Factors... Chinese Onshore Stock Prices Are Largely Driven By Domestic Rather Than External Factors... Given the limited impact of the Russia/Ukraine conflict on China’s domestic economy and the low correlation to the global equity index, Chinese onshore stock prices may also fall in absolute terms in the coming weeks, but not by as much as their offshore and European counterparts (Chart 9). Furthermore, while we maintain a cautious cyclical outlook for China’s stimulus, the ongoing geopolitical crisis has the potential to provide a catalyst for Chinese policymakers to stimulate the domestic economy more forcefully. If the clash evolves into a real risk to the European economy and global financial markets, odds are high that Chinese policymakers will step up stimulus measures to ensure domestic stability. In this scenario, Chinese onshore stocks will likely outperform global equities. In the past, Chinese authorities refrained from a credit overshoot when the business cycle slowed in an orderly manner, but they stimulated substantially following an exogenous shock. For example, China rolled out massive stimulus packages after the 2008 Global Financial and the 2011/12 European credit crises. Beijing did not directly respond to Russia’s 2014 annexation of Crimea with additional monetary support to China’s domestic economy. However, the Chinese authorities started to aggressively stimulate when a collapse in domestic demand coincided with a global manufacturing recession in 2015. Chart 10...Whereas Chinese Offshore Stocks Are More Vulnerable To Global Risk-Off Sentiment ...Whereas Chinese Offshore Stocks Are More Vulnerable To Global Risk-Off Sentiment ...Whereas Chinese Offshore Stocks Are More Vulnerable To Global Risk-Off Sentiment The PBoC’s outsized liquidity injection in the interbank system last Friday is also a sign that Beijing is willing to accelerate policy easing if the geopolitical backdrop meaningfully worsens.  Regarding Chinese investable stocks, we maintain our cyclical underweight stance relative to global equities. In the near term, risk-off sentiment among global investors will undermine the performance of Chinese offshore stocks in both absolute and relative terms (Chart 10). Over a longer time horizon (6 to 12 months), growth stocks will likely underperform value stocks when global stocks recover. Thus, the tech-heavy MSCI China Index is less attractive to investors compared with other emerging and developed market equities that are more value-centric. Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations