Economy

Executive Summary Russia Squeezes EU Natural Gas Major geopolitical shocks tend to coincide with bear markets, so the market is getting closer to pricing this year’s bad news. But investors are not out of the woods yet. Russia is cutting off Europe’s natural gas supply ahead of this winter in retaliation to Europe’s oil embargo. Europe is sliding toward recession. China is reverting to autocratic rule and suffering a cyclical and structural downshift in growth rates. Only after Xi Jinping consolidates power will the ruling party focus exclusively on economic stabilization. The US can afford to take risks with Russia, opening up the possibility of a direct confrontation between the two giants before the US midterm election. A new strategic equilibrium is not yet at hand. Tactical Recommendation Inception Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 18.3% Bottom Line: Maintain a defensive posture in the third quarter but look for opportunities to buy oversold assets with long-term macro and policy tailwinds. Feature 2022 is a year of geopolitics and supply shocks. Global investors should remain defensive at least until the Chinese national party congress and US midterm election have passed. More fundamentally, an equilibrium must be established between Russia and NATO and between the US and Iran. Until then supply shocks will destroy demand. Checking Up On Our Three Key Views For 2022 Our three key views for the year are broadly on track: 1.  China’s Reversion To Autocracy: For ten years now, the fall in Chinese potential economic growth has coincided with a rise in neo-Maoist autocracy and foreign policy assertiveness, leading to capital flight, international tensions, and depressed animal spirits (Chart 1). Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Rising incomes provided legitimacy for the Communist Party over the past four decades. Less rapidly rising incomes – and extreme disparities in standards of living – undermine the party and force it to find other sources of public support. Fighting pollution and expanding the social safety net are positives for political stability and potentially for economic productivity. But converting the political system from single-party rule to single-person rule is negative for productivity. Mercantilist trade policy and nationalist security policy are also negative. China’s political crackdown, struggle with Covid-19, waning exports, and deflating property market have led to an abrupt slowdown this year. The government is responding by easing monetary, fiscal, and regulatory policy, though so far with limited effect (Chart 2). Economic policy will not be decisive in the third quarter unless a crash forces the administration to stimulate aggressively. Chart 1China's Slowdown Leads To Maoism, Nationalism​​​​​​ Chart 2Chinese Policy Easing: Limited Effect So Far​​​​​ Chart 3Nascent Rally In Chinese Shares Will Be Dashed Once General Secretary Xi Jinping secures another five-to-ten years in power at the twentieth national party congress this fall, he will be able to “let 100 flowers bloom,” i.e. ease policy further and focus exclusively on securing the economic recovery in 2023. But policy uncertainty will remain high until then. The party may have to crack down anew to ensure Xi’s power consolidation goes according to plan. China is highly vulnerable to social unrest for both structural and cyclical reasons. The US would jump to slap sanctions on China for human rights abuses. Hence the nascent recovery in Chinese domestic and offshore equities can easily be interrupted until the political reshuffle is over (Chart 3). If China’s economy stabilizes and a recession is avoided, investors will pile into the rally, but over the long run they will still be vulnerable to stranded capital due to Chinese autocracy and US-China cold war. If the Politburo and Politburo Standing Committee are stacked with members of Xi’s faction, as one should expect, then the reduction in policy uncertainty will only be temporary. Autocracy will lead to unpredictable and draconian policy measures – and it cannot solve the problem of a shrinking and overly indebted population. If the Communist Party changes course and stacks the Politburo with Xi’s factional rivals, to prevent China from going down the Maoist, Stalinist, and Putinist route, then global financial markets will cheer. But that outcome is unlikely. Hawkish foreign policy means that China will continue to increase its military threats against Taiwan, while not yet invading outright. Beijing has tightened its grip over Tibet, Xinjiang, and Hong Kong since 2008; Taiwan and the South China Sea are the only critical buffer areas that remain to be subjugated. Taiwan’s midterm elections, US midterms, and China’s party congress will keep uncertainty elevated. Taiwan has underperformed global and emerging market equities as the semiconductor boom and shortage has declined (Chart 4). Hong Kong is vulnerable to another outbreak of social unrest and government repression. Quality of life has deteriorated for the native population. Democracy activists are disaffected and prone to radicalization. Singapore will continue to benefit at Hong Kong’s expense (Chart 5). Chart 4Taiwan Equity Relative Performance Peaked​​​​​​ Chart 5Hong Kong Faces More Troubles​​​​​​ Chart 6Japan Undercuts China China and Japan are likely to engage in clashes in the East China Sea. Beijing’s military modernization, nuclear weapons expansion, and technological development pose a threat to Japanese security. The gradual encirclement of Taiwan jeopardizes Japan’s vital sea lines of communication. Prime Minister Fumio Kishida is well positioned to lead the Liberal Democratic Party into the upper house election on July 10 – he does not need to trigger a diplomatic showdown but he would not suffer from it. Meanwhile China is hungry for foreign distractions and unhappy that Japan is reviving its military and depreciating its currency (Chart 6). A Sino-Japanese crisis cannot be ruled out, especially if the Biden administration looks as if it will lose its nerve in containing China. Financial markets would react negatively, depending on the magnitude of the crisis. North Korea is going back to testing ballistic missiles and likely nuclear weapons. It is expanding its doctrine for the use of such weapons. It could take advantage of China’s and America’s domestic politics to stage aggressive provocations. South Korea, which has a hawkish new president who lacks parliamentary support, is strengthening its deterrence with the United States. These efforts could provoke a negative response from the North. Financial markets will only temporarily react to North Korean provocations unless they are serious enough to elicit military threats from Japan or the United States. China would be happy to offer negotiations to distract the Biden administration from Xi’s power grab. South Korean equities will benefit on a relative basis as China adds more stimulus. 2.  America’s Policy Insularity: President Biden’s net approval rating, at -15%, is now worse than President Trump’s in 2018, when the Republicans suffered a beating in midterm elections (Chart 7). Biden is now fighting inflation to try to salvage the elections for his party. That means US foreign policy will be domestically focused and erratic in the third quarter. Aside from “letting” the Federal Reserve hike rates, Biden’s executive options are limited. Pausing the federal gasoline tax requires congressional approval, and yet if he unilaterally orders tax collectors to stand down, the result will be a $10 billion tax cut – a drop in the bucket. Biden is considering waiving some of former President Trump’s tariffs on China, which he can do on his own. But doing so will hurt his standing in Rust Belt swing states without reducing inflation enough to get a payoff at the voting booth – after all, import prices are growing slower from China than elsewhere (Chart 8). He would also give Xi Jinping a last-minute victory over America that would silence Xi’s critics and cement his dictatorship at the critical hour. Chart 7Democrats Face Shellacking In Midterm Elections​​​​​​ Chart 8Paring Trump Tariffs Won't Reduce Inflation Much​​​​​​ Chart 9Only OPEC Can Help Biden - And Help May Come Late Biden is offering to lift sanctions on Iran, which would free up 1.3 million barrels of oil per day. But Iran is not being forced to freeze its nuclear program by weak oil prices or Russian and Chinese pressure – quite the opposite. If Biden eases sanctions anyway, prices at the pump may not fall enough to win votes. Hence Biden is traveling to Saudi Arabia to make amends with Crown Prince Mohammed bin Salman. OPEC’s interest lies in producing enough oil to prevent a global recession, not in flooding the market on Biden’s whims to rescue the Democratic Party. Saudi and Emirati production may come but it may not come early in the third quarter. Lifting sanctions on Venezuela is a joke and Libya recently collapsed again (Chart 9). Even in dealing with Russia the Biden administration will exhibit an insular perspective. The US is not immediately threatened, like Europe, so it can afford to take risks, such as selling Ukraine advanced and long-range weapons and providing intelligence used to sink Russian ships. If Russia reacts negatively, a direct US-Russia confrontation will generate a rally around the flag that would help the Democrats, as it did under President John F. Kennedy in 1962 – one of the rare years in which the ruling party minimized its midterm election losses (Chart 10). The Cuban Missile Crisis counted more with voters than the earlier stock market slide. 3.  Petro-States’ Geopolitical Leverage: Oil-producing states have immense geopolitical leverage this year thanks to the commodity cycle. Russia will not be forced to conclude its assault on Ukraine until global energy prices collapse, as occurred in 2014. In fact Russia’s leverage over Europe will be greatly reduced in the coming years since Europe is diversifying away from Russian energy exports. Hence Moscow is cutting natural gas flows to Europe today while it still can (Chart 11). Chart 10Biden Can Afford To Take Risks With Russia​​​​​​ Chart 11Russia Squeezes EU's Natural Gas​​​​​​ Chart 12EU/China Slowdown Will Weigh On World Russia’s objective is to inflict a recession and cause changes in either policy or government in Europe. This will make it easier to conclude a favorable ceasefire in Ukraine. More importantly it will increase the odds that the EU’s 27 members, having suffered the cost of their coal and oil embargo, will fail to agree to a natural gas embargo by 2027 as they intend. Italy, for example, faces an election by June 2023, which could come earlier. The national unity coalition was formed to distribute the EU’s pandemic recovery funds. Now those funds are drying up, the economy is sliding toward recession, and the coalition is cracking. The most popular party is an anti-establishment right-wing party, the Brothers of Italy, which is waiting in the wings and can ally with the populist League, which has some sympathies with Russia. A recession could very easily produce a change in government and a more pragmatic approach to Moscow. The Italian economy is getting squeezed by energy prices and rising interest rates at the same time and cannot withstand the combination very long. A European recession or near-recession will cause further downgrades to global growth, especially when considering the knock-on effects in China, where the slowdown is more pronounced than is likely reported. The US economy is more robust but it will have to be very robust indeed to withstand a recession in Europe and growth recession in China (Chart 12). Russia does not have to retaliate against Finland and Sweden joining NATO until Turkey clears the path for them to join, which may not be until just before the Turkish general election due in June 2023. But imposing a recession on Europe is already retaliation – maybe a government change will produce a new veto against NATO enlargement. Russian retaliation against Lithuania for blocking 50% of its shipments to the Kaliningrad exclave is also forthcoming – unless Lithuania effectively stops enforcing the EU’s sanctions on Russian resources. Russia cannot wage a full-scale attack on the Baltic states without triggering direct hostilities with NATO since they are members of NATO. But it can retaliate in other ways. In a negative scenario Moscow could stage a small “accidental” attack against Lithuania to test NATO. But that would force Biden to uphold his pledge to defend “every inch” of NATO territory. Biden would probably do so by staging a proportionate military response or coordinating with an ally to do it. The target would be the Russian origin of attack or comparable assets in the Baltic Sea, the Black Sea, Ukraine, Belarus, or elsewhere. The result would be a dangerous escalation. Russia could also opt for cyber-attacks or economic warfare – such as squeezing Europe’s natural gas supply further. Ultimately Russia can afford to take greater risks than the US over Kaliningrad, other territories, and its periphery more broadly. That is the difference between Kennedy and Biden – the confrontation is not over Cuba. Russia is also likely to take a page out of Josef Stalin’s playbook and open a new front – not so much in Nicaragua as in the Middle East and North Africa. The US betrayal of the 2015 nuclear deal with Iran opens the opportunity for Russia to strengthen cooperation with Iran, stir up the Iranians’ courage, sell them weapons, and generate a security crisis in the Middle East. The US military would be distracted keeping peace in the Persian Gulf while the Europeans would lose their long-term energy alternative to Russia – and energy prices would rise. The Iranians – who also have leverage during a time of high oil prices – are not inclined to freeze their nuclear program. That would be to trade their long-term regime survival for economic benefits that the next American president can revoke unilaterally. Bottom Line: Xi Jinping is converting China back into an autocracy, the Biden administration lacks options and is willing to have a showdown with Russia, and the Putin administration is trying to inflict a European recession and political upheaval. Stay defensive. Checking Up On Our Strategic Themes For The 2020s As for our long-term themes, the following points are relevant after what we have learned in the second quarter: 1.  Great Power Rivalry: The war in Ukraine has reminded investors of the primacy of national security. In an anarchic international system, if a single great nation pursues power to the neglect of its neighbors’ interests, then its neighbors need to pursue power to defend themselves. Before long every nation is out for itself. At least until a new equilibrium is established. For example, Russia’s decision to neutralize Ukraine by force is driving Germany to abandon its formerly liberal policy of energy cooperation in order to reduce Russia’s energy revenues and avoid feeding its military ambitions. Russia in turn is reducing natural gas exports to weaken Europe’s economy this winter. Germany will re-arm, Finland and Sweden will eventually join NATO, and Russia will underscore its red line against NATO bases or forces in Finland and Sweden. If this red line is violated then a larger war could ensue. Chart 13China Will Shift To Russian Energy Until Russia and NATO come to a new understanding, neither Europe nor Russia can be secure. Meanwhile China cannot reject Russia’s turn to the east. China believes it may need to use force to prevent Taiwan independence at some point, so it must prepare for the US and its allies to treat it the same way that they have treated Russia. It must secure energy supply from Russia, Central Asia, and the Middle East via land routes that the US navy cannot blockade (Chart 13). Beijing must also diversify away from the US dollar, lest the Treasury Department freeze its foreign exchange reserves like it did Russia’s. Global investors will see diversification as a sign of China’s exit from the international order and preparation for conflict, which is negative for its economic future. However, the Russo-Chinese alliance presents a historic threat to the US’s security, coming close to the geopolitical nightmare of a unified Eurasia. The US is bound to oppose this development, whether coherently or not, and whether alone or in concert with its allies. After all, the US cannot offer credible security guarantees to negotiate a détente with China or Iran because its domestic divisions are so extreme that its foreign policy can change overnight. Other powers cannot be sure that the US will not suffer a radical domestic policy change or revolution that leads to belligerent foreign policy. Insecurity will drive the US and China apart rather than bringing them together. For example, Russia’s difficulties in Ukraine will encourage Chinese strategists to go back to the drawing board to adjust their plans for military contingencies in Taiwan. But the American lesson from Ukraine is to increase deterrence in Taiwan. That will provoke China and encourage the belief that China cannot wait forever to resolve the Taiwan problem. Until there is a strategic understanding between Russia and NATO, and the US and China, the world will remain in a painful and dangerous transitional phase – a multipolar disequilibrium. Chart 14Hypo-Globalization: Globalizing Less Than Potential 2.  Hypo-Globalization: If national security rises to the fore, then economics becomes a tool of state power. Mercantilism becomes the basis of globalization rather than free market liberalism. Hypo-globalization is the result. The term is fitting because the trade intensity of global growth is not yet in a total free fall (i.e. de-globalization) but merely dropping off from its peaks during the phase of “hyper-globalization” in the 1990s and early 2000s (Chart 14). Hypo-globalization is probably a structural rather than cyclical phenomenon. The EU cannot re-engage with Russia and ease sanctions without rehabilitating Russia’s economy and hence its military capacity – which could enable Russia to attack Europe again. The US and China can try to re-engage but they will fail. Russo-Chinese alliance ensures that the US would be enriching not one but both of its greatest strategic rivals if it reopened its doors to Chinese technology acquisition and intellectual property theft. Iran will see its security in alliance with Russia and China. China has an incentive to develop Iran’s economy so as not to depend solely on Russia and Central Asia. Russia has an incentive to develop Iran’s military capacity so as to deprive Europe of an energy alternative. Both Russia and China wish to deprive the US of strategic hegemony in the Middle East. By contrast the US and EU cannot offer ironclad security guarantees to Iran because of its nuclear ambitions and America’s occasional belligerence. Thus the world can see expanding Russian and Chinese economic integration with Eurasia, and expanding American and European integration with various regions, but it cannot see further European integration with Russia or American integration with China. And ultimately Europe and China will be forced to sever links (Chart 15). Globalization will not cease – it is a multi-millennial trend – but it will slow down. It will be subordinated to national security and mercantilist economic theory. 3.  Populism/Nationalism: In theory, domestic instability can cause introversion or extroversion. But in practice we are seeing extroversion, which is dangerous for global stability (Chart 16). Chart 15Global Economic Disintegration​​​​​​ Chart 16Internal Sources Of Nationalism​​​​​​ Russia’s invasion of Ukraine derived from domestic Russian instability – and instability across the former Soviet space, including Belarus, which the Kremlin feared could suffer a color revolution after the rigged election and mass protests of 2020-21. The reason the northern European countries are rapidly revising their national defense and foreign policies to counter Russia is because they perceive that the threat to their security is driven by factors within the former Soviet sphere that they cannot easily remove. These factors will get worse as a result of the Ukraine war. Russian aggression still poses the risk of spilling out of Ukraine’s borders. China’s Maoist nostalgia and return to autocratic government is also about nationalism. The end of the rapid growth phase of industrialization is giving way to the Asian scourge: debt-deflation. The Communist Party is trying to orchestrate a great leap forward into the next phase of development. But in case that leap fails like the last one, Beijing is promoting “the great rejuvenation of the Chinese nation” and blaming the rest of the world for excluding and containing China. Taiwan, unfortunately, is the last relic of China’s past humiliation at the hands of western imperialists. China will also seek to control the strategic approach to Taiwan, i.e. the South China Sea. China’s claim that the Taiwan Strait is sovereign sea, not international waters, will force the American navy to assert freedom of passage. American efforts to upgrade Taiwan relations and increase deterrence will be perceived as neo-imperialism. The United States, for its part, could also see nationalism convert into international aggression. The US is veering on the brink of a miniature civil war as nationalist forces in the interior of the country struggle with the political establishment in the coastal states. Polarization has abated since 2020, as stagflation has discredited the Democrats. But it is now likely to rebound, making congressional gridlock all but inevitable. A Republican-controlled House will find a reason to impeach President Biden in 2023-24, in hopes of undermining his party and reclaiming the presidency. Another hotly contested election is possible, or worse, a full-blown constitutional crisis. American institutions proved impervious to the attempt of former President Trump and his followers to disrupt the certification of the Electoral College vote. However, security forces will be much more aggressive against rebellions of whatever stripe in future, which could lead to episodes in which social unrest is aggravated by police repression. If the GOP retakes the White House – especially if it is a second-term Trump presidency with a vendetta against political enemies and nothing to lose – then the US will return to aggressive foreign policy, whether directed at China or Iran or both. In short, polarization has contaminated foreign policy such that the most powerful country in the world cannot lead with a steady hand. Over the long run polarization will decline in the face of common foreign enemies but for now the trend vitiates global stability. Chart 17Germany And Japan Rearming It goes without saying that nationalism is also an active force in Iran, where 83-year-old Supreme Leader Ayatollah Khamenei is attempting to ensure the survival of his regime in the face of youthful social unrest and an unclear succession process. If Khamenei takes advantage of the commodity cycle, and American and Israeli disarray, he can make a mad dash for the bomb and try to achieve regime security. But if he does so then nationalism will betray him, since Israel and/or the US are willing to conduct air strikes to uphold the red line against nuclear weaponization. If any more proof of global nationalism is needed, look no further than Germany and Japan, the principal aggressors of World War II. Their pacifist foreign policies have served as the linchpins of the post-war international order. Now they are both pursuing rearmament and a more proactive foreign policy (Chart 17). Nationalism may be very nascent in Germany but it has clearly made a comeback in Japan, which exacerbates China’s fears of containment. The rise of nationalism in India is widely known and reinforces the trend. Bottom Line: Great power rivalry is intensifying because of Russia’s conflict with the West and China’s inability to reject Russia. Hypo-globalization is the result since EU-Russia and US-China economic integration cannot easily be mended in the context of great power struggle. Domestic instability in Russia, China, and the US is leading to nationalism and aggressive foreign policy, as leaders find themselves unwilling or unable to stabilize domestic politics through productive economic pursuits. Investment Takeaways BCA has shifted its House View to a neutral asset allocation stance on equities relative to bonds (Chart 18). Chart 18BCA House View: Neutral Stocks Versus Bonds Geopolitical Strategy remains defensively positioned, favoring defensive markets and sectors, albeit with some exceptions that reflect our long-term views. Tactically stay long US 10-year Treasuries, large caps versus small caps, and defensives versus cyclicals. Stay long Mexico and short the UAE (Chart 19). Strategically stay long gold, US equities relative to global, and aerospace/defense sectors (Chart 20). Among currencies favor the USD, EUR, JPY, and GBP. Chart 19Stay Defensive In Q3 2022​​​​​​ Chart 20Stick To Long-Term Geopolitical Trades​​​​​​ Chart 21Favor Semiconductors But Not Taiwan​​​​​ Chart 22Indian Tech Will Rebound Amid China's Geopolitical Risks​​​​​ Chart 23Overweight ASEAN Go long US semiconductors and semi equipment versus Taiwan broad market (Chart 21). While we correctly called the peak in Taiwanese stocks relative to global and EM equities, our long Korea / short Taiwan trade was the wrong way to articulate this view and remains deeply in the red. Similarly our attempt to double down on Indian tech versus Chinese tech was ill-timed. China eased tech regulations sooner than we expected. However, the long-term profile of the trade is still attractive and Chinese tech will still suffer from excessive government and foreign interference (Chart 22). Go long Singapore over Hong Kong, as Asian financial leadership continues to rotate (see Chart 5 above). Stay long ASEAN among emerging markets. We will also put Malaysia on upgrade watch, given recent Malaysian equity outperformance on the back of Chinese stimulus and growing western interest in alternatives to China (Chart 23).     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Special Report

Listen to a short summary of this report.       Executive Summary Gold Has Established A Double-Top Formation Gold has done quite well amidst the turmoil in global financial markets. BCA is neutral global equities, which bodes well for gold as a hedge. The shiny metal is a great inflation hedge. Investors betting on non-transitory inflation should be overweight gold in their portfolios. Historically, gold has held up relatively well during equity market downturns. Most of our fair-value models are pinning gold at neutral valuations. This suggests that positioning should be tactical rather than strategic.   Bottom Line: Gold can be expected to trade higher over the next few months, as global central banks fall behind the curve in fighting inflation. Once it becomes clear that inflation has peaked, either via a soft landing in major economies or an outright recession, gold will lag other commodity prices. According to our models, the near-term target for gold is 1848 USD/oz, suggesting a modest overweight stance. Feature Gold has held up remarkably well, amidst very poor returns for traditional asset classes. The bellwether S&P 500 index is down 20% year to date. US 10-year treasury prices are down 14%. Even copper, a barometer for commodity prices is off 20% from its peak, despite a supply-driven bull market in many resources from grains to energy. Investors who decided to park their wealth in gold are flat year-to-date, not a desirable result, but a much better outcome compared to a 60/40 equity-bond portfolio, which is down 18% year-to-date. What is remarkable about gold’s resilience is that traditional tailwinds for the yellow metal are now opposing forces. For example, gold trends with falling real rates, but the 10-year TIPS yield has rebounded violently as the Federal Reserve has turned more hawkish. Gold also moves inversely to the dollar, but the DXY dollar index hit fresh cycle highs this year. In fact, we are witnessing the rare occurrence where both gold and the dollar are up this year (Chart 1). Gold’s resilience comes at an important time since, from a technical standpoint, a classic double-top formation has been established. For chartists, this means either a major downturn is in the cards, or some consolidation is due before new highs are established (Chart 2). In this report, we try to gauge the outlook for gold from the lens of the current macroeconomic paradigm, valuations, and shifts in investors’ perception of what defines a safe-haven asset. Chart 1Gold Has Held Up Remarkably Well Chart 2Gold Has Established A Double-Top Formation Gold As An Inflation Hedge Chart 3Gold Prices Track US Inflation Gold prices have historically been a good inflation hedge. Chart 3 shows that gold has done an excellent job at tracking consumer prices in the US. According to this chart, gold has lagged the overshoot in inflation. This suggests that bullion prices could be poised for a coiled spring rebound. Gold’s link to inflation dates back many centuries, given that it has historically been a monetary standard. The pre-war period in the early 1900s saw tremendously undervaluation in gold, as an economic boom was met with a rigid money supply. It was not until the 1929 stock market crash, and the ensuing Great Depression, that Western governments had to debase fiat money vis-à-vis gold to stop price deflation. Under the post-WW2 Bretton Woods system, the widespread implementation of social welfare schemes in the late 1960s, excessive government spending, and the Vietnam war all created a huge fiscal burden for the US government. This caused the current-account deficit to widen, leading to a sharp fall in confidence in the dollar. Inflationary pressures began to fester. As a result, the Nixon administration was forced to shut the gold window in 1971 and delink the US dollar from gold. The dollar collapsed and gold soared as a result. Today, most currencies are freely floating, adjusting to price differentials in a timely manner, but rising inflation once again is a global problem. This is an environment where gold usually does well. Proponents of the gold standard generally point out that since 2020, the US monetary base has expanded by 71%, but gold output has risen only by 4%. Ergo, monetary policy would have been extremely tight under a gold-exchange standard, helping curtail inflation. The bottom line is that inflation risks are here to stay, as outlined in various Commodity & Energy Strategy reports. This will be a tailwind for bullion. Gold And The Dollar It has become clear in recent weeks that the Fed (and most other central banks) are behind the curve on inflation. As an anti-fiat currency, gold typically does well in this environment. Chart 4 highlights that the real Fed fund’s rate is below a variety of reasonable estimates of neutral. Gold typically moves inversely to the dollar so the question becomes how fast the Fed can tighten financial conditions, while engineering a soft landing in the US. In our view, it is possible but not probable. The Fed’s hawkish shift has triggered a tremendous outflow from long-duration US equities (Chart 5). Bonds remain the overarching driver of US portfolio flows, but rising inflation volatility is keeping big buyers such as Japan on the sidelines. This raises the likelihood that the Fed will pivot in a dovish fashion, as financial conditions tighten. Chart 4Real Rates In The US Are Very Low Chart 5Higher Rates Are A Threat To US Equity Inflows Even if the US avoids a recession, it is likely that countries that were starved of growth during the pandemic will increasingly benefit, including China. It is noteworthy that currency strength has been bifurcated. Commodity-producing currencies have done relatively well (BRL, CAD, AUD), while commodity importers’ currencies have been hammered (EUR, JPY, SEK). Excluding the supply side of the commodity picture, the dollar would be marginally weaker. Gold And Commodities Most of gold’s demand comes from investment, but there is some industrial and jewelry use as well. As such, gold remains very highly correlated to overall commodity prices. The prices of many commodities are in a supply-side bull market. This has helped keep gold prices elevated. Gold’s industrial demand is likely to be a bane in the near term, even if it would support prices longer term. Most industrial powers are seeing a slowdown in their economies, notably China. This puts a lot of industrial commodities, including gold, at risk of a price reversal. Looking ahead, commodity demand is expected to remain firm especially in the face of supply-side bottlenecks. This will put a floor on how low gold prices can fall. Consumer demand could become a key source of support for gold prices. Chinese and Indian gold imports have surged this year, amidst soft prices. Gold coin and bar investment demand is also above its 5-year average. There is high seasonality to India’s demand for gold, so upcoming festival and wedding seasons, many of which were postponed due to Covid-19 restrictions, will provide a boost to gold purchases. In the US, gold coin sales in May were at the highest level in over a decade. Even Russia, which recently removed the VAT tax on gold purchases, saw a 54% year-on-year rise in gold coin sales. Gold And Central Banks The one profound change in the gold market has been the behavior of global central banks. Global allocations of foreign-exchange reserves have drifted away from the dollar and towards gold and other currencies (Chart 6). This helps underpin the gold bull market. This diversification away from the USD has been particularly acute among countries with a geopolitical incentive to increase non-dollar holdings. China has seen its gold reserves rise from 1.9% to 3.6% since 2016. Russia, which presently is at war with the West, has little Treasury holdings with 21% of its reserves in gold. With every country having an implicit geopolitical imperative to diversify its reserve holdings, gold sits as a neutral monetary standard. As such, the allocation of global FX reserves towards gold will continue to rise (Chart 7). Chart 6A Stealth Diversification From US Dollars Chart 7Central Banks Have Become Gold Buyers Gold And Financial Markets The biggest demand for gold is likely to come from hedging against equity volatility. Historically, gold has done relatively well during equity market drawdowns (Chart 8). This has been the case so far this year. As outlined above, if inflation continues to surprise to the upside, then gold should be a core holding in investor portfolios. That said, TIPS yields are rising; as such, should global central banks contain the risk of a wage-inflation spiral, gold will underperform other asset classes. Chart 8Gold Does Well During Crises The gold/commodity ratio has an eery correlation with the VIX (Chart 9). This cements gold’s role as a safe-haven asset. Given rising political and economic uncertainty, a gold hedge is practical. Chart 9Higher Volatility Will Benefit Gold How To Value Gold Valuing gold is an extremely difficult exercise. As an inflation hedge, gold is trading at a 210% premium relative to its purchasingpower (Chart 10). However, shorter-term models are more sanguine. Our in-house models using a combination of monetary and financial variables suggest gold is much closer to fair value at current levels (Chart 11). From a holistic sense, gold is a hedge against geopolitical uncertainty, overly abundant liquidity, and inflation risk, as well as a source of capital preservation. Putting all these together, the gold price is fair. Chart 10Gold Is Expensive In Real Terms Chart 11Gold At Fair Value According To Our Models From a commodity standpoint, gold is trading at a hefty premium to cash costs (Chart 12). This has always been the case during gold bull markets. Should the current paradigm shift to one of low inflation and little geopolitical risk, investors need to be cognizant of the safety premium currently embedded in gold prices. Chart 12Gold Is Trading Well Above Cash Costs From a technical standpoint, our indicators suggest gold is oversold but not yet at a nadir (Chart 13). This implies some consolidation is due before the next leg of the gold trend is established. Chart 13Sentiment On Gold Is Not Yet At A Nadir From a valuation standpoint, we will be buyers of gold today, but will not hold it for the long term. Investment Conclusions Gold can be expected to trade higher over the next few months, as global central banks fall behind the curve in fighting inflation. Once it becomes clear that inflation has peaked, either via a soft landing in major economies or an outright recession, gold will lag other commodity prices. According to our models, the near-term target for gold is 1848 USD/oz, suggesting a modest overweight stance is appropriate.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary  

Executive Summary Biden Can Take Risks With Russia President Biden will make a last-ditch effort to mitigate Democratic losses in the midterm elections and the effect will be still-high policy uncertainty and erratic US behavior. Biden can take several executive actions against inflation but we do not expect them to resolve the global supply shock or to save the Democrats from a Republican takeover of Congress this fall. There is substantial risk of a direct US-Russia crisis ahead of the election that would sustain bearish sentiment. US policy remains a headwind for equities in 2022 but possibly a tailwind in 2023. A rally after the midterm is fairly likely.   Recommendation (Tactical) Initiation Date  Return Long DXY (Dollar Index) 23-FEB-22 8.8% Bottom Line: Maintain a defensive posture in the third quarter but look for opportunities to buy oversold assets with long-term macro and policy tailwinds. Feature President Biden and the Democratic Party will make a last-ditch effort in the third quarter to mitigate their large expected losses in the midterm elections. The president will concentrate on fighting inflation, which is weighing on wages, incomes, and consumer and business sentiment (Chart 1). Related Report  US Political StrategyBiden Opens The Border Biden’s frantic efforts will induce additional market volatility. The president has a few limited tools to address global energy and supply shocks that probably will not work. Inflation will remain problematic even if it slows down over the next three months as our bond strategists expect. The odds of recession have risen sharply. Our Chief Global Strategist Peter Berezin suggests that the odds are 40% – a point underscored by inversion of some parts of the yield curve and a falling leading economic indicator (Chart 2). President Biden recently met with outside economic adviser Larry Summers and concluded that a recession is “not inevitable.” Not very comforting. Chart 1Inflation's Toll Chart 2Odds Of Recession Rising Summers, who warned Biden and the Democrats not to add $1.9 trillion in spending at the beginning of 2021, has put forward research showing recession odds at 60%-70% over the next 12-24 months.1 However, BCA’s own recession checklist is still ambivalent (Table 1). BCA’s House View is now neutral on equities. Table 1BCA Recession Checklist What could change the US policy outlook? Not much. Avoiding recession, reducing inflation, mobilizing women voters, and clashing directly with Russia could mitigate some of the Democrats’ expected losses this fall, but the outcome would probably be the same. Betting markets give a 72%probability to Democrats losing control of both the House of Representatives and the Senate. Our own election models show Democrats losing 22 seats in the House and two seats in the Senate (see Appendix), reinforcing our February forecast. The implication is congressional gridlock in 2023-24. Gridlock is marginally positive for the broad US equity market beginning in Q4 2022 … but marginally negative before then. Checking Up On Our Three Key Views For 2022 Our three key views for 2022 remain intact at the halfway point of the year. : 1.   From Single-Party Rule To Gridlock: The Democrats are highly likely to lose control of the House of Representatives this fall, meaning that unified government will end with the lame duck legislative session in November and December. The Democrats’ fiscal 2022 budget reconciliation bill is less likely to pass now that midterm campaigning has begun. A fiscally expansive bill would add to inflation. A deficit-reducing bill – i.e. one with substantial tax hikes – would increase the odds of recession. Biden no longer has an interest in pushing the bill until he is reasonably sure a recession can be avoided. It is very hard to garner 218 votes in the House and 51 votes in the Senate now that Biden’s and Democrats’ popular support is melting down. Democrats are polling comparably to Republicans who lost 41 House seats in the 2018 midterms (Chart 3). Thus while it is still possible for Democrats to pass an energy security and climate change bill under Biden’s presidency, we have no conviction that they can do it before the midterm. More likely it would have to pass during the lame-duck session in the fourth quarter – or as a compromise law with a Republican Congress in 2023-24. Until 2025, at earliest, US government will be divided, which means that the post-election drop in policy uncertainty will be short-lived, as fears will emerge of breaching the debt ceiling in early 2023. Chart 3Democratic Party Troubles 2.   From Legislative To Executive Power: With the legislature stymied, Biden will resort to executive power to keep his presidency afloat. So what will he do? Fight inflation. Biden’s anti-inflation plan consists of three prongs. The first is “letting” the Fed raise interest rates, which is well under way. The Fed hiked rates by 75 basis points on June 15 and plans to raise the Fed funds rate to 3.25% or 3.5% by end of year. The second prong is passing his Build Back Better plan and the third is consolidating the fiscal deficit. But these two options are bogged down in Congress – no new belt-tightening will occur until 2023 at earliest. So Biden’s remaining options consist of administrative maneuvers and executive orders. Biden could stop collecting the federal gas tax, although the tax has not risen since 1993 and its removal will have a marginal impact (Chart 4). He has already tapped the strategic petroleum reserve, to an unprecedented degree, without preventing the surge in prices at the pump (Chart 5). Chart 4Biden To Defer Federal Gas Tax Chart 5Strategic Petroleum Reserve Already Tapped   3.   From Domestic To Foreign Policy: Part of Biden’s turn toward executive power will be a turn toward foreign policy orientation. However, before the midterm, Biden’s foreign policy will be defensive or reactive. That is, with the exception of Russia, he will attempt to placate foreign threats and mitigate the energy shock. On China, Biden is considering pulling back on some of President Trump’s extraordinary tariffs, though probably not the Section 301 tariffs related to technology theft. He has the authority to do so unilaterally just as Trump had the authority to put them on. The problem is that easing the China tariffs will have little effect on inflation, and only after the midterm, while it would weaken Biden’s political standing in the Rust Belt and undermine the US’s strategic competition with China. Tariff relief would only temporarily benefit the renminbi, if at all, given China’s need for a weak currency amid its economic slowdown (Chart 6). Hence Biden may reduce some tariffs but it will be underwhelming. Not a reliable way to bring down inflation. Chart 6Biden Can Ease China Tariffs (But Don't Bet On It) Second, Biden has proposed to ease sanctions on Iran if it will freeze its nuclear program and come back into compliance with the 2015 nuclear deal that the Trump administration rejected. But the Iranians can export oil anyway at today’s prices, they have customers in China and India, and they have immense military leverage over Iraqi production, which means they are not forced to capitulate (Chart 7). Not a reliable way to bring down inflation. Third, Biden is courting the Gulf Arab states and tinkering with easing sanctions on Venezuela and others. OPEC support is a better option than Iran/Venezuela. However, OPEC will decide when and how much support to give. The Arab states will act to prolong the global business cycle but will not base their strategy on helping Democrats win an election. Hence they may not come to the rescue as early as the third quarter (Chart 8). Chart 7Biden Can Ease Iran Sanctions (But Don't Bet On It) Chart 8Biden Casting About For Oil Providers Moreover if the Biden administration makes amends with Saudi Arabia, then Iran’s nuclear progress will steam ahead and ignite tensions in the Middle East within the year. That would vitiate the impact of increased OPEC production. Not a reliable way to bring down inflation. Biden has even sought to exempt Russia from some sanctions for the sake of reducing inflation, such as with grain exports. However, these arrangements may not last. Given Biden’s weak domestic support and given the way that the Cuban Missile Crisis helped President Kennedy to mitigate his party’s losses in 1962, Biden can afford to be confrontational and even provocative toward Russia (Chart 9). After all, Russia is already pulling levers to add to inflation. The problem is that a direct US-Russia showdown would increase inflation while heightening global risk aversion. Bottom Line: Gridlock is coming, which is marginally negative for US equities in Q3 2022 but marginally positive as early as Q4 2022 and in 2023. It is not good for equities in 2022 because of elevated uncertainty – uncertainty not so much about the election results as about the volatile and unpredictable impacts of the president’s last-ditch efforts to fight inflation. Chart 9Biden Can Take Risks With Russia Checking Up On Our Strategic Themes For The 2020s Looking beyond the short term, this year’s inflation outbreak and geopolitical events will largely reinforce our three long-term US political themes, in the following ways: 1.   Millennials/GenZ Rising: In the coming 12 months, a fall in job openings due to the economic slowdown, combined with a recovering labor participation rate, could reduce wage pressures and inflation, in accordance with the Federal Reserve’s plan for a “soft landing” (Chart 10). Of course, that is not happening yet. And conversely labor participation will fall again if recession risks materialize. So there will be a lot of noise in the short run. Over the long run, a rising dependency ratio, in the context of a growing population, has inflationary implications. It decreases the pool of savings, increases the need for public investment, and increases the cost of each prime-age worker. Today the headline labor participation rate has mostly recovered but workers over the age of 55 are failing to return to pre-pandemic levels of participation, as are young people, which will keep wage pressures up (Chart 11). Chart 10The Fed's Idea Of A Soft Landing Chart 11Generational Shift In Labor Market Thus generational change will be marginally inflationary and will have powerful political effects. An increasingly multi-ethnic and educated population will hold different opinions from previous generations. Political parties will evolve to capture these voters. Underlying the shift will be the fact that government support will be necessary for the rising share of dependents, yet fiscal discipline will be necessary to restrict inflation. The current quarrel between older and younger generations will intensify before it subsides. The Silent Generation, along with the conservative Baby Boomers, will remain the decisive voting bloc in the 2022 midterm and will seek to freeze fiscal policy. That brings us to our next theme … 2.   Peak Polarization: Political polarization has declined since the 2020 election, as we predicted. All voters dislike high inflation (Chart 12). However, polarization will remain at historically high levels at least over the short and medium term. Chart 12Everyone Loathes Inflation Chart 13Women’s Turnout Will MatterPolarization will remain high in part because of the generational divide, which is still very wide and underpins stark ideological divides. For example, a short-term driver of polarization will be abortion. The Supreme Court is likely, though not certain, to overturn the 1972 Roe v. Wade decision that guarantees nationwide access to abortion. If it does, protests and civil unrest will occur. Women turned out in droves against President Trump’s Republicans in the 2018 midterms and will do so again in 2022 (Chart 13), helping Democrats to mitigate some of their losses. Polarization will also remain high due to the electoral system and intra-party dynamics. While Democrats ensconce themselves in formal institutions, Republicans continue to transform into a populist party. So far in the Republican primary elections, candidates endorsed by former President Trump are winning the nomination at a 94% rate. Table 2 shows the outcomes in the GOP primary elections for the House of Representatives so far. A GOP House majority is likely to impeach President Biden for one or another reason, even though they will not be able to remove him from office. Table 2Polarization Will Stay Near Historic Peaks Over 2022-24 Cycle Today’s extreme polarization entails that congressional gridlock will return and that the US remains at high risk of social unrest, political violence, and domestic terrorism (Chart 14). A terrorist attack that affects critical infrastructure, high-level personnel, or the electoral system would lead to greater sociopolitical instability. Especially if violence tips the narrow political balance of one of the branches of government and has a concrete impact on national policy.2 Social unrest alone will hardly move markets but unrest that fundamentally damages US political stability is possible and would engender risk-aversion. Over the long run, however, the US will avoid a second civil war since Washington possesses the world’s most powerful military and intelligence apparatus, which is highly unlikely to be coopted or defeated by an extremist movement. The military swears allegiance to the constitution. For example, neither the military nor the political institutions (as opposed to individuals) showed any serious sign of breaking down during the January 6, 2021 insurrection. The vast majority of voters will recoil from any major incidents of terrorism or militancy. While opinion polls show non-negligible support for political violence, such polls need to be interpreted carefully (Chart 15). A recent study shows that these polls overstate public support for violence.3 Chart 14Major Risk Of Domestic Terrorism, Political Violence Chart 15Opinion Growing More Militant … Until Militancy Happens The emerging Russo-Chinese strategic challenge, combined with generational change, will force political elites to cooperate to prevent domestic insurrections, regime fracture, and foreign humiliation. Polarization will give way to a new American consensus which is largely directed at domestic stabilization and fighting the Second Cold War. 3.   Limited Big Government: The inflation outbreak has dealt a blow to arguments in favor of unlimited government, including Modern Monetary Theory. While the US rediscovered the need for “Big Government” during the deflationary 2010s, it is already starting to rediscover the need for limited government via the inflationary 2020s (Chart 16). The next Congress will reimpose some fiscal discipline – and future governments will face some checks and balances on spending due to their fear of an inflationary surge and negative consequences at the voting booth. Unless Democrats somehow retain control of Congress this fall, they will reinforce the precedent set by the Carter administration that high inflation is politically undesirable. Chart 16Inflation Outbreak Will Limit Big Government Fiscal policy will be more expansive in the coming decade than in recent decades due to structural factors. But it will still face limitations from democratic politics, i.e. gridlock. As long as polarization does not spiral out of control, the US government will not become authoritarian or autocratic and fiscal policy will not result in Big Government Socialism or No Government Anarchism. A new compromise will be found which will be Limited Big Government. Bottom Line: Generational tensions will rise and then fall – and so will political polarization. The US faces a high risk of sociopolitical instability in the short term. The 2022 midterm will become a source of uncertainty, volatility, and a still-elevated equity risk premium. After the midterm, uncertainty and risk premiums will dissipate temporarily. But avoiding a recession will become the critical factor in maintaining policy continuity and national stability through the 2024 election cycle. Investment Takeaways BCA has shifted its House View to a neutral asset allocation stance on equities relative to bonds, as noted. US Political Strategy remains defensively positioned, as midterm elections typically provide a tailwind to defensive sectors for the first three quarters of the election year. This is also true when unified governments shift to divided governments – and in that case bond yields tend to be higher than usual (Chart 17). While the inflation outbreak makes this year different from many recent midterm years, these trends have persisted. For this reason, and our Geopolitical Strategy views, we will maintain our defensive bias in the third quarter. Chart 17Stocks Flat, Bond Yields High, Until After Midterm Elections We remain overweigh health care relative to the broad market and overweight nominal Treasuries relative to inflation-protected securities. Having said that, we are putting our long US dollar (DXY) trade on downgrade watch. We do not doubt that the dollar can go higher this year but our bearish views have come to fruition both within the US and in the geopolitical space and they are now largely priced. It may soon be time to step back and reassess, especially because interest rate differentials are turning against the dollar (Chart 18). In addition China’s government will take a pro-growth turn to try to secure the economic recovery over the next 12 months. In the energy space, we expect volatility. The Biden administration is focused on fighting inflation and could pull various levers to affect the oil market, outlined above. If Biden succeeds against expectations, then the oil price would suffer a substantial setback. Moreover OPEC has an independent interest in prolonging the business cycle now that global prices have become punitive. Hence we are neutral on oil prices and booked gains on our long energy trades for the time (Chart 19). Chart 18Put US Dollar On Downgrade Watch If inflation subsides and bond yields moderate, then growth stocks should rebound against value stocks. However, we implemented this idea prematurely earlier this year and suffered for it. Therefore we remain neutral on the question of portfolio styles for now. Our cyclical plays remain the same: long cyber security stocks, defense stocks, and infrastructure stocks. We also remain long renewable energy, although for now we only recommend it as a tactical trade (Chart 20). Chart 19Energy Prices Will Be Volatile Chart 20Stick With Cyber Security, Defense, And Renewables     Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com     Footnotes 1     See Lawrence H. Summers and Alex Domash, “History Suggests a High Chance of Recession over the Next 24 Months,” Harvard Kennedy School, March 15, 2022, www.hks.harvard.edu. 2     Consider the January 6 insurrection, the recent plot against Supreme Court Justice Brett Kavanaugh’s life, the gun attack on Republican Senators in 2017, and the risk of assassinations or other extremist incidents. 3    See Sean J. Westwood et al, “Current research overstates American support for political violence,” Proceedings of the National Academy of Sciences, 119:12 (2022), pnas.org. Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model  Table A4House Election Model Table A5APolitical Capital: White House And Congress Table A5BPolitical Capital: Household And Business Sentiment Table A5CPolitical Capital: The Economy And Markets