Emerging Markets

Special Report

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

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

Last Friday, my colleague Dhaval Joshi and I held a webcast discussing investment strategies. The topics of discussion included global equity valuations, mega-cap stocks leadership and the outlook for EM stocks, fixed-income and currencies. You can listen to the webcast recording by clicking here.   An Opportunity In Pakistani Equities And Bonds Pakistani stock prices in US dollar terms are currently 20% lower than their January high and 56% lower than their 2017 high (Chart I-1, top panel). Meanwhile, the government projected a contraction in real GDP during the fiscal year 2019-20 (ending on June 30), the first in 68 years. We believe stock prices have already priced in plenty of negatives, and that Pakistani equities are likely to move higher over the next six months. Strengthening the balance of payments (BoP) position and continuing policy rate cuts will increase investors’ confidence and benefit its stock market (Chart I-2). We also expect the Pakistani bourse to outperform the EM equity benchmark (Chart I-1, bottom panel). Chart I-1Pakistani Equities: More Upside Ahead Chart I-2Monetary Easing Will Help Pakistani Equities   Chart I-3The Current Account Deficit Is Set To Shrink Further Balance Of Payments Position Pakistan’s BoP position is set to improve. First, its trade deficit will shrink further, as Pakistan’s export will likely improve more than its imports (Chart I-3). The country’s total exports declined 6.8% year-on-year in June, which is a considerable improvement as compared to the massive 54% and 33% contractions that occurred in April and May, respectively. The country was on a strict lockdown for the whole month of April, which was then lifted in early May. As the number of daily new cases and deaths are falling, the country is likely to remain open, lowering the odds of a domestic supply disruption. In addition, as DM growth recovers, the demand for Pakistani products will improve as well. Europe and the US together account for about 54% of Pakistan’s exports. The government is keen to boost the performance of the domestic textile sector, which accounts for nearly 60% of the country’s total exports. The government will likely approve the industry’s request for supportive measures, including access to competitively priced energy, a lower sales tax rate, quick refunds, and a reduction of the turnover tax rate. Moreover, the government has prepared an incentive package for the global promotion of the country’s information technology (IT) sector, aiming to increase IT service exports from the current level of US$1 billion to US$10 billion by 2023. Currently, over 6,000 Pakistan-based IT companies are providing IT products and services to entities in over 100 countries worldwide. Regarding Pakistan’s imports, low oil prices will help reduce the country’s import bill year-on-year over the next six months. Second, remittance inflows – currently at 9% of GDP – have become an extremely important source of financing for Pakistan’s trade deficit. Even though about half of the remittances sent to Pakistan are from oil-producing regions like Saudi Arabia, UAE, Oman and Qatar, low oil prices may only have a limited impact on Pakistan’s remittance inflows. For example, when Brent oil prices fell to US$40 in early 2016, remittances sent to Pakistan in the second half of that year declined by only 1.9% on year-on-year terms. Over the first six months of this year, the remittances received by Pakistan still had a year-on-year growth of 8.7%.   At the same time, the government has planned various measures to boost remittances. For example, a “national remittance loyalty program” will be launched on September 1, 2020, in which various incentives would be given to remitters. Strengthening the balance of payments (BoP) position and continuing policy rate cuts will increase investors’ confidence and benefit its stock market. Third, Pakistan will receive considerable financial inflows this year, probably amounting to over US$12 billion1 from multilateral and bilateral sources. This will be more than enough to finance its current account deficit, which was at US$11 billion over the past 12 months. In April, the International Monetary Fund (IMF) approved the disbursement of about US$1.4 billion to Pakistan under the Rapid Financing Instrument designed to address the economic impact of the Covid-19 shock. The World Bank and the Asian Development Bank have also pledged around US$ 2.5 billion in assistance. The IMF and the Pakistani government are in talks about the completion of the second review for the Extended Fund Facility (EFF) program. If completed in the coming months, the IMF will likely disburse about US$1 billion to Pakistan in the second half of this year.  In April, G20 countries also awarded Pakistan a suspension of debt service payments, valued at US$ 1.8 billion, which will be used to pay for Pakistan’s welfare programs. In early July, the State Bank of Pakistan (SBP) received a US$1 billion loan disbursement from China. This came after Beijing awarded Pakistan a US$300 million loan last month. The authorities plan to raise US$1.5 billion through the issuance of Eurobonds over the next 12 months. Other than the funds borrowed by the Pakistani government, net foreign direct inflows, mainly driven by phase II of the China-Pakistan Economic Corridor (CPEC), are set to continue to increase over the remainder of this year, having already grown 40% year-on-year during the first six months of this year. About 63% of that increase came from China. Meanwhile, as we expect macro dynamics to improve in the next six months, net portfolio investment is also likely to increase after having been record low this year (Chart I-4). In addition, as the geopolitical confrontation between the US and China is likely to persist over many years, both Chinese and global manufacturers may move their factories from China to Pakistan.2 Bottom Line: Pakistan’s BoP position will be ameliorating in the months to come. Lower Inflation And Monetary Easing Continuous monetary easing is very likely and will depend on the extent of the decline in domestic inflation. Both headline and core inflation rates seem to have peaked in January (Chart I-5). Significant local currency depreciation last year had spurred inflation in Pakistan. Then, early this year, supply disruptions and hoarding behaviors attributed to the pandemic have contributed to elevated inflation. Chart I-4Net Portfolio Investment Inflows Are Likely To Increase Chart I-5Both Headline And Core Inflation Rates Will Likely Fall Further   A closer look at the inflation subcomponents shows that recreation and culture, communication, and education have already fallen well below 5% in the last month. Transport inflation came in negative at 4.4% in June.  The inflation of non-perishable food items was still stubbornly high at 14.9% last month. Increasing the food supply and reducing hoarding will help ease that. This, along with a stable exchange rate and a negative output gap will cause a meaningful drop in inflation. As inflation drops, interest rates will be reduced to facilitate an economic recovery. While the current 7% policy rate is lower than headline inflation, and on par with core inflation, Pakistani interest rates remain much higher than those in many other emerging countries. Investment Recommendations We recommend buying Pakistani equities in absolute terms and continuing to overweight this bourse within the emerging markets space. The stock market will benefit from a business cycle recovery following the worst recession in history, worse than during the 2008 Great Recession (Chart I-6). Fertilizer and cement producers, which together account for nearly 30% of the overall stock market, will benefit from falling energy prices, a significant cut in interest rates and supportive government measures. The government recently approved subsidies to encourage fertilizer output. In the meantime, the country’s construction stimulus package and its easing of lockdown orders will help lift demand for cement over the second half of 2020.  As a result, both fertilizer and cement output are set to increase (Chart I-7). Besides, a cheapened currency will limit fertilizer imports and help cement producers export their output, which will benefit their revenue. Chart I-6Manufacturing Activity In Pakistan Will Soon Rebound Chart I-7Both Fertilizer And Cement Output Are Set To Increase   Banks account for about 22% of the overall stock market. Our stress test on the Pakistani banking sector shows it is modestly undervalued at present (Table I-1). Even assuming the worst-case scenario for non-performing loans (NPL), where the NPL ratio would rise to 17.5% from the current 6.6%, the resulting adjusted price-to-book ratio will be only 1.6. Table I-1Stress Test On Pakistani Banking Sector Both in absolute terms, and relative to EM valuations, Pakistani stocks appear attractive (Charts I-8 and I-9). Finally, foreign investors have bailed out of Pakistani stocks and local currency bonds since 2018, as illustrated in Chart I-4 on page 4. Ameliorating economic conditions will lure foreign investors back. Chart I-8Pakistani Equities: Valuation Measures Are Attractive In Both Absolute Terms… Chart I-9…And Relative To The EM Benchmark   For fixed-income investors, we recommend continuing to hold the long Pakistani local currency 5-year government bonds position, which has produced a 12% return since our recommendation on December 5th 2019. We expect interest rates to drop another 100 basis points (Chart I-5, bottom panel, on page 5).  Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Chile: Not Out Of The Woods Copper prices have staged an impressive rally in the past four months, but the performance of Chilean markets remains lackluster (Chart II-1). While the red metal has broken above its January highs, Chile’s equities and currency are still trading 25% and 5% below their January peak, respectively.    The government’s mismanagement of the pandemic has reignited and heightened the existing socio-political discontent, thus increasing the fragility of the situation. We therefore recommend that investors maintain a cautious stance on Chilean assets. As for dedicated EM portfolios, we recommend moving this bourse from neutral to underweight: First, the lockdowns resulting from the pandemic have revealed the precarious financial condition of low and middle-class households. The lack of savings among these groups prevented workers from self-isolating for more than a couple of weeks. The urge for them to return to work enabled the outbreak to escalate in May. Consequently, these social groups have suffered from infections, and Chile has rapidly become one of the worst affected countries in the world in terms of per-capita COVID-19 cases and deaths. Chart II-2 shows that, as a share of total population, Chile tops the region in terms of cummulative cases and deaths. Moreover, Chile has the eighth highest COVID-19 infections per capita in the world, even though its testing rate per capita is lower than that of Europe and the US. Chart II-1Chilean Markets Have Been Much Weaker Than Copper Chart II-2The Pandemic Has Hit Chile Hard   Chart II-3The Economy Is In The Doldrums Given the wide spread of the virus, Chile has implemented harsher quarantine measures than the rest of the region, which means that the economic reopening and recovery will start from a lower level of activity. The inability of President Pinera’s administration to protect low and middle-class households from being exposed to the virus has renewed a nation-wide distrust in the government. According to Cadem, one of the country’s most cited polling companies, President Pinera’s approval rating has fallen back to just 17%, not far from the lows seen during last year’s violent social unrest. In sum, these recent events have confirmed our major theme for Chile, discussed in our December Special Report. It reads as follows: Chile’s political elite has been greatly underestimating the depth and gravity of the popular frustration and has been reluctant to address the issue in a meaningful way. Consequently, Chile is set to experience a renewal in protests and a rise in political volatility as the date of the referendum on the Constitution, which is scheduled to take place in October, nears. Second, Chile is experiencing its worst recession in modern history. Chart II-3shows that the economy was already in a slump at the beginning of the year, and the economic lockdown has caused double-digit contractions in many sectors. Further, business confidence never fully recovered from last year’s social protests and has been plummeting deeper since the start of the pandemic (Chart II-3, bottom panel). Chart II-4Banks' NPLs Are Set To Rise While President Pinera’s decision to prioritize small and medium-sized businesses (SMEs) has been popular among the middle class, the reality is that Chile remains a highly oligopolistic market, dominated by large companies. The failure to support these businesses will prevent a revival in business sentiment, hiring and investment and, hence, prolong the economic downtrend. This unprecedent economic contraction has caused a rapid surge in non-performing loans (NPLs), which will hurt banks’ capital profits and tighten lending standards. NPLs will rise much further given the record depth of this recession (Chart II-4). Moreover, bank stocks compose 25% of the MSCI Chile index, so a hit to banking profitability will exert downward pressure on the equity index. Third, even though fiscal and monetary stimuli have been large and were implemented rapidly, they are probably insufficient to produce a quick recovery. The government first announced a fiscal plan between March 19 and April 8 worth US$ 17 billion (or 6% of GDP), the third largest in the region. However, it is still quite small compared to that of OECD members. Excluding liquidity provisions for SMEs and tax reductions, the size of new government spending in 2020 is only 3.5% of GDP. On June 14, the government devised another fiscal plan, worth US$ 12 billon (or 5% of GDP). However, it will be spread out over the next 24 months – only 1.5% of GDP of additional stimulus will be injected over the next 12 months. This extra kick in spending seems too small given the depth of the recession.  In terms of monetary policy, the Chilean central bank has already reached the limits of its orthodox toolkit. The monetary authorities have cut the policy rate by 125 basis points since November of last year, but they have reached the constitutional technical minimum of 0.5%. The central bank is now using alternative tools to stimulate the economy, such as offering cheap lending to SMEs and a US$ 8 billion quantitative easing program for buying financial institutions’ bonds, as the Constitution forbids the purchasing of government and non-financial corporate debt. In a nutshell, the overall efficiency of these monetary policies will be subdued as the main drags on the economy are downbeat business and consumer confidence stemming from ongoing socio-political tensions, not high interest rates. Chile is shrouded in a cloud of political uncertainty. Monetary policy has reached its limits, and fiscal stimulus is insufficient for now. Fourth, higher copper prices will help on the margin, but will not bail out the Chilean economy.  Even with the latest rally in copper prices, Chilean copper exports will continue contracting in US$ terms. The latest increase in prices will be more than offset by output cuts caused by social distancing rules and reduced staff in mines all over the country.  Bottom Line: Chile is shrouded in a cloud of political uncertainty. Monetary policy has reached its limits, and fiscal stimulus is insufficient for now. Investment recommendations Chart II-5Our CLP vs. USD Trade Continue shorting the CLP relative to a basket of the CHF, EUR and JPY. We closed our short CLP/USD on July 9th with a 29% profit (Chart II-5) and began shorting it versus an equal-weighted basket of the CHF, EUR and JPY. Within an EM equity portfolio, downgrade Chilean stocks from neutral to underweight. An ailing economy and political uncertainty will divert capital from the country despite attractive equity valuations. For an EM local bond portfolio, we are also downgrading Chile from neutral to underweight, as the risk of renewed currency depreciation is too large to ignore and downside in yields is limited due to the zero bound. Juan Egaña Research Associate juane@bcaresearch.com The Czech Republic: Pay Rates And Go Long The Currency An opportunity to bet on higher longer-term interest rates and on a stronger currency has emerged in the Czech Republic (Chart III-1). Consumer price inflation is above the central bank’s 2% target and will continue to rise, which will necessitate higher interest rates (Chart III-2). The latter will lead to currency appreciation. Chart III-1Pay Rates And Go Long CZK vs. USD Chart III-2Inflation Is Above The CB Bands   The Czech authorities’ strong fiscal and monetary support of the economy amid the COVID recession will keep both labor demand and, thereby, wages supported. In turn, core inflation will likely prove resilient in the near term and will rise over the coming 12-18 months, putting upward pressure on long-term interest rates. First, Prime Minister Andrej Babis is determined to promote a rapid economic recovery, as there are upcoming elections scheduled for next year. In early July, the government approved another spending program that will in part finance infrastructure projects and promote job creation in the non-manufacturing sector. The bill is expected to boost infrastructure spending by 140 billion koruna (or 2.5% of GDP) in 2020, and is part of a multi-decade national investment plan to increase domestic productivity. In particular, the construction sector will benefit from a massive uplift in domestic capex that will go towards upgrading the transport network. This will produce a job boom in the construction industry which should mitigate the employment losses in manufacturing and tourism. Second, shortages continue to persist in the labor market. Our labor shortage proxy is at an all-time high, suggesting that labor shortages will continue to facilitate faster wage growth (Chart III-3). Interestingly, Chart III-4 suggests that overall job vacancies have plateaued but have not dropped. This signifies pent-up demand for labor. Critically, this hiring challenge is likely to make industrial firms reluctant to shed workers amid the transitory pandemic-induced manufacturing downturn. Chart III-3Labor Shortages = Wages Higher Chart III-4Job Vacancies Are Holding Up   Either way, competition for labor in manufacturing and other sectors will keep a firm bid on both wages and unit labor costs in the medium to long term (Chart III-5). Third, low real interest rates will promote domestic credit growth (Chart III-6), helping support final domestic demand which, in turn, will lift inflation. Chart III-5Structural Pressure On Labor Costs Chart III-6Low Rates Will Bolster Domestic Demand   Similarly, residential real estate prices and rents will continue to grow at a hefty pace due to low borrowing costs and residential property shortages. Core inflation will likely prove resilient in the near term and will rise over the coming 12-18 months, putting upward pressure on long-term interest rates. Finally, core inflation measures are hovering well above the 2% target and the upper band of 3% (Chart III-2 on page 13). As such, the Czech National Bank (CNB) is likely to hike interest rates sooner rather than later. Critically, inflation is acute across various parts of the economy. Specifically, service price inflation is likely to continue rising in the wake of announced price hikes in public services, such as transport. These are being devised by local authorities to counteract a loss in tax revenue. Altogether, easy fiscal policy (infrastructure spending) will support labor demand, wage growth and final domestic demand, in turn heightening inflationary pressures. Unlike its counterparts in the EU, the CNB is more sensitive to price increases due to the relatively higher starting point of inflation in the Czech economy. As such, the central bank will be the first to hike interest rates among its EU counterparts, tolerating the currency appreciation that will come with it. The basis is Czech domestic demand and income growth will be robust. Investment Recommendation Czech swap rates are currently pricing a rise of only 55 bps in interest rates over the next 10 years. As a result, we recommend investors pay 10-year swap rates (see the top panel of Chart III-1 on page 13). We also recommend going long the Czech koruna versus the US dollar. Unlike the Czech central bank, the US Federal Reserve will keep interest rates very low for too long. In short, the Fed will fall well behind the curve, while the CNB will hike earlier. Rising Czech rates versus US rates favor the koruna against the dollar. This is a structural position that will be held for the next couple of years. It is also consistent with the change in our view on the USD, which has gone from positive to negative in our report from July 9. Andrija Vesic Associate Editor andrijav@bcaresearch.com   Footnotes 1 Regarding Pakistan’s net financial inflows this year, we estimated that net foreign investment inflows, net foreign portfolio inflows and net other financial inflows to be about US$ 1.5 billion, US$ 0.5 billion, and US$ 10.5 billion, respectively, based on past data and the six-month outlook of the country’s economy. 2 Please see the following articles: Chinese Companies to Relocate Factories to Pakistan Under CPEC Project Importers Survey Shows Production Leaving China for Vietnam, Pakistan, Bangladesh   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Chinese stocks are still in the “public participation phase” of a cyclical bull market and have not yet reached the “excess phase.” Economic fundamentals should provide support for more upside in Chinese stock prices in the next 6 to 12 months. Even if Chinese stocks evolve into a boom-bust cycle reminiscent of 2014-15, near-term technical price corrections should provide good buying opportunities. We remain overweight Chinese equities in both absolute and relative terms, and recommend investors increase their exposure to beaten-down cyclically-geared stocks, particularly in China’s domestic market.  Feature Chinese stocks rallied by 15% and 13% in the onshore and offshore markets, respectively, in the first 10 days of July. However, both markets gave up almost half of their gains in the third week of the month. The above-expectation Q2 GDP growth figure, which was released last Thursday, only exacerbated the market selloffs. This month’s rollercoaster ride in Chinese equities reminds investors of the boom-bust stock market cycle in 2014-2015, and raises the inevitable question: is it too late to buy or is it too early to sell Chinese stocks? We believe Chinese stocks are still at an early stage of a cyclical bull market.  While the recent near-vertical escalation in equity prices was clearly overdone, any near-term technical corrections will provide good buying opportunities. Three Phases Of A Bull Market Chinese bull markets typically last 2-2.5 years and involve three phases.1 The length and boundaries of each phase in a bull run are often blurred and are best identified in hindsight. However, this framework helps put the ongoing market rally in both A shares and investable stocks into perspective. In our view, the A share market is currently in the early stage of the “public participation phase”, whereas investable stocks seem to be halfway through (Chart 1A and 1B). Chart 1AA Shares In Early Stage Of The “Public Participation Phase (PPP)” Chart 1BChinese Investable Shares May Be Halfway Through PPP We think that the current bull market started in January 2019, following a bear market from 2016 to 2018. We upgraded Chinese stocks from neutral to cyclically overweight in April 2019, which was a couple of months into the “accumulation phase” of the bull market underway. The accumulation phase is the start of an uptrend, typically after a bear market, when smart money begins to buy stocks; fundamentals still look bleak and valuations are at exceptionally depressed levels. Chart 2China’s Economy Should Be On Track To A Cyclical Upturn The public participation phase typically exhibits a massive increase in trading volumes and explosive growth in new investor accounts. This phase begins when the market is already off the bottom and negative sentiment begins to wane on signs of economic improvement (Chart 2). As the bull trend is clearly established, technical and trend traders also begin to pile in, generating a self-feeding cycle. The market begins to feel overheated, making value investors uncomfortable, but valuations are not yet extreme (Chart 3). This phase tends to last longer than the other two stages in a bull market primary trend. The expansion of multiples remains the dominant driver for the broad market while earnings struggle (Chart 4). Chart 3Valuations In A Shares Are Not Too Extreme For investable shares, we believe that the bull market is probably more than halfway through the public participation phase (Chart 5). The market has decisively broken out of its key technical resistance and entered into expensive territory (Chart 6). Still, neither A-share nor investable markets seem to be in the “excess phase” as witnessed in 2015 (Table 1). Chart 4Market Returns Between Multiples And Earnings Growth: Chinese A Shares Chart 5Market Returns Between Multiples And Earnings Growth: Chinese Investable Shares Chart 6Valuations In Chinese Investable Shares Are Becoming Expensive, But Not Too Stretched Table 1Multiples In Chinese Stocks Are Not Yet In The “Excess Phase” China's short and volatile stock market history provides some classic examples of equity boom-bust cycles. The massive bull market in Chinese A shares between 2013 and 2016 fits the three phases perfectly: stock prices jumped by a whopping 93% in the three phases of the bull market between early 2013 and May 2015. The bull market eventually marched onto the excess phase in the first half of 2015 and reached the ultimate top in May 2015 with a trailing P/E of 25 and price-to-book of over 3. Bottom Line: Both the A-share and investable bourses still have room for upside in the ongoing bull market. Remain overweight on both investable and domestic shares, but domestic stocks have more latitude for rally as China’s economy and earnings continue to recover. Pullbacks Not Enough To Turn Bearish On July 1 we upgraded our tactical (0 to 3 months) call on Chinese stocks and initiated long Chinese domestic and investable stock trades relative to global benchmarks. While it is impossible to predict whether the current market will supercharge into a boom-bust cycle as seen in 2014-15, we intend to keep the trades given our conviction that cyclically there is still upside to Chinese stock prices. To turn cyclically bearish on Chinese shares, the following conditions need to develop: First, the broad market should reach an overvalued extreme, at which point gravity would set in. Some sectors and small-cap names, particularly in the ChiNext board, are currently stretched (Chart 7).  However, overall market valuations still appear reasonable, based on our composite valuation indicator. Historically, major peaks in the market occurred when the valuation indicator reached much higher levels. Further, cyclically-adjusted equity risk premiums (ERPs) in both Chinese onshore and offshore stocks are materially higher than their historical means (Chart 8). This suggests investors have already priced in extremely high uncertainties surrounding the Chinese economy. Perhaps overdone, in our view. As China's economy continues to recover, their ERPs should shrink, pushing stock prices higher. Chart 7A Structural Bull Run In Chinese Tech Stocks Chart 8Equity Risk Premium In Chinese Stocks Are Extremely High And Will Likely Shrink, Pushing Stock Prices Higher   Secondly, liquidity should tighten. An important liquidity source is margin lending, which has gone up exponentially since late June and invited regulatory attention (Chart 9). Instead of waiting for overleverage in the market to form a momentum like in the 2014 cycle, Chinese regulators seem to be more vigilant and restrictive this time. By acting early and removing some steam from recent market velocity, a healthier secular bull market can develop.   China’s overall monetary conditions are another important source of liquidity. If the policy stance turns from easing to tightening before the economy fully recovers, then it will lead to a compression in multiples in the equity market before stock prices can gain support from an earnings recovery. Historically, Chinese authorities tend to maintain an easing stance for at least three quarters following a nadir in the economy (Chart 10). The track record of Chinese policymakers suggests that the PBoC will likely keep monetary policy accommodative through the end of this year. Chart 9Chinese Authorities Have Been Cracking Down On Overleverage Early In This Bull Run Chart 10Easy Policy Should Sustain Through End Of 2020 Finally, the economy should weaken significantly, which would elevate the equity risk premium and threaten the earnings outlook. A second wave of COVID-19 would have to be severe enough to substantially impact China’s economic recovery, however, the pandemic situation in China seems to be contained and earnings recovery is on course (Chart 11, 12A, 12B, and 12C). Additionally, a major pandemic-triggered shock would only force Chinese authorities to up their ante on reflation and revive domestic demand, which could benefit stocks. Chart 11COVID-19 Virus Spread Has Been Largely Contained Within China Chart 12AA Share Prices Are Not Too Far Ahead Of Earnings Recovery Bottom Line: Chinese equities will likely experience technical corrections in the near term, but the downside risks are not enough to turn bearish.   Chart 12BChinese Investable Stock Prices Seem A Bit Ahead Of Its Own Historical Performance… Chart 12C…But Still Not Too Expensive Compared With Global Benchmarks Investment Conclusions Regardless of the direction of Chinese stocks in absolute terms, we recommend investors overweight equities within a global equity portfolio (Chart 13). Investors should also tilt their exposure to battered cyclicals, particularly in China’s domestic stock market (Chart 14). We favor consumer discretionary, materials and industrials in the next 6 to 12 months. Chart 13We Remain Overweight On Chinese Stocks Chart 14Cyclical Stocks Are Likely To Prevail Over Defensives Chinese equity prices have run ahead of economic fundamentals and setbacks will be likely in the near term. Still, these setbacks are buying opportunities and we recommend buying on the dip if Chinese equities, in either onshore or offshore markets, were to fall by 5% to 10% from current levels. However, consecutive selloffs accumulating to a 15% or greater fall in Chinese stock prices within a short period of time (e.g. 2 to 3 weeks) would prompt us to close our long Chinese equity trades. Historically, when the prices of Chinese equities fell by such a magnitude, the selloffs tended to trigger panic among China’s massive retail investors and, in turn, form a self-reinforcing downward spiral and push Chinese stocks into a prolonged bear market (Chart 15). Chart 15Oversized Selloffs Historically Tend To Push Chinese Stocks Into Prolonged Bear Markets   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    Please see China Investment Strategy Weekly Report "Three Phases Of A Bull Market," dated April 22, 2015, available at cis.bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations

Special Report

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