Sectors

Executive Summary 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? Chart 2Oil 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 Chart 4Geopolitics 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 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 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... Chart 7B...The EU Is Not 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 Chart 8BUS Will Not Replace Russian Energy Anytime Soon 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 Chart 9BUS 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 Chart 11Russia Needs EU Energy Imports 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... Chart 12B...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 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 Chart 15Current Oil Price Comfortably Supports Fiscal Spending In OPEC 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 Chart 17Production 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 Chart 18BMarket 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 Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets

Executive Summary Winners And Losers 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 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 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 Chart 3Wheat Is Exported To North Africa And Asia 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 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 Chart 5Winners And Losers 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 Chart 7Consumer 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

Highlights Chart 1A Tough Balancing Act For The Fed In last week’s Congressional testimony, Fed Chair Jay Powell talked about his goal of achieving a “soft landing”. That is, the Fed will tighten enough to slow inflation but not so much that the economy tips into recession. This balancing act was always going to be difficult, and recent world events have only complicated it. On the one hand, the US labor market has essentially returned to full employment. The prime-age employment-to-population ratio is just 1% below its pre-COVID level, a gap that will soon be filled by the 1.2 million people being kept out of the labor force by the pandemic (Chart 1). On the other hand, risk-off market moves driven by the war in Ukraine have caused the yield curve to flatten (Chart 1, bottom panel). The Fed’s task is to respond to the strong US economy by lifting rates, but to also avoid inverting the yield curve. To split the difference, the Fed will proceed with a 25 bps rate hike at each FOMC meeting, but will slow down if the curve inverts. Our recommended strategy is to keep portfolio duration close to benchmark for the time being given the uncertainty in Ukraine. However, the Treasury curve is now priced for too shallow a path for rate hikes. We are actively looking for a good time to re-initiate duration shorts. Feature   Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 124 basis points in February, dragging year-to-date excess returns down to -238 bps. The index option-adjusted spread widened 16 bps on the month and it currently sits at 130 bps. Our quality-adjusted 12-month breakeven spread has moved up to its 36th percentile since 1995 (Chart 2). The corporate bond sell-off that began late last year on heightened expectations of Fed tightening has accelerated in recent weeks, this time driven by the war in Ukraine. The result of the turmoil is that a significant amount of value has returned to the corporate bond market. In fact, spreads have not been this wide since early 2021. Continued uncertainty about how the Ukrainian situation will evolve causes us to recommend a neutral stance on investment grade corporate bonds in the near term. However, enough value has been created that a buying opportunity could soon emerge. Corporate balance sheets remain healthy. In fact, the ratio of total debt to net worth on nonfinancial corporate balance sheets is at its lowest level since 2010 (bottom panel). Further, the most likely scenario is that the economic contagion from Russia/Ukraine to the United States will be limited. While Fed tightening is set to begin this month, spreads are now wide enough that a flat but positively sloped yield curve is not sufficient to justify an underweight stance on corporate bonds. Investors should stay neutral for now but look for an opportunity to turn more bullish. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 56 basis points in February, dragging year-to-date excess returns down to -213 bps. The index option-adjusted spread widened 17 bps on the month and it currently sits at 376 bps. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – also moved up to 4.6% (Chart 3). The odds are good that defaults will come in below 4.6% during the next 12 months, and as such, we expect high-yield bonds to outperform a duration-matched position in Treasuries. This warrants a continued overweight allocation to High-Yield on a cyclical (6-12 month) horizon, though we acknowledge that further spread widening is likely until the situation in Ukraine reaches a place of greater stability. High-Yield valuations continue to be more favorable than for investment grade corporates (panel 3). We therefore maintain a preference for high-yield corporate bonds over investment grade.       MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 48 basis points in February, dragging year-to-date excess returns down to -60 bps. The zero-volatility spread for conventional 30-year agency MBS widened 12 bps on the month, driven by an 11 bps widening of the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) increased by 1 bp on the month (Chart 4). We wrote in a recent report that MBS’ poor performance in 2021 was attributable to an option cost that was too low relative to the pace of mortgage refinancings, noting that the MBA Refinance Index was slow to fall in 2021 despite the back-up in yields.1 This valuation picture is starting to change. The option cost is now up to 44 bps, its highest level since 2016 and refi activity is slowing as the Fed moves toward rate hikes. At 30 bps, the index OAS remains unattractive. However, the elevated option cost raises the possibility that the OAS may be over-estimating the pace of mortgage refinancings for the first time in a while. If these trends continue, it may soon make sense to increase exposure to agency MBS. We closed our recommendation to favor high coupon over low coupon securities on February 15th, concurrent with our decision to increase portfolio duration. We will likely re-establish this position when we move portfolio duration back to below benchmark. Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Market bonds underperformed the duration-equivalent Treasury index by 399 basis points in February, dragging year-to-date excess returns down to -483 bps. EM Sovereigns underperformed the Treasury benchmark by 519 bps on the month, dragging year-to-date excess returns down to -646 bps. The EM Corporate & Quasi-Sovereign Index underperformed by 323 bps on the month, dragging year-to-date excess returns down to -379 bps. Russian sovereign bonds were recently downgraded to below investment grade, but before they were removed from the index they contributed -367 bps to Sovereign excess returns in February. In other words, if Russian securities are excluded, the EM Sovereign index only lagged Treasuries by 152 bps in February and actually outperformed a duration-matched position in US corporate bonds. As a result, the EM Sovereign index now offers less yield than a credit rating and duration-matched position in US corporate bonds (Chart 5). This recent shift in valuation leads us to reduce our recommended exposure to EM Sovereigns from overweight to underweight. Russian securities also negatively influenced EM Corporate & Quasi-Sovereign returns in February, but that index still offers a significant yield premium over US corporates whether Russian bonds are included or not (bottom panel). The turmoil overseas causes us to reduce exposure to this sector as well, but we will retain a neutral allocation instead of underweight because of still-attractive valuations. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 5 basis points in February, dragging year-to-date excess returns down to -126 bps (before adjusting for the tax advantage). While the war in Ukraine introduces a great deal of uncertainty into the economic outlook, the municipal bond sector should be better placed than most to deal with the fallout. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and 2021’s federal spending splurge will continue to support state & local government coffers for some time. That said, relative muni valuations have tightened significantly during the past few months and the recent back-up in corporate spreads will eventually give us an opportunity to increase exposure to that sector. With that in mind, this week we downgrade our municipal bond allocation from “maximum overweight” (5 out of 5) to “overweight” (4 out of 5). We calculate that 12-17 year maturity Revenue munis offer a breakeven tax rate of 5% relative to credit rating and duration matched US corporate bonds. 12-17 year General Obligation Munis offer a breakeven tax rate of 11% versus corporates (panel 2). Both figures are down considerably from their 2020 peaks. For their part, high-yield muni spreads have also not kept pace with the recent widening in high-yield corporate spreads (bottom panel). Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve flattened dramatically In February, driven by a re-pricing of Fed expectations in the first half of the month and then later by flight-to-quality flows spurred by the war in Ukraine. The 2/10 and 5/30 Treasury slopes flattened by 22 bps and 3 bps in February. They currently sit at 24 bps and 51 bps, respectively (Chart 7). As noted on the first page of this report, during the next few months the Fed will be forced to strike a balance between tightening policy fast enough to prevent a de-stabilizing increase in inflation expectations and slow enough to prevent an inversion of the yield curve. The latter would likely signal an unacceptable increase in recession risk. In the near-term, we view the risks as clearly tilted toward further curve flattening as the Fed initiates a rate hike cycle while geopolitical uncertainties keep a lid on long-dated yields. However, this dynamic will eventually give way when political uncertainties abate and/or the Fed is forced to move more slowly in response to an inverted (or almost inverted) curve. With that in mind, a position in curve steepeners continues to make sense on a 6-12 month investment horizon. We also maintain our recommendation to favor the 20-year bond over a duration-matched barbell consisting of the 10-year note and 30-year bond. This position offers an enticing 26 bps of duration-neutral carry. TIPS: Neutral Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 150 basis points in February, bringing year-to-date excess returns up to +127 bps. The 10-year TIPS breakeven inflation rate rose 19 bps on the month and the 5-year/5-year forward TIPS breakeven inflation rate rose 7 bps. Perhaps the most interesting recent market move is that TIPS breakeven inflation rates rose during the past month, even as flight-to-safety flows surged into the US bond market. That is, while nominal Treasury yields declined, TIPS yields fell even more, and the cost of inflation compensation embedded in US bond prices increased. At present, the 10-year TIPS breakeven inflation rate is 2.70%, above the Fed’s 2.3% to 2.5% target range (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate is 2.16%, still below the Fed’s target range but significantly higher than where it was in January. The bond market has responded to the war in Ukraine and resultant surge in commodity prices by bidding up the cost of inflation compensation. While we agree that higher commodity prices increase the risk that inflation will remain elevated in the second half of the year, we still think the most likely outcome is that core inflation starts to moderate in the coming months as supply chain pressures ease and the pandemic exerts less of an impact on daily life. Upcoming Fed rate hikes will also apply downward pressure to long-maturity TIPS breakeven inflation rates. As a result, we maintain our recommended neutral allocation to TIPS versus nominal Treasuries at the long-end of the curve and re-iterate our recommendation to underweight TIPS versus nominal Treasuries at the front-end of the curve.  ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 25 basis points in February, dragging year-to-date excess returns down to -5 bps. Aaa-rated ABS underperformed by 25 bps on the month, dragging year-to-date excess returns down to -6 bps. Non-Aaa ABS underperformed by 22 bps on the month, dragging year-to-date excess returns down to -1 bp. During the past two years, substantial federal government support for household incomes has caused US households to build up an extremely large buffer of excess savings. During this period, many households have used their windfalls to pay down consumer debt and credit card debt levels have fallen to well below pre-COVID levels (Chart 9). Though consumer credit growth has rebounded, debt levels are still low. This indicates that the collateral quality backing consumer ABS remains exceptionally strong. This also indicates that while surging gasoline prices will weigh on consumer activity in the coming months, household balance sheets are starting from such a good place that we don’t expect a meaningful increase in consumer credit delinquencies. Investors should remain overweight consumer ABS and should take advantage of the high quality of household balance sheets by moving down the quality spectrum, favoring non-Aaa rated securities over Aaa-rated ones. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 95 basis points in February, dragging year-to-date excess returns down to -98 bps. Aaa Non-Agency CMBS underperformed Treasuries by 90 bps on the month, dragging year-to-date excess returns down to -92 bps. Non-Aaa Non-Agency CMBS underperformed by 108 bps on the month, dragging year-to-date excess returns down to -105 bps (Chart 10). Though CMBS spreads remain wide compared to other similarly risky spread products, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 24 basis points in February, dragging year-to-date excess returns down to -21 bps. The average index option-adjusted spread widened 6 bps on the month. It currently sits at 46 bps (bottom panel). The average Agency CMBS spread remains below its pre-COVID level, but it continues to look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 172 basis points of rate hikes during the next 12 months. Chart 11The Golden Rule's Track Record Appendix A: The Golden Rule Of Bond Investing We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with excess returns for a front-loaded and a back-loaded rate hike scenario. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of February 28, 2022) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of February 28, 2022) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -29 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 29 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of February 28, 2022) Recommended Portfolio Specification Other Recommendations Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. Treasury Index Returns Spread Product Returns

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 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 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 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 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 Chart I-5Fears 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 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 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 Alternative Electricity Is Rebounding From An Oversold Position 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 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5 Indicators To Watch - Interest Rate Expectations Chart II-6 Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Executive Summary Chinese Onshore Stocks Are Less Impacted By External Factors 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 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 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 Chart 3Russia'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 Chart 5Rising 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 Chart 7Although 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... 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 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

Executive Summary Wars Don’t Usually Affect Markets For Long We expect the war in Ukraine to stay within its borders, and therefore to have little impact on global growth. Markets will be volatile, but we recommend allocators stay invested – with some moderate hedges in place. The Fed won’t tighten as fast as markets expect, and US long rates will not rise much further this year. So, within fixed-income, we raise government bonds to neutral. Flat rates remove a positive for the Financials equity sector, which we lower to neutral. The oil price will fall back to $85 by the second half, as Saudi and others increase supply. We reduce our recommendation for Canadian equities and the CAD. Recommendation Changes Bottom Line: Stay invested in risk assets, but have some hedges. We shift from Financials to the defensive-growth IT sector, raise our weight in UK equities, and suggest long positions in cash, CHF and JPY.   Recommended Allocation The war in Ukraine is likely to have only a limited impact on markets beyond the short term. As disturbing as the human tragedy is, Russia’s aims are limited to regime change in Kyiv. The European Union and US face restraints on how draconian sanctions against Russia can be, balking (so far at least) at blocking imports of Russian energy to the EU, given how much this would hurt the economy. The risk of the conflict spreading beyond Ukraine’s borders is low, limited perhaps to cyberattacks on Western targets. A Russian attack on a NATO member, such as Poland or one of the Baltic states, is extraordinarily unlikely – though Moldova and Georgia (not NATO members) might be more vulnerable at some point in the future. For more detailed analysis, please read the two reports on the Ukraine situation by our Geopolitical Service that we have made available to all BCA Research subscribers.1 Asset allocators need to look at these events dispassionately. Markets are likely to remain volatile over the coming months, as events in Ukraine unfold. But the lesson of most major conflicts is that they typically do not have a long-lasting impact on asset performance (Chart 1). There is little chance that the Ukraine war will significantly dent global growth. The only exception would be if the oil price were to rise much further to, say, $120 a barrel as some are forecasting. Certainly, in the past, a jump in the oil price has often been associated with recessions – even though the causality is unclear (Chart 2). But BCA’s Energy strategists expect to see an increase in oil supply by Saudi Arabia and Gulf states which will bring Brent crude back to $85 by the second half (from $98 now). Chart 1Wars Don't Usually Affect Markets For Long Chart 2But A Jump In Oil Prices Would Meanwhile, global growth remains robust, with all major economies expected to continue to grow well above trend this year, supported by robust consumption and capex (Chart 3). And sentiment towards equities has turned very pessimistic since the start of the year, with indicators such the US Association of Individual Investors’ weekly survey at its most bearish level since 2008 (Chart 4). These sort of sentiment levels have typically pointed to a rebound in risk assets. Chart 4Sentiment Is At Rock-Bottom Chart 3Economic Growth Still Above Trend         Our advice now would be to stay invested, but with some moderate safe-haven hedges in place – largely as we have recommended since late last year. We continue to recommend an overweight in cash, but will look to allocate this to risk assets when it becomes clearer how the situation in Ukraine will pan out. The trajectory of markets over the rest of this year still largely comes down to what the Fed and other central banks will do. The hawkish turn by the Fed in December has been the driver of markets in the past two months, with the result that none of the major asset classes have produced positive returns year to-date – only inflation hedges such as commodities and gold (Chart 5). Chart 5Most Asset Classes Are Down Year-To-Date The futures market is pricing the Fed to raise rates seven times over the next 12 months, the fastest rate of predicted tightening since the early 2000s (Chart 6). We think that is a little excessive. Inflation, as we have argued previously, is likely to fade over the coming quarters, as the supply response to strong consumer demand for manufactured goods brings down the price of cars, semiconductors, shipping and other major items. The Fed may well start in March with the intention of raising rates by 25bps every meeting, but the slowing of inflation we expect, and the tightening of financial conditions already under way (Chart 7), make it unlikely that it will continue at that pace. And remember that Fed policy will need to be even more hawkish than the market is currently pricing in for it to have an incrementally negative impact on risk assets. Chart 6Market Believes Fed Will Hike Fast Chart 7Financial Conditions Have Already Tightened There are certainly risks to this scenario. The forward yield curve is pointing to inversion one year ahead, something which normally presages recession over the following 1-3 years (Chart 8). Higher prices are starting to hurt consumer confidence, though there is a big disparity between the two main US indicators (Chart 9). Chart 8Will Yield Curve Invert Within A Year? Chart 9Inflation May Be Hurting Consumer Confidence What all this boils down to is how high a level of interest rates the economy is able to withstand. The futures markets imply that, in most countries, central banks will raise rates aggressively this year, but then be forced to stop or even cut rates after that because their actions cause an economic slowdown (Table 1). Our view is that the terminal rate is much higher than what is priced by markets and projected by central banks: In the US perhaps 3-4% in nominal terms.2 Even with seven Fed hikes over the next year, the policy rate would therefore remain well below neutral – an environment in which historically equities have outperformed bonds (Chart 10). Table 1Central Banks Will Hike Aggressively – But Then Stop Soon Chart 10Even In A Year, Rates Will Be Well Below Neutral One final comment: On long-term returns. As a result of the recent moderate equity correction, strong earnings growth, and higher long-term rates, the outlook is somewhat rosier than when we published our most recent report on Return Assumptions in May 2021 – though admittedly forward long-term returns are still likely to be lower than over the past 20 years (Table 2). This is not, then, a time to turn defensive. Table 2Long-Term Return Outlook No Longer Looks So Gloomy Fixed Income: In the short-term, government bonds look oversold (Chart 11). With inflation set to peak and the Fed likely to be less hawkish than the market has priced in, we do not see the 10-year US Treasury yield rising more than another 25 basis points or so above its current level this year. Accordingly, we are changing our duration call from underweight to neutral, and raise our recommendation for government bonds within the (still underweight) fixed-income bucket to neutral. For more cautious investors, a slight increase in government bond holdings might be warranted. Within credit, investment-grade bonds still offer little pickup, despite the moderate rise in spreads this year (from 92 to 121 in the US, for example), and so we lower this asset class to underweight. We continue to prefer high-yield bonds, which in the US now imply a jump in the default rate from 1.2% over the past 12 months to 4.5% over the coming year (Chart 12). As long as the economy grows in line with our expectations, that is very unlikely. Chart 11Government Bonds Look Oversold Chart 12Will Defaults Really Jump This Much?   Equities: With the economy continuing to grow above-trend, global earnings should remain robust. This will not be a classic year for equity returns, but we expect them to do better than bonds. We continue to prefer US over European equities. As was seen in the aftermath of the invasion of Ukraine, US stocks are more defensive, and European growth will continue to be under threat from higher energy prices (Chart 13). We also move our recommended portfolio a little in the defensive direction by going overweight UK equities (which have a particularly high weight in defensive growth sectors, such as a 13 point overweight in Consumer Staples); we fund this by lowering Canadian equities to underweight, given their close linkage with oil (Chart 14), and the vulnerability of the Canadian housing market to rising rates. We remain underweight EM, but Chinese stocks (which were very oversold in late 2021) have been a relative safe haven as China started to stimulate, and so we continue with our neutral position for now. Chart 13Higher Energy Prices Threaten Europe Chart 14Canadian Stocks Move With The Oil Price Chart 15Financials Not So Attractive If Rates Don't Rise Our view that long-term rates have limited upside this year makes us more cautious on Financials stocks, which are closely correlated with rates, and so we cut this sector to neutral (Chart 15). A period of slowing growth points towards a preference for defensive growth, and so we raise our recommended weight in the IT sector to overweight from neutral. It is tempting to think of this sector as being composed of ridiculously overvalued speculative internet names, but it is in fact dominated by established hardware and software titans with deep competitive moats (Table 3). While the sector is not exactly cheap, its risk premium over bonds is quite reasonable by historical standards (Chart 16).   Table 3Tech Sector Is Not Made Up Of Speculative Stocks Chart 16Tech Is Not Unreasonably Priced Chart 17Relative Rates Suggest Some Upward Pressure On USD Currencies: A neutral position on the US dollar still makes sense. Short-term rates are likely to rise somewhat faster in the US, relative to expectations, than in Europe or Japan (Chart 17). Nevertheless, the USD is expensive, and long-dollar is a consensus trade – reasons why the dollar has risen by less than 1% year-to-date on a trade-weighted basis, despite all the higher rate expectations and geopolitical shocks. Investors looking for hedges against downside risk might look to the Japanese yen, which is particularly cheap, and the Swiss franc. By contrast, the Canadian dollar, like Canadian equities, is closely linked to the oil price and a fallback in the Brent price would be negative; we move underweight. We also raise the CNY to neutral, since it may become a safe haven currency in the current geopolitical situation, though the Chinese authorities won’t let it rise too much since that would slow the economy. Commodities: China’s stimulus remains somewhat halfhearted (Chart 18). Although the credit and fiscal impulse has bottomed, we expect to see it rebound only moderately, with just minor cuts in interest rates and the reserve ratio. This will stabilize Chinese growth, but not cause a boom as in 2020, 2016 or 2013. The rise in industrial commodities prices, therefore, is likely to be limited from here. For oil, as mentioned above, we expect to see Brent crude return to around $85 by the second half, as new supply comes onto the market. Gold has done well, as expected, in the face of a major geopolitical event. But it is expensive by historical standards, vulnerable to a rise in real (as opposed to nominal rates) as inflation eases (Chart 19), and faces cryptocurrencies as a rival. We keep our neutral, as a hedge against the tail-risk of much higher inflation, but would not chase the price at this level. Chart 18China's Stimulus Isn't Enough To Help Metals Prices Chart 19Rising Real Rates Are Negative For Gold Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Footnotes 1     Please see Geopolitical Strategy Special Reports, “Russia Takes Ukraine: What Next?” dated February 24, 2022, and "From Nixon-Mao To Putin-Xi," dated February 25, 2022. 2     Please see Global Investment Strategy, “The New Neutral” dated January 14, 2022.   Recommended Asset Allocation Model Portfolio (USD Terms)

Special Report

Highlights The buildup of excessive household debt in Canada over the past two decades has occurred because of outsized demand for housing, not because of the impact of constrained housing supply on house prices. Outsized demand for housing has occurred because interest rates have been persistently too low, pointing to the need for the Bank of Canada to tighten monetary policy in order to prevent even further leveraging. The burden of Canada’s household sector debt may exceed its pre-pandemic level next year given current market expectations for the path of rate hikes. This implies that the prior peak in the Canadian policy rate (1.75%) likely reflects a high-end estimate of the neutral rate of interest in Canada. Regulatory changes have occurred in recognition of Canada’s extreme levels of household debt. Although a massive decline in Canadian house prices would cause a very severe recession, it would not likely precipitate a Lehman-style collapse of the Canadian financial system. Over the next twelve months, investors should position favorably toward CAD-USD. As the Canadian policy rate approaches our estimate of the neutral rate, a short CAD position and an overweight stance towards long-maturity Canadian bonds versus US Treasurys will likely be warranted. Within a global equity portfolio, exposure to relatively high-yielding Canadian banks should not be reduced until hard evidence of a significant slowdown in the housing market emerges. Feature The outlook for monetary policy in advanced economies has shifted rapidly in a hawkish direction over the past few months. While we believe that the Fed and other central banks will end up raising interest rates this year fewer times than investors currently expect, it is clear that monetary policy will tighten in the DM world over the coming 12-18 months. This has raised the question of how high policy rates may rise before monetary policy begins to restrict economic activity. Some investors have specifically focused this question on countries like Canada, which has a highly indebted household sector and has seen house prices rise at a 7% average annual pace for the past 20 years. In this report, we explore the root cause of Canada’s extreme household debt and argue against the constrained housing supply view. Instead, we conclude that persistently low interest rates have fueled excessive housing demand and that the prior peak in the Canadian policy rate (1.75%) probably reflects a high-end estimate of the neutral rate of interest in Canada – in contrast with that of the US. Finally, we note that the regulatory changes that have occurred in recognition of the risk from excessive household debt suggest that a massive decline in Canadian house prices would not likely precipitate a Lehman-style collapse of the Canadian financial system – it would, however, clearly cause a severe recession. Over the next twelve months, investors should position favorably toward CAD-USD. As the Canadian policy rate approaches our estimate of the neutral rate, a short CAD position and an overweight stance towards long-maturity Canadian bonds versus US Treasurys will likely be warranted. Within a global equity portfolio, exposure to relatively high-yielding Canadian banks should not be reduced until hard evidence of a significant slowdown in the housing market emerges. The Root Cause Of Canada’s Extreme Household Debt Chart II-1Canadian Households Are Massively Indebted Relative to disposable income, Canadian household debt has risen substantially over the past two decades. Chart II-1 highlights that Canada’s household debt to disposable income ratio has risen by 180% since 2000, and is currently over 50 percentage points higher than that in the US, even when nonfinancial noncorporate debt is included in the latter.1 Rising Canadian household indebtedness is a problem that is well known to investors, policymakers, regulators, banks, and consumers themselves. Organizations such as the IMF have repeatedly warned that excess household debt poses a potential economic stability risk. In the years prior to the pandemic, policymakers have responded with a series of macroprudential measures designed to limit speculation and foreign ownership in the housing market and to reduce the incremental risk to the economy posed by new borrowers. When asked why Canadian households have leveraged themselves so significantly over the past 20 years, most market commentators in Canada point to insufficient housing supply as the main driver of excessive house prices. Given normal ongoing demand for housing, they argue, persistent supply-side pressure on housing prices will naturally lead to a rising stock of debt relative to income. According to this narrative, the solution to Canada’s housing crisis is centered squarely on incentives to build more homes. Raising interest rates to cool mortgage demand will simply exacerbate the housing affordability problem, while simultaneously discouraging additional residential investment needed to decrease home prices structurally. Chart II-2The Supply Of Non-Apartment Dwellings Has Indeed Declined Over Time... We hold a different perspective. We do agree that there are some limitations on the supply side that likely are unduly boosting prices of certain dwelling types. For example, the Greenbelt that surrounds Ontario’s Golden Horseshoe region - a permanently protected area of land - has likely constrained some housing activity, and Chart II-2 highlights that single detached, semi-detached, and row/townhouses have fallen significantly as a share of overall housing completions. Apartments and other dwellings now account for a clear majority of new housing construction in Canada. However, there is a great deal of evidence positioned against the view that supply-side factors are the primary cause of outsized housing inflation and, by extension, a massive increase in Canadian household debt to GDP: Based on real residential investment, the pace of housing construction in Canada has not fallen relative to GDP or the population. Chart II-3 highlights that, compared with the US, residential investment has trended higher over the past 20 years. Based on Canadian housing completion data, Chart II-4 highlights that the number of completions has generally kept pace with half of the change in Canada’s population, a ratio that is easily consistent with two or more people per household. In addition, the chart highlights that the periods when houses were completed at a below-average rate relative to population growth have not been the same as when Canadian household debt has increased relative to disposable income. Chart II-3...But Overall Real Residential Investment Has Kept Pace With Canada's GDP And Population Chart II-4Housing Supply Has Not Been The Main Driver Of Rising Canadian Indebtedness Chart II-5Prices For All Canadian Property Types Have Surged Over The Past Two Decades If the rise in Canadian household indebtedness has been caused by the increasing scarcity of single-detached, semi-detached, and row/townhouses, then we would expect to see a persistent and growing divergence between overall Canadian house prices and those of apartment/condominiums. Chart II-5 highlights that this is not the case: while apartment/condo prices have at times grown at a slower rate than overall home prices over the past 15 years (as in the period from 2011 to 2016), they have also at times grown at a faster rate. The chart clearly highlights that the Canadian housing market is driven by a common factor, and that average house price gains have not been significantly different across property types over time. Similarly, if a scarcity of housing supply was the main driver of rising house prices and household debt, we would not expect to see a significant increase in the homeownership rate. Chart II-6 highlights that the Canadian homeownership rate did rise substantially from the mid-1990s to 2016 (the last available datapoint). While it is not clear what the sustainable or “equilibrium” homeownership rate is, it is notable that the most recent datapoint was not significantly lower than the peak rate reached in the US following that country’s massive housing bubble. Finally, Chart II-7 reiterates a point we made in our June 2021 Special Report: in several economies (including Canada), interest rates have remained well below levels that macroeconomic theory would traditionally consider to be in equilibrium over the past two decades. This has occurred alongside significant household sector leveraging. Chart II-7Too-Low Interest Rates Have Fueled Rising Household Indebtedness In Canada (And Other DM Economies) Chart II-6The Canadian Homeownership Rate Has Risen Significantly, Pointing To Excess Housing Demand     These factors strongly point to rising household debt levels as being driven by demand-side rather than supply-side factors – demand that has been fueled by persistently low interest rates. How High Can The Bank Of Canada Raise Interest Rates? Over the next 12 months, investors expect the Bank of Canada (BoC) to raise interest rates by 180 basis points, in line with the Fed (Chart II-8). Over the longer term, the BoC believes that interest rates will average between 1.75% and 2.75%. In the US, the 2/10 yield curve has flattened significantly in response to the Fed’s hawkish shift, and neither the explosion in headline consumer price inflation nor the Fed’s about face have significantly raised the market’s longer-term expectations for interest rates (which are even below the Fed’s estimates). In Canada, investors expect essentially the same long-term interest rate outlook, as evidenced by 5-year / 5-year forward government bond yields (Chart II-9). Chart II-8Investors Expect A Similar Magnitude Of Tightening In Canada And The US Over The Next Year... Chart II-9...And A Similar Average Interest Rate Over The Longer Term As in the case in the US, the hawkish shift among major central banks has left investors asking how high the BoC can raise interest rates, and what implications that might have for Canadian assets – especially the CAD and long-maturity Canadian government bonds. In our view, the best way for investors to assess the impact of rising interest rates on the private sector – especially a highly indebted one – is to project the impact that an increase in interest rates will have on the debt service ratio (DSR). The burden of servicing debt, rather than the stock of debt relative to income, is the right way to measure the impact of shifting monetary policy because it considers the combined effect of changes in leverage, income, and interest rates. The primary drawback of debt service ratio analysis is that the question of sustainability must be answered empirically. In countries experiencing an ever-rising debt service ratio, it can be difficult for investors to judge where the breaking point will be. Cross-country comparisons may sometimes be helpful in this respect, but Chart II-10 highlights that BIS estimates for household debt service ratios vary widely even among advanced economies. However, in Canada, the 2017-2019 tightening cycle provides a useful framework. As we anticipated in a 2017 Special Report,2 the rise in Canadian interest rates during that period caused the household debt service ratio to exceed the level reached in 2007, which contributed to a collapse in Canadian house price appreciation to its lowest level since the global financial crisis (Chart II-11). The decline in house prices during this period was also caused by the introduction of new macroprudential measures (particularly the introduction of a minimum qualifying rate for mortgages, more commonly referred to as a mortgage “stress test” rule), but the impact of higher interest rates was likely significant. Chart II-11The Last Tightening Cycle In Canada Contributed Significantly To A Major Slowdown In Canadian House Prices Chart II-10Private Sector Debt Service Ratios Vary Significantly Across DM Countries   Chart II-11 highlights that the Canadian household debt service ratio collapsed during the pandemic, which seems to suggest that the Bank of Canada has ample room to raise interest rates. However, the decline in the DSR occurred not only because of falling interest rates, but also because of the significant excess savings amassed as a result of the pandemic. As in the US, excess savings in Canada were the result of reduced spending on services and the generation of significant excess income from government transfers (see Chart I-20 from Section 1 of this month’s report). These fiscal transfers will eventually disappear, implying that the Canadian household DSR is artificially low. Chart II-12 shows our estimate of the evolution of the overall Canadian household sector DSR based on the following assumptions: Mortgage rates rise in line with market expectations for the change in the policy rate Government transfers fall back to their pre-pandemic trend Disposable income growth ex-transfers grows in line with consensus expectations for nominal GDP growth The overall debt-to-disposable income ratio, using our estimate for total disposable income, remains flat. The chart highlights that the Canadian household sector DSR may exceed its pre-pandemic level next year, and that a 1.75% policy rate is the threshold at which the DSR will hit a new high. The implication of our projection is that the re-acceleration in household sector debt that has occurred during the pandemic, shown in Chart II-13, will again contribute to a significant slowdown in the Canadian housing market as the BoC begins to raise interest rates as in 2018/2019. It also implies that the prior peak in the Canadian policy rate probably reflects a high-end estimate of the neutral rate of interest in Canada. Chart II-12Market Expectations For The Canadian Policy Rate Imply A Record High Debt Burden Chart II-13Canadian Household Loan Growth Has Reaccelerated During The Pandemic   As we discuss below, this is likely to lead to significant implications for CAD-USD and an allocation to long-maturity Canadian government bonds, once investors begin to upwardly revise their expectations for the US neutral rate. Extreme Household Debt And Canadian Financial Stability The question of financial stability is often posed by investors when discussing Canada’s extreme household debt burden. Some investors view the US subprime financial crisis as the likely template for the Canadian economy, given the fact that the US credit bubble also focused on the housing market. Despite our pessimistic assessment of the capacity of the Canadian economy to tolerate higher interest rates (unlike the US today), we do not share the view that the Canadian financial system faces a potential insolvency risk, like the US banking system did in 2008. We see two potential arguments in favor of the instability view. The first is related to the sheer concentration of debt in Canada relative to other countries. Chart II-14 highlights that the median debt-to-income ratio of indebted Canadian households is currently the second highest in the world (after Norway) among the 29 countries that the OECD tracks. This concentration measure has worsened considerably since we published our 2017 Special Report. The combination of a very high average level of debt and extremely high leverage among those who are indebted suggests that Canadian banks may be exposed to significant credit losses in the event of a serious housing market crash. Chart II-14The Degree Of Concentration In Canadian Household Debt Is A Potential Financial Stability Risk Chart II-15A Decline In The CMHC's Footprint In The Mortgage Insurance Market Is Also Concerning The second argument relates to the declining share of mortgages insured by the Canada Mortgage and Housing Corporation (CMHC). The CMHC is a Crown corporation that provides mortgage-default insurance to Canadian banks. Banks must purchase such insurance when a borrower’s loan-to-value ratio exceeds 80%. The CMHC has seen increased competition from two private mortgage insurers, and Chart II-15 highlights that the number of mortgages with CHMC insurance has been steadily falling over time. In order for the CMHC to be able to reduce systemic risk during a crisis, it must be present enough in the mortgage market to be able to replace private insurers in the event of a shock that causes them to leave the market. In effect, the CMHC should be able to act as a ballast to prevent a sharp tightening in Canadian mortgage lending standards and credit provision, which could occur if banks find themselves unable to purchase mortgage insurance to cover borrowers with relatively small down payments. In this respect, the reduced footprint of the CMHC is concerning. However, these risks have to be weighed against two key structural changes that legitimately lower the systemic risk facing the Canadian banking system (or lower the impact of a major adverse housing event). The first of these changes is the introduction of the minimum qualifying rate for mortgages in Canada (the mortgage stress test), which we regard as one of the most important macroprudential policies that Canada has enacted to reduce the systemic risk of rising household debt. The stress test rules – which apply to all borrowers – force mortgage borrowers to pass the CMHC’s gross debt and total debt service ratio thresholds under the assumption of higher interest rates than borrowers will actually pay: either the contracted mortgage rate plus 2 percentage points, or 5.65% – whichever is higher. Given prevailing mortgage rates in Canada, this effectively means that new borrowers will not exceed the CMHC’s debt service thresholds until the Bank of Canada’s policy rate exceeds 2.5%. That is positive from a financial stability perspective, although it does not rule out the slowdown in household spending that we would expect if the aggregate household debt service ratio hits a new high next year in response to BoC tightening. The second important risk-reducing structural change is a significant improvement in Canadian bank capital levels. Chart II-16 highlights that Tier 1 capital has risen significantly relative to risk-weighted assets for Canadian depository institutions, and is now on par with US levels (in contrast to a typically lower level over the past decade). The IMF stress tested Canadian banks in 2019, when capital levels were lower than they are today. They found that most Canadian banks would run down conservation capital buffers in the adverse economic scenario that they modeled, subjecting them to dividend restrictions for a period of time following the adverse event. However, Canadian banks would not breach their minimum capital requirements in the scenario modeled by the IMF, which involved a 40% decline in house prices and a 2% cumulative decline in Canadian real GDP over a two year period – which is essentially what occurred in the US and Canada in 2008 and 2009 (Chart II-17). Chart II-16Canadian Bank Capital Appears Sufficient To Weather A Storm Chart II-17The IMF's Stress Tests Modeled A Repeat Of The 2008/2009 Crisis To conclude on the question of financial stability, it is clear that the magnitude and concentration of household debt implies that the impact of a serious housing market crash on the Canadian economy would be severe. But the fact that regulatory changes have occurred in recognition of this risk suggests that although a massive decline in Canadian house prices would cause a very severe recession, it would not likely precipitate a Lehman-style collapse of the Canadian financial system. Investment Conclusions Three conclusions emerge from our report. First, when considering the total experience of the past two decades, it is clear that the buildup of excessive household debt in Canada has occurred because of outsized demand for housing, not because of the impact of constrained housing supply on house prices. Outsized demand for housing has occurred because interest rates have been persistently below what traditional monetary policy rules such as the Taylor Rule would prescribe, pointing to the need for the Bank of Canada to tighten monetary policy in order to prevent even further leveraging. While US interest rates were also below what the Taylor Rule would have suggested for several years following the global financial crisis, the US household sector did not leverage itself significantly during that period because of the multi-year impact of the 2008/2009 financial crisis on US household balance sheets (Chart II-18). Canadian households did not suffer the same type of balance sheet impairment, and yet the Bank of Canada wrongly imported hyper-accommodative US monetary policy in an attempt to prevent a significant further increase in the exchange rate (which was still persistently strong for several years following the crisis). Through its actions, the Bank of Canada succeeded in staving off “Dutch Disease”, but at the cost of fueling a substantial housing and credit market bubble. Second, the fact that the Bank of Canada is likely to struggle to raise interest rates above 1.75% implies that a sizeable divergence may emerge between Canadian and US monetary policy over the coming few years if we are correct in our view that the US neutral rate is higher than the Fed currently expects. While such a divergence is not likely to occur over the coming year, Chart II-19 highlights that a 125 basis point policy rate spread – consistent with a nominal neutral rate of 1.75% in Canada and 3% in the US – last occurred in the mid-to-late 1990s, when CAD-USD ultimately declined to 0.65. Chart II-18The Bank Of Canada Staved Off "Dutch Disease", At The Cost Of Fueling A Major Housing And Credit Bubble Chart II-19Some Potentially Large Downside For CAD If US Neutral Rate Expectations Move Higher Over the coming year, we expect Canadian dollar strength rather than weakness: we are generally bearish toward the US dollar on the expectation of above-trend global growth, and our fundamental intermediate-term model suggests that CAD should strengthen. Thus, while it is too early to short the Canadian dollar, we would be inclined to turn bearish in response to rising long-term US interest rate expectations. We would draw similar conclusions for Canadian government bonds: investors should raise exposure to long-dated Canadian government bonds versus similar maturity US Treasurys as the Bank of Canada raises its policy rate toward our estimate of the neutral rate. Chart II-20Relative ROE Justifies A Valuation Premium For Canadian Banks Finally, the improvements that have been made over the past several years to dampen the impact of a housing market crash on the Canadian financial system suggests that exposure to Canadian banks should not be reduced until hard evidence of a significant slowdown in the housing market emerges. Chart II-20 highlights that the valuation premium of Canadian banks appears to be supported by a sizeable ROE advantage relative to global banks. Panel 2 highlights how composite relative valuation indicator for Canadian banks suggests that they have been persistently expensive for some time, but not extremely so. Canadian banks would certainly underperform their global peers should the adverse scenario modeled by the IMF’s 2019 stress test of the banking system to occur, especially if it implied that Canadian banks would be forced to restrict dividends for a time to bolster capital adequacy. However, we would advise investors against shorting relatively high-yielding Canadian banks as Canadian interest rates rise, until they see clear signs of Canada-specific slowdown in housing demand in response to higher rates. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate   Footnotes 1 For an explanation of why we add US nonfinancial noncorporate debt to the numerator of the US household sector debt to disposable income ratio when comparing Canada to the US, please see: “Reconciling Canadian-U.S. measures of household disposable income and household debt: Update”. 2 Please see Global Investment Strategy "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at gis.bcaresearch.com

Special Report

Executive Summary From Nixon-Mao To Putin-Xi The geopolitical “big picture” of Russia’s invasion of Ukraine is the deepening of the Russo-Chinese strategic partnership. While Russia’s economic and military constraints did not prohibit military action in Ukraine, they are still relevant. Most likely they will prevent a broader war with NATO or a total energy embargo of Europe. Still, volatility will persist in the near term as saber-rattling, aftershocks, and spillover incidents will occur this year.  Russo-Chinese relations are well grounded. Russia needs investment capital and resource sales, while China needs overland supply routes and supply security. Both seek to undermine the US in a new game of Great Power competition that will prevent global politics and globalization from normalizing. Tactically we remain defensive but buying opportunities are emerging. We maintain a cyclically constructive view. Favor equity markets of US allies and partners that are geopolitically secure. Trade Recommendation Inception Date Return Long Gold (Strategic) 2019-12-06 32.7% Bottom Line: Tactically investors should remain defensive but cyclically they should look favorably on cheap, geopolitically secure equity markets like those of Australia, Canada, and Mexico. Feature To understand the Russian invasion of Ukraine and the likely consequences, investors need to consider three factors: 1.  Why Russia’s constraints did not prohibit war and how constraints must always be measured against political will. 2.  Why Russia’s constraints will grow more relevant going forward, as the costs of occupation and sanctions take hold, the economy weakens, and sociopolitical pressures build. 3.  Why the struggle of the Great Powers will drive a Russo-Chinese alliance, whose competition with the US-led alliance will further destabilize global trade and investment. Russia’s Geopolitical Will Perhaps the gravest national security threat that Russia can face, according to Russian history, is a western military power based in the Ukraine. Time and again Russia has staged dramatic national efforts at great cost of blood and treasure to defeat western forces that try to encroach on this broad, flat road to Moscow. Putin has been in power for 22 years and his national strategy is well-defined: he aims to resurrect Russian primacy within the former Soviet Union, carve out a regional sphere of influence, and reduce American military threats in Russia’s periphery. He has long aimed to prevent Ukraine from becoming a western defense partner. Chart 1Russia Structured For Conflict While Moscow faced material limitations to military action in Ukraine, these were not prohibitive, as we have argued. Consider the following constraints and their mitigating factors: Costs of war: The first mistake lay in assuming that Russia was not willing to engage in war. Russia had already invaded Ukraine in 2014 and before that Georgia in 2008. The modern Russian economy is structured for conflict: it is heavily militarized (Chart 1). Military spending accounts for 4.3% of GDP, comparable to the United States, also known for waging gratuitous wars and preemptive invasions. Financial burdens: The second mistake was to think that Moscow would avoid conflict for fear of the collapse of the ruble or financial markets. Since Putin rose to power in 2000, the ruble has depreciated by 48% against the dollar and the benchmark stock index has fallen by 57% against EMs. Each new crackdown on domestic or foreign enemies has led to a new round of depreciation and yet Putin remains undeterred from his long-term strategy (Chart 2). Chart 2Putin Doesn't Eschew Conflict For Sake Of Ruble Or Stocks Economic health: Putin’s foreign policy is not constrained by the desire to make the Russian economy more open, complex, advanced, or productive. While China long practiced a foreign policy of lying low, so as to focus on generating wealth that could later be converted into strategic power (which it is doing now), Russia pursued a hawkish foreign policy for the past twenty years despite the blowback on the economy. Russia is still an undiversified petro-state and total factor productivity is approaching zero (Chart 3). Chart 3Putin Doesn't Eschew Conflict For Sake Of Productivity​​​​​​ Chart 4Putin Doesn’t Eschew Conflict For Fear Of Sanctions​​​​​​ Western sanctions: Western sanctions never provided a powerful argument against Russian intervention into Ukraine. Russia knew all along that if it invaded Ukraine, the West would impose a new round of sanctions, as it has done periodically since 2014. The 2014 oil crash had a much greater impact on Russia than the sanctions. Of course, Russia’s overall economic competitiveness is suffering, although it is capable of gaining market share in exporting raw materials, especially as it depreciates its currency (Chart 4). Chart 5Putin Doesn't Eschew Conflict For Sake Of Popular Opinion Public opinion: Surely the average Russian is not interested in Ukraine and hence Putin lacks popular support for a new war? True. But Putin has a strong record of using foreign military adventures as a means of propping up domestic support. Of course, opinion polls, which confirm this pattern, are manipulated and massaged (Chart 5). Nevertheless Russians like all people are highly likely to side with their own country in a military confrontation with foreign countries, at least in the short run. Over the long haul, the public will come to rue the war. Moscow believes that it can manage the domestic fallout when that time comes because it has done so since 2014. We doubt it but that is a question for a later time. Investors also need to consider Putin’s position if he did not stage ever-escalating confrontations with the West. Russia is an autocracy with a weak economy – it cannot win over the hearts and minds of its neighboring nations in a fair, voluntary competition with the West, the EU, and NATO. Russia’s neighbors are made up of formerly repressed Soviet ethnic minorities who now have a chance at national self-determination. But to secure their nationhood, they need economic and military support, and if they receive that support, then they inherently threaten Russia and help the US keep Russia strategically contained. Russia traditionally fights against this risk. Bottom Line: Investors and the media focused on the obstacles to Russian military intervention without analyzing whether there was sufficient political will to surmount the hurdles. Constraints Eroded None of the above suggests that Putin can do whatever he wants. Economic and military constraints are significant. However, constraints erode over time – and they may not be effective when needed. Europe did not promise to cancel all energy trade if Russia invaded: Exports make up 27% of Russian GDP, and 51% of exports go to advanced economies, especially European. Russia is less exposed to trade than the EU but more exposed than the US or even China (Chart 6). However, Russia trades in essential goods, natural resources, and the Europeans cannot afford to cut off their own energy supply. When Russia first invaded Ukraine in 2014, the Germans responded by building the Nord Stream pipeline, basically increasing energy cooperation. Russia concluded that Europeans, not bound to defend Ukraine by any treaty, would continue to import energy in the event of a conflict limited to Ukraine. Chart 6Putin Limits Conflict For Sake Of EU Energy Trade​​​​​​ Chart 7Putin Limits Conflict For Sake Of Chinese Trade​​​​​​ Russia substitutes China for Europe: As trade with the West declines, Russia is shifting toward the Far East, especially China (Chart 7). China is unlikely to reduce any trade and investment for the sake of Ukraine – it desperately needs the resources and the import-security that strong relations with Russia can provide. It cannot replace Europe – but Russia does not expect to lose the European energy trade entirely. (Over time, of course, the EU/China shift to renewables will undermine Russia’s economy and capabilities.) Ukraine is right next door: Aside from active military personnel, the US advantage over Iraq in 2002-03 was greater than the Russian advantage over Ukraine in 2022 (Chart 8). And yet the US got sucked into a quagmire and ultimately suffered political unrest at home. However, Ukraine is not Afghanistan or Iraq. Russia wagers that it can seize strategic territory, including Kiev, without paying the full price that the Soviets paid in Afghanistan and the US paid in Afghanistan and Iraq. This is a very risky gamble. But the point is that the bar to invading Ukraine was lower than that of other recent invasions – it is not on the opposite side of the world. ​​​​​​​Chart 8Putin Limits Conflict For Fear Of Military Overreach Chart 9Putin Limits Conflict For Fear Of Military Weakness NATO faces mutually assured destruction: NATO’s conventional military weight far surpasses Russia’s. For example, Russia, with its Eurasian Union, does not have enough air superiority to engage in offensive initiatives against Europe, even assuming that the United States is not involved. Even if we assume that China joins Russia in a full-fledged military alliance under the Shanghai Cooperation Organization (SCO), NATO’s military budget is more than twice as large (Chart 9). However, this military constraint is not operable in the case of Ukraine, which is not a NATO member. Indeed, Russia’s aggression toward Ukraine stems from its fear that Ukraine will become a real or de facto member of NATO. It is the fear of NATO that prompted Russia to attack rather than deterring it, precisely because Ukraine was not a member but wanted to join. Bottom Line: Russia’s constraints did not prohibit military action because several of them had eroded over time. NATO was so threatening as to provoke rather than deter military action. Going forward, Russia’s economic and military constraints will prevent it from expanding the war beyond Ukraine.  Isn’t Russia Overreaching? Yes, Russia is overreaching – the military balances highlighted in Charts 8 and 9 above should make that plain. The Ukrainian insurgency will be fierce and Russia will pay steep costs in occupation and economic sanctions. These will vitiate the economy and popular support for Putin’s regime over the long run. Chart 10The West Is Politically Divided And Vulnerable The West is also vulnerable, however, which has given rise to a fiscal and commodity cycle that helps to explain why Putin staged his risky invasion at this juncture in time: The US and West are politically divided. Western elites see themselves as surrounded by radical parties that threaten to throw them out and overturn the entire political establishment. Their tenuous grip on power is clear from the thin majorities they hold in their legislatures (Chart 10). Nowhere is this clearer than in the United States, where Democrats cannot spare a single seat in the Senate, five in the House of Representatives, in this fall’s midterm elections, yet are facing much bigger losses. Russia believes that its hawkish foreign policy can keep the democracies divided.​​​​​​​ Elites are turning to populist spending: Governments have adopted liberal fiscal policies in the wake of the global financial crisis and the pandemic. They are trying to grow their way out of populist unrest, debt, and various strategic challenges, from supply chains to cyber security to research and development (Chart 11). China is also part of this process, despite its mixed economic policies. The result is greater demand for commodities, which benefits Russia.    Elites are turning to climate change to justify public spending: Governments, particularly in Europe and China, are using fears of climate change to increase their political legitimacy and launch a new government “moonshot” that justifies more robust public investment and pump-priming. The long-term trend toward renewable energy is fundamentally threatening to Russia, although in the short term it makes Russian natural gas and metals all the more necessary. Germany especially envisions natural gas as the fossil-fuel bridge to a green future as it has turned against both nuclear power and coal (Chart 12). Russian aggression will provoke a rethink in some countries but Germany, as a manufacturing economy, is unlikely to abandon its goals for green industrial innovation. Chart 11Politically Vulnerable States Need Fiscal Stimulus​​​​​​ Chart 12The West Reluctant To Abandon Climate Goals​​​​​​ Proactive fiscal and climate policy motivate new capex and commodity cycle: The West’s attempt to revive big government and strategic spending will require vast resource inputs – resources that Russia can sell at higher prices. The new commodity cycle gives Russia maximum leverage over Europe, especially Germany, at this point in time (Chart 13). Later, as inflation and fiscal fatigue halt this cycle, Russia will lose leverage. Chart 13Commodity Cycle Gives Russia Advantage (For Now) Meanwhile Russia’s economic and hence strategic power will subside over time. Russia’s potential GDP growth has fallen since the Great Recession as productivity growth slows and the labor force shrinks (Chart 14). Chart 14Future Will Not Yield Strategic Opportunities For Russia​​​​​​ Chart 15Younger Russians Not Calling The Shots (But Will Someday) In short, the Kremlin has chosen the path of economic austerity and military aggression as a means of maintaining political legitimacy and achieving national security objectives. Western divisions, de-carbonization, the commodity cycle, and Russia’s bleak economic outlook indicated that 2022 was the opportunity to achieve a pressing national security objective, rather than some future date when Russia will be less capable relative to its opponents. In the worst-case scenario – not our base case – the invasion of Ukraine will trigger an escalation of European sanctions that will lead to Russia cutting off Europe’s energy and producing a global energy price shock. And yet that outcome would upset US and European politics in Russia’s favor, while Putin would maintain absolute control at home in a society that is already used to economic austerity and that benefits from high commodity prices. Note that Putin’s strategy will not last forever. Ukraine will mark another case of Russian strategic overreach that will generate a social and political backlash in coming years. While Putin has sufficient support among older, more Soviet-minded Russians for his Ukraine adventure, he lacks support among the younger and middle-aged cohorts who will have to live with the negative economic consequences (Chart 15). The entire former Soviet Union is vulnerable to social unrest and revolution in the coming decade and Russia is no exception. The Russo-Chinese Geopolitical Realignment Chart 16From Nixon-Mao To Putin-Xi From a broader, geopolitical point of view, Russia’s invasion of Ukraine drives another nail into the coffin of the post-Cold War system and hyper-globalization. Russia is further divorcing itself from the western economy, with even the linchpin European energy trade falling victim to renewables and diversification. The US and its allies are imposing export controls on critical technologies such as semiconductors against Russia to cripple any attempts at modernization. The US is already restricting China’s access to semiconductors and from now on is locked into a campaign to try to enforce these export controls via secondary sanctions, giving rise to proxy battles in countries that Russia and China use to circumvent the sanctions. Russia will be forced to link its austere, militarized, resource-driven economy to the Chinese economy. Hence a major new geopolitical realignment is taking place between the US, Russia, and China, on the order of previous realignments since World War II. When the Sino-Soviet communist bloc first arose it threatened to overwhelm the US in economic heft and dominate Eurasia. This communist threat drove the US to undertake vast expeditionary wars, such as in South Korea and Vietnam. These were too costly, so the US sought economic engagement with China in 1972, which isolated the Soviet Union and ultimately helped bring about its demise. Yet China’s economic boom predictably translated into a strategic rise that began to threaten US preeminence, especially since the Great Recession. Today Russia and China have no option other than to cooperate in the face of the US’s increasingly frantic attempts to preserve its global status – and China’s economic growth and technological potential makes this alliance formidable (Chart 16). In short, the last vestiges of the “Nixon-Mao” moment are fading and the “Putin-Xi” alignment is already well-established. Russia cannot accept vassalage to China but it can make many compromises for the sake of strategic security. Their economies are much more complimentary today than they were at the time of the Sino-Soviet split. And Russia’s austere economy will not collapse as long as it retains some energy trade with Europe throughout the pivot to China. In turn the US will attempt to exploit Russian and Chinese regional aggression as a basis for a revitalization of its alliances. But Europe will dampen US enthusiasm by preserving economic engagement with Russia and China. The EU is increasingly an independent geopolitical actor and a neutral one at that. This environment of multipolarity – or Great Power Struggle – will define the coming decades. It will ensure not only periodic shocks, like the Ukraine war, but also a steady undercurrent of growing government involvement in the global economy in pursuit of supply security, energy security, and national security. Competition for security is not stabilizing but destabilizing. Hyper-globalization has given way to hypo-globalization, as regional geopolitical blocs take the place of what once promised to be a highly efficient and thoroughly interconnected global economy. Investment Takeaways Tactically, Geopolitical Strategy believes it is too soon to go long emerging markets. Russia is at war, China is reverting to autocracy, and Brazil is still on the path to debt crisis. Multiples have compressed sharply but the bad news is not fully priced (Chart 17). The dollar is likely to be resilient as the Fed hikes rates and a major European war rages. Europe’s geopolitical and energy insecurity will weigh on investment appetite and corporate earnings. American equities are likely to outperform in the short run. Chart 17Investors Should Not Bet On Russian And European Equities In This Context​​​​​ Chart 18Investors Find Value, Minimize Risk In Geopolitically Secure Equity Markets​​​​​​ Cyclically, global equities outside the US, and pro-cyclical assets offer better value, as long as the war in Ukraine remains contained, a Europe-wide energy shock is averted, and China’s policy easing secures its economic recovery. While European equities will snap back, Europe still faces structural challenges and eastern European emerging markets face a permanent increase in geopolitical risk due to Russian geopolitical decline and aggression. Investors should seek markets that are both cheap and geopolitically secure – namely Australia, Canada, and Mexico (Chart 18). We are also bullish on India over the long run.    Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Executive Summary US biotech is trading at its greatest discount to the market. Ever. Much of biotech’s underperformance is due to transient factors: specifically, the sell-off in long-duration bonds; the focus on delivering a Covid vaccine; regulatory concerns; a drought in M&A; and a flood of IPOs. Overweight US biotech versus US big-tech, both tactically and structurally. Long-only investors with a time horizon of at least 2 years should go outright long biotech, especially US biotech. If, as we expect, the 30-year T-bond (price) continues to rally, then long-duration sectors and stock markets will resume their outperformance versus shorter-duration sectors and stock markets. Fractal trading watchlist: We focus on biotech, and add US banks versus consumer services, Norway versus China, Greece versus euro area, and BRL/NZD. US Biotech Is Trading At Its Greatest Discount To The Market. Ever Bottom Line: Every now and then comes a rare opportunity to buy a deeply unloved asset at a bargain basement price. We believe that now provides such an opportunity for the beaten-down biotech sector – especially the US biotech sector which is trading at its greatest discount to the market. Ever. Feature Every now and then comes a rare opportunity to buy a deeply unloved asset at a bargain basement price. We believe that now provides such an opportunity for the beaten-down biotech sector – especially the US biotech sector which is trading at its greatest discount to the market. Ever. But before we go into the specifics of biotech, let’s quickly discuss the recent action in the broader market. The Past Year Has Been All About ‘Duration’ A good way to think of any investment is to compress all its cashflows into one future ‘lump-sum payment.’ The length of time to this lump-sum payment is the investment’s ‘duration.’ And the present value of the investment is just the discounted value of this lump-sum payment, where the discount factor will depend on the required return on the investment combined with its duration.1 It follows that, all else being equal, the present value of a long-duration stock must rise and fall in line with the present value of an equally long-duration bond – because their discount factors move in lockstep. And, as we have been banging on in recent weeks, this simple observation is all you need to explain market action over the past year. For the 30-year T-bond, 2.4-2.5 percent is an important resistance level. Given that long-duration indexes such as the Nasdaq, S&P 500 and MSCI Growth have the same duration as the 30-year T-bond, they have been tracking the 30-year T-bond price one-for-one (Chart I-1 and Chart I-2). Hence, when the long-duration bond rallied, these stock markets outperformed shorter-duration indexes such as the FTSE100 and MSCI Value; and when the long-duration bond sold off, they underperformed. Chart I-1The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One Chart I-2MSCI Growth Has Been Tracking The 30-Year T-Bond Price One-For-One The Russian invasion of Ukraine has catalysed a retreat in the 30-year T-bond yield from a ‘line in the sand’ at 2.4-2.5 percent, which we have previously highlighted as an important resistance level. If, as we argued in A Massive Economic Imbalance, Staring Us In The Face, the 30-year T-bond (price) continues to rally, then long-duration sectors and stock markets will resume their outperformance versus shorter-duration sectors and stock markets. US Biotech Is Trading At Its Greatest Discount To The Market. Ever Over the longer term, the bigger driver of the stock price will not be the discount factor on the future lump-sum payment; the bigger driver will be the size of the lump-sum payment itself. For any company, industry, or stock market, this expected lump-sum payment will evolve in line with current profits multiplied by a ‘structural growth multiple.’ It turns out that while current profits are updated every quarter, the structural growth multiple does not change much from quarter to quarter, year to year, or even decade to decade. Yet occasionally, it can phase-shift violently downwards when an event, or realisation, shatters the market’s lofty hopes for structural growth. Occasionally, an event or realisation shatters the market’s lofty hopes for structural growth. For example, after the dot com bubble burst it became clear that the sky-high hopes for non-US tech companies were just pie in the sky. The result was that their structural growth multiple halved, which weighed down non-US tech stocks for the subsequent 10 years (Chart I-3). Chart I-3After The Dot Com Bust, The Structural Growth Multiple For Non-US Tech Collapsed More recently, the realisation that Facebook – or Meta Platforms as it is now known – is losing subscribers was the gestalt moment that shattered hopes for its structural growth. Note that while its 2022 profits are down slightly, the Meta share price has collapsed, indicating a big hit to the structural growth multiple (Chart I-4). Chart I-4Facebook's Structural Growth Multiple Has Collapsed Conversely, there are rare occasions when a phase-shift down in a structural growth multiple is unwarranted or has gone too far. Right now, a case in point is the biotech sector, especially the US biotech sector. Relative to the relationship of the 2010s decade, US biotech’s structural growth multiple has halved (Chart I-5). The result is that US biotech is trading at the greatest valuation discount to the market (-20 percent). Ever. It is also trading at its greatest valuation discount to the broader tech sector (-35 percent). Ever (Chart I-6 and Chart I-7). Chart I-5US Biotech's Structural Growth Multiple Has Halved, But Is Such A Massive De-Rating Justified? Chart I-6US Biotech Is Trading At Its Greatest Ever Discount To The Market... Chart I-7...And Its Greatest Ever Discount To Big-Tech Another way of putting it is that in the post-pandemic era, while the structural growth multiple for the broader tech sector is largely unchanged, the structural growth multiple for biotech has collapsed by 40 percent (Charts I-8, I-11). Begging the question, is such a massive structural de-rating justified? Chart I-8US Tech's Structural Growth Multiple ##br##Is Unchanged... Chart I-9...But US Biotech's Structural Growth Multiple Has Collapsed Chart I-10Global Tech's Structural Growth Multiple##br## Is Unchanged... Chart I-11...But Global Biotech's Structural Growth Multiple Has Collapsed Much Of Biotech’s Underperformance Is Due To Transient Factors We have identified five culprits for biotech’s recent underperformance, but they are largely transient: The sell-off in long-duration bonds: Ironically, though the market has downgraded biotech’s structural growth, it has still behaved like a long-duration sector that has tracked the sell-off in the 30-year T-bond. Hence, if the long-duration bond rallies, it will boost biotech stocks. The focus on delivering a Covid vaccine: While biotech was developing a Covid vaccine, investors became enamoured with the sector, but once the vaccine was delivered, investors fell out of love with the sector. Yet there is more to biotech than a provider of vaccines, and as we show in the final section, the sell-off has gone too far. Regulatory concerns: In the US there has been some concern about the dilution of a biotech company’s intellectual property (IP) rights – known as March-In-Rights – if government funding or research has contributed to an innovation. In practice though, the sophistication of most innovations means that IP would remain with the innovator. There has also been concern about drug pricing reform, but as is normal in any negotiation, the opening extreme position is likely to get watered down. A drought in M&A: The focus on Covid, plus the uncertainty around regulation, has led to a drought in the M&A activity that is usually the mechanism to crystallize value. Still, for long-term investors, value is value, whether it is crystallized or not. Furthermore, the drought in M&A cannot last forever. A flood of IPOs: The more than 100 biotech IPOs in 2021 was double the usual rate, creating an oversupply and indigestion for specialist investors in the sector. But given the poor performance of the sector, the IPO flood is likely to recede through 2022-23 in a self-correction. So, we come back to the question: is it right to price a structural growth outlook for biotech worse than the overall market and much worse than for big-tech? If anything, it is big-tech that faces the much greater existential risk in the form of Web 3.0 – which will remove big-tech’s current ownership of the internet, thereby wiping out its very lucrative business model. Look out for our upcoming Special Report on this major theme. To repeat, the market is valuing US biotech at a record 40 percent discount to big-tech, and at its most unloved versus the broad market, when most of the headwinds it faces are transient. All of which leads to two investment conclusions. The market is valuing US biotech at a record 40 percent discount to big-tech, and at its most unloved versus the broad market. Overweight US biotech versus US big-tech, both tactically and structurally. Long-only investors with a time horizon of at least 2 years should go outright long biotech, especially US biotech. Fractal Trading Watchlist This week’s analysis focusses on our main theme, biotech, and we add US banks versus consumer services, Norway versus China, Greece versus euro area, and BRL/NZD. Reinforcing the arguments in the preceding sections, US biotech is deeply oversold versus broader tech, reaching a point of fractal fragility that signalled several significant turning-points through the past two decades (Chart I-12). Accordingly, this week’s recommended trade is to go long US biotech versus US tech, setting the profit target and symmetrical stop-loss at 17.5 percent. Chart I-12US Biotech Is Deeply Oversold Versus Broader Tech   US Banks Are At Risk Of Reversal Norway's Outperformance Could End Greece's Snapback At A Resistance Point BRL/NZD At A Resistance Point Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 Defined fully, the duration of an investment is the weighted-average of the times of its cashflows, in which the weights are the present values of the cashflows. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Special Report

Executive Summary US Policy Uncertainty Rises With ERP The US is witnessing a rolling political crisis that will escalate again in the 2022-24 election cycle and presents a tail-risk of constitutional fracture. However, fundamental economic, constitutional, and geopolitical factors are structurally positive. US domestic political risk is not greater than foreign geopolitical risk affecting other major markets like Europe. The US faces challenges to maintain its competitive and technological edge. But the combination of a vibrant private sector and increasingly proactive fiscal policy give reason for optimism. The 2022-24 macroeconomic and political cycles will likely cause an increase in policy uncertainty and hence the equity risk premium – but foreign markets face even greater risks. Recommendation (Tactical) Inception Level Initiation Date Stop Loss Long DXY   Feb 23/2022   Bottom Line: Go tactically long US dollar (DXY) on the anticipation that US and especially global policy uncertainty and political risk premiums will rise. Feature With President Joe Biden’s approval rating falling to a new net low of -13%, investors are starting to ask about the future of American politics once again. It is highly likely that Democrats will lose control of Congress this fall, setting up a tumultuous 2024 election cycle. With political polarization at historic highs, it is worth asking whether US policy uncertainty will inject a risk premium into US equities. Our answer is yes, uncertainty and the risk premium will rise. But the US also contains fundamental strengths, especially relative to other major markets. With geopolitical risk rising for Europe as Russia engages in new military adventures, the US market will remain attractive over the long run. Natural Advantages Any fundamental assessment of US capability should begin with its people. The US working-age population continues to grow, while that of Europe and China has started to plateau or decline (Chart 1). China’s working population is four times bigger than that of the US, so if China can manage its transition to a higher-wage economy (i.e. if it can maintain productivity growth) then it can compete for global investment capital. But the US’s continued labor force growth, despite social change and political instability, suggests that the US will not follow Japan and Europe into sluggish trend growth, unless sharp curbs on immigration are put into place. The maxim that “the people are the riches of a nation” is only true if economic opportunity and job creation are sufficient. People need access to capital to become more productive. Europe has the largest capital stock in the world, at $100,000 per capita, compared to the US’s $71,000 and China’s $33,000. But Europe’s capital stock has been flat-to-down since the Great Recession. China’s capital stock is rising rapidly and has a lot further to go given its low level. But the country also faces a difficult transition to a new economic model and a debt-deleveraging process that may slow down the pace of capital deepening in the coming years, forcing the government to step in and promote capital projects (Chart 2). Meanwhile the US’s capital stock continues to grow steadily.  Chart 1The People Are The Riches Of A Nation... Chart 2...As Long As The People Are Not Starved Of Capital Since the shale boom the US has become nearly energy self-sufficient and now produces 20% of global oil and fuel. This development is a blessing from an economic and national security perspective. But it also poses the risk of a kind of resource curse, in which the US could lack the motivation to pioneer renewable energy technology. Currently the US only produces 4% of the world’s renewable energy, a share that has been declining. Europe and China are both energy import-dependent, which is a national security vulnerability, and they will continue to invest in renewable solutions to improve their energy security (Chart 3). Russian aggression will motivate Europe to go down this path, whereas China will go down this path for fear of American strategic containment. For now, however, the US is energy self-sufficient while technologically capable of advancing in renewable energy. The US has a range of structural problems: rising income inequality, extreme political polarization, and a policy turn away from globalization over the past 20 years. However, these problems have not weighed on GDP per capita growth. Of course, the greatest strides in GDP per capita are occurring in the developing world: China and India show the most promise. But the US’s GDP per capita is still growing at an annual average rate of 3%, putting it alongside Germany and ahead of the much less developed Brazil (Chart 4). Germany did not see anywhere near as big of increases in inequality and polarization and is still generally committed to globalization, yet its GDP per capita growth is about the same as the US’s, despite faster US population growth. Chart 3North America's Natural Resource Blessing Chart 4Does Political Instability Harm Productivity? Partisanship Means Big Government None of the above benefits have been reversed by the US’s historic increase in political polarization and partisanship over the past three decades. Make no mistake, the latter trends are harmful and could weigh on US stability and productivity in coming years, primarily through deteriorating fiscal management. But so far their bad effects have been contained. The two US political parties have won control of the White House, the Senate, and the House of Representatives a roughly equal number of times. While Republicans have a larger regional presence, across the 50 states, and tend to perform better in the Electoral College and the Senate, this advantage is very slight judging by the number of electoral victories. Meanwhile Democrats have a larger popular presence and perform better in the House of Representatives but this advantage is also slight (Chart 5). The two parties are evenly balanced, which is one explanation for why they compete so viciously for marginal victories. But it also prevents either party from achieving absolute power and distorting or corrupting American bureaucracy and corporate structures to perpetuate single-party rule. Chart 5An Even Balance Of Power Between The Parties The size of the federal government fluctuates within a fairly low and narrow range. Federal government receipts hovered around 16% of GDP in the 1950s-60s, peaked at 20.4% in 2000, and today stand right in the middle of this post-war range at 18.5%. Major increases in revenue follow the business cycle and it is rare that Democrats manage to raise taxes enough to have a substantial impact. This point is clear from looking at periods when Democrats controlled both the House of Representatives and the White House (shaded areas in Chart 6): the large increases in tax take mostly coincide with economic growth spurts. It is conceivable that the Biden administration will raise a minimum corporate tax this year via the budget reconciliation process, but the odds of that have been falling and it will not change the pattern in this chart, which shows rising revenue relative to GDP as the economy recovers but is not likely to match what was seen in the late 1990s. From the perspective of federal government spending, the growth in the size of government is clearer, rising from the post-war 15% of GDP to today’s 25% of GDP, with a pronounced structural uptrend. Republicans rarely control both the White House and the House of Representatives and only in the 1950s did they reduce spending outright. The past two Republican administrations presided over large increases in spending, while also capping revenue via tax cuts (Chart 7). Chart 6US Federal Revenue Does Not Change Much Over Time Chart 7US Federal Spending Does Not Change Much Over Time Thus in America’s highly polarized and populist political scene, Republicans fail to cut spending while Democrats fail to increase taxes. The takeaway is that budget deficits will remain structurally large. The political outlook reinforces this point as it promises a return to congressional gridlock. Historically speaking, Biden’s net negative approval rating implies that Democrats will lose 40 seats in the House of Representatives and 4 seats in the Senate this fall. It is unlikely that Democratic fortunes will improve much between now and this November given that midterm elections almost always punish the ruling party and midterm voters tend to make up their minds early in the year. Moreover the ruling party’s ailments are not easily reversed: headline inflation is running at 7.5%, crime and immigration are growing at historic rates, while foreign policy challenges will likely feed the narrative that the Biden administration is weak on the global stage. The likelihood of congressional gridlock from 2022-24 (and maybe beyond) entails that future increases in fiscal spending will be automatic, through lack of entitlement reform, rather than through grandiose new spending programs, which will not pass into law. As such, “Big Government” is back but it is still “limited government” in the US tradition – i.e. limited big government. Neither party has a blank check or dominates for long. And if anything a period of fiscal normalization (or pseudo-normalization) is on the horizon. Constitutional And Geopolitical Advantages The balance of the parties is not accidental but essential to the American constitutional system. This system is based on the tradition of “mixed” or “balanced” constitutionalism, which developed in ancient Greece and Rome and came to the Americas via the United Kingdom. The system can be discussed in philosophical or ideological terms but it is rooted in real, physical, institutional power. The tradition begins with great philosophers like Plato and Aristotle but is perhaps best illustrated by the Greek historian Polybius. Polybius observed a violent historical cycle that ceaselessly shifted from despotism to oligarchy to the tyranny of the masses to anarchy and finally back to despotism. He argued that the Roman constitution, by mingling the different social classes (the leaders, the elite, and the masses), could produce a durable constitutional order that would prolong the time period until the state decayed and collapsed. We call this the “Polybius Solution” (Diagram 1). Diagram 1The Polybius Solution The US constitution is successful because, like several of the oldest European constitutions, it mixes the different social classes and sources of power so that the leaders, elites, and masses each have a share in the political system and no single group can predominate and overwhelm the others. It is an extra benefit that the US constitution is one of the longest continually operating constitutions in the world, since the long fortification of the system in practice helps provide sociopolitical and economic stability, whereas the ideas themselves are not well taught or understood (Table 1). The fact that the constitution is written in a single document is useful but not decisive, as the British constitution similarly provides stability over long periods of change and upheaval both at home and abroad. Table 1The Balanced Constitution Investors should not mistake this constitutional system merely for a set of preferential ideas. Opinions change very easily. But it is physically difficult for ruling classes to take away rights and privileges that the masses of people have been given. Thus the mixture of constitutional powers is based in political realism, not idealism. The US constitution operates not because Americans are more well-meaning, educated, civic-minded, altruistic, or enlightened than others. It operates because the oligarchy is not powerful enough to disenfranchise the democracy, while the democracy is not powerful enough to purge the oligarchy. The government leaders themselves (the president, the lawmakers, the career bureaucrats, etc) are not powerful enough to suspend term limits and stay in power forever. Nor have they been able to ally with either the oligarchy or the democracy closely enough to permanently exclude the other one from its share of power within the system. There is a clear and present danger that the constitutional system could come under too much strain and fracture amid recent power struggles among the American social classes. The struggles between the classes have intensified since the fall of the Soviet Union (which deprived America of a common enemy) and especially the Great Recession (which provoked populist democratic movements). Some fear that a president could turn into an autocrat and refuse to yield power, others fear that the oligarchic faction could steal elections or manipulate the legal system, others fear that the democratic faction could steal elections or ride roughshod over legal procedures. Of these risks, the risk of autocracy is the lowest, while the risk of institutional corruption or electoral manipulation or majoritarian rule-breaking are the highest. Certainly political risk and policy uncertainty will rise from current levels over the 2022-24 election cycle, which promises to be extremely disruptive. However, there are three reasons to hold the baseline view that the US political structure will remain stable enough to sustain economic productivity over the coming years, despite enormous upheaval on the cyclical level of politics. The US remains secure from invasion, while provoked to meet rising geopolitical challenges. Neither Canada nor Mexico poses a fundamental threat to US national security – the US is capable of militarizing the borders, however undesirable – and the US is inaccessible to more distant enemies due to the tyranny of distance across the Atlantic and Pacific oceans. Yet the resurgence of Russia and the rise of China are likely to present common external rivals around which America’s elites will attempt to galvanize public opinion to maintain national security and keep themselves in office. Because elections still tend to swing on historically critical regions, such as the Midwestern heartland, politicians will need to pursue some degree of economic nationalism to stay in power (Map 1). Map 1USA: Splendid Isolation? The US continues to benefit from a “brain drain” of talented foreign immigrants and will keep that door open if and when it curbs immigration more broadly. Immigration flows into the US are typically robust according to various indicators, including the numbers of newly naturalized citizens, which is itself an indicator of the US’s abiding advantages (Chart 8). The global pandemic caused a decline that is quickly rebounding. Immigration is one of the major outstanding sources of power struggle between the US political factions. It will become a centerpiece of the 2022-24 election cycle. The outcome is unclear. But general American attitudes toward immigration are not hostile, while elite attitudes favor immigration. Therefore whatever government policy finally emerges, it will likely preserve the US’s national interest of continuing to import global talent . Chart 8People Voting With Their Feet The US’s chronic trade imbalance generated a new policy consensus in favor of strengthening American competitiveness. The US pursued a policy of globalization and de-industrialization for decades but it became untenable in the wake of the Great Recession, which spawned a populist backlash. The Biden administration has largely coopted the Trump administration’s hawkish approach to trade. While US trade and current account deficits will remain very large for the foreseeable future, reflecting a fundamental imbalance of savings relative to investment (Chart 9), nevertheless the US will undertake targeted policies to improve supply chain resilience and domestic high-tech competitive edge. The Congress’s likely passage of the American Competes Act of 2022 exemplifies the new bipartisan consensus around the need to invest in American industrial and technological capabilities so as to better compete with great powers overseas (Table 2). Chart 9US Competitiveness Waning? Table 2US Bipartisan Consensus On Restoring Competitiveness By contrast, other regions face greater geopolitical threats to their homelands and greater difficulties coping with hypo-globalization. Europe’s strategic vulnerability to Russia will dampen investment sentiment and risk appetite. Russia’s economic trajectory has suffered since 2014 and its ongoing conflict with the West will result in isolation and lower productivity. China will see rising tensions with its neighbors due to its economic transition, emerging protectionism, and its need to become more assertive for the sake of supply security. By contrast the US is relatively insulated. Investment Takeaways The US’s economic, constitutional, and geopolitical advantages are structural positives. Rising domestic policy uncertainty over the 2022-24 election cycle might overshadow these positives temporarily, but they are likely to persist over the long run. Increasing geopolitical risks abroad suggest that domestic American policy uncertainty is likely to be overrated. Great power competition – stemming from geopolitical risks – will fuel capital spending among the major nations as well as research and development investments. In this respect the United States faces challenges to maintain its competitive edge. But it is still the leader and the combination of a vibrant private sector and an increasingly proactive public sector are positive (Chart 10). Are the US’s structural advantages already priced? To a great extent, yes. The US equity risk premium today stands at 300 basis points, compared to 660 in Europe and 570 in China. And yet global geopolitical risk, highlighted by Russia’s escalating conflict with the West, suggest that this divergence can get worse before it gets better. We expect the 2022-24 election cycle to cause an increase in policy uncertainty and the political risk premium. But as things stand the increase in uncertainty and risk premiums abroad will be even greater (Chart 11). Chart 10US Investing In The Future? Chart 11US Stocks Priced The Good News?       Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)   Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets Footnotes