Economy

Listen to a short summary of this report.     Dear Client, In lieu of our weekly report next week, I will be hosting a webcast on Tuesday with my colleague Mathieu Savary, Chief European Strategist, on the implications of stagflation on European assets and global FX markets. I look forward to answering any questions you might have. Kind regards, Chester Executive Summary The Yen And Interest Rates The Japanese yen is in liquidation. The historical evidence suggests waiting for an exhaustion in selling pressure, before placing fresh bets. This exhaustion is likely to occur once global bond yields stabilize (Feature chart), and energy price inflation abates. A move lower in these two key variables would catalyze an explosive rebound in the yen, on the back of very cheap valuations and a large net short speculative position. The Bank of Japan will not meaningfully pivot soon. The reason is that downside risks to the Japanese economy supersede the risk of an inflation overshoot. What Japan needs is stronger fiscal spending, that would offset deficient domestic demand. That said, Japan is also one of the best candidates for generating non-inflationary growth, a bullish backdrop for the currency. Our 2022 target for the yen is 110. Our sense is that most of the downside risks are well understood by markets, while upside surprises are much underappreciated. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short chf/JPY 135 2022-04-21 - Bottom Line: The yen has undershot. According to our in-house PPP models, the Japanese currency is undervalued by 35%. Historically, an investor buying the yen at such undervalued levels has made 6% per year over the subsequent 5 years. Feature The yen’s move in recent weeks has been explosive. Since early March, the yen has collapsed by 11%, pushing USD/JPY from around 115 to a nudge below 130. Over the last year, the yen is down 16%. In retrospect, a chart formation since 1990 suggests this is a classic liquidation phase that is unlikely to reverse until fundamentals shift. The two key drivers of yen weakness have been higher global yields, and elevated energy prices. Chart 1 shows that the yen has been perfectly tracking the US 10-year Treasury yield. Yield curve control (YCC) is leading to a capitulation of both domestic and foreign investors, fleeing from Japanese bonds towards external bond markets. Looking out the curve, investors do not expect the Bank of Japan to lift rates higher than 50 bps until 2028 (Chart 2). Chart 1The Yen And Interest Rates Chart 2The BoJ Is Expected To Stay Dovish Meanwhile, higher energy costs are also putting selling pressure on the yen as merchants sell JPY to pay for more expensive imports in US dollars.    Is Selling Pressure Exhausted? Chart 3A Technical Profile Of The Japanese Yen The key question for investors is whether the carnage in the yen is in an apocalyptic phase. The answer depends on the time horizon. Daily traders, reconciling positions every few hours, should continue shorting the yen. Exhaustion in selling pressure is likely to manifest itself through a few technical patterns, most notably, a consolidation phase. Chart 3 suggests that reversals in the yen have tended to pass through a period of indigestion, allowing investors enough time to play on a reversal. We are not there yet.  That said, for longer-term investors, being contrarian could pay off handsomely. The 1-year drawdown in the yen is within the scope of historical capitulation phases (Chart 4). Since JPY became freely floating, selloffs have been around 15%-20% especially during major events (the Asian financial crisis or the manufacturing recession the last decade, for example). The last major selloff was around Abenomics in 2012, a pivotal event. Chart 4The Yen Drawdown Has Matched Previous Capitulation Phases Speculators are also very short JPY and sentiment is quite depressed. This is bullish from a contrarian perspective. Low rates in Japan have led to the proliferation of carry trades. While these are likely to persist, the bulk of investors have already jumped on this bandwagon. A stabilization and/or reversal in US Treasury yields could flush out stale shorts in the yen (Chart 5). If, as we expect, the greenback does weaken in the second half of this year, that will also support the yen. Chart 5Sentiment On The Yen Is Very Depressed Japan’s Economic Outlook The yen tends to appreciate when the Japanese economy is exiting a recession (Chart 6). Part of the reason why the yen has been so weak is because economic growth in Japan has been anemic. While the external sector has been benefiting from a global trade boom, the domestic sector has been under siege from the pandemic, until recently. Chart 6The Yen Tends To Rebound When The Japanese Economy Recovers It is notable that while goods spending has been picking up around the world, the personal consumption component of GDP in Japan remains 5% below the pre-pandemic trend. Shinkansen passenger volumes are still down 42% this year after an even bigger collapse last year. Inbound tourists, a meaningful source of demand, has collapsed from about 25% of the overall Japanese population before the pandemic to zero today. These dire statistics are likely to reverse. The manufacturing PMI is ticking higher. The number of daily new COVID-19 cases has dramatically rolled over. This will be a welcome fillip to much subdued consumer and business sentiment. 2% Inflation = Mission Impossible? The BoJ is likely to get its wish of 2% inflation in the coming months. However, it will prove fleeting. The overarching theme for Japan is an aging and declining population which has put a lid on consumer prices (Chart 7). This will support real interest rates. Inflation does not tend to accelerate on the island until the output gap is fully closed. That has yet to occur. Meanwhile, the political push to cut mobile phone prices has been a drag on CPI. Mobile phone charges alone have cut around 1.2%-1.5% from the core core measure of Japanese inflation, according to the BoJ. This has been a structural trend. As a result, long-term inflation expectations in Japan remain anchored near 1%, even though the rest of the world is seeing a price boom (Chart 8). The revealed preference is for low/stable prices. Chart 7Demographics Are Weighing On Japanese##br##Inflation Chart 8Long-Term Inflation Expectations In Japan Are Rising, But Muted Clearly, the Bank of Japan would like this to change, as it aims for a persistent 2% inflation target. That said, it will be unable to adjust monetary settings aggressively. The BoJ already owns over 50% of Japanese government bonds, and that has made the market very illiquid. As a result, ownership as a share of GDP is nearing attrition (Chart 9). Related Report  Foreign Exchange StrategyThe Yen In 2022 Arguably, the BoJ could widen the target band for yield curve control, while lowering short rates further below zero, but that is unlikely to do much for inflation expectations. It could also expand its 0% bank loan scheme beyond renewable industries, and/or small/medium-sized firms, but the problem in Japan is a lack of demand. The currency remains the sole policy lever for the BoJ. Unfortunately, for a small, open economy, the BoJ has less control over the currency. The Ministry of Finance last intervened to support the currency in 1998 (Chart 10). That helped the yen temporarily, but global factors dictated its longer-term trend. Intervention this time around will not assuage the whale of carry traders. Chart 9The BoJ Has Not Been Aggressively Buying Government Bonds Chart 10The MoF Could Soon ##br##Intervene A falling yen would allow some pass-through inflation, but this is unlikely to be sticky. The yen needs to fall 10% every year to generate 1% inflation in Japan (Chart 11). Meanwhile, a policy based on depreciating your currency could lead to a crisis of confidence, especially vis-à-vis Japanese trade partners. Our model for core core inflation suggests that all the weakness in the currency will only boost this print to 0.5% in the coming months (Chart 12). Chart 11Currency Weakness Will Only Temporarily Help Boost Inflation Chart 12Core CPI Will Not Meaningfully ##br##Recover What Japan needs is more fiscal spending. For a low-growth economy, with ultra-loose monetary settings, the fiscal multiplier tends to be much larger. Putting it all together, real rates are unlikely to fall very much in Japan. This is very positive for the yen in a world with deeply negative real rates. As demand recovers, and the Japanese economy generates non-inflationary growth, the currency should find a solid footing. Why Valuation Matters Chart 13The Yen Is Very Cheap Japan is running a big trade deficit on the back of high energy prices. A cheap currency at least increases Japan’s competitiveness. This is particularly the case since the boom in external demand has been a much welcome cushion for Japanese growth. According to our PPP models, the Japanese yen is the cheapest G10 currency, undervalued by around 35% (Chart 13). Why valuations matter is because an investor who buys the yen today can expect to make 6% a year over the next half decade, based on the historical correlation between valuation and subsequent currency returns (Chart 14). This will especially be the case if Japanese inflation keeps lagging inflation in the US. As we argued at the beginning of this report, US yields will need to stabilize before long yen positions make sense on a tactical basis (Chart 15). Chart 14Valuation Matters For The Japanese Yen Chart 15Global Yields Need To Stabilize For The Yen To Bounce The Yen As A Safe Haven The yen still appears to have the best correlation with a rising VIX (Chart 16). In a world of slowing global growth and the potential for equity market turbulence, this bodes well for long yen positions. That said, the carry on this position will be unbearable especially if the Federal Reserve continues to sound hawkish. The better play on potential yen strength is a short CHF/JPY position. Historically, these currencies have tended to move together. However, more recently, the CHF has risen substantially versus the JPY, suggesting some mean reversion is due (Chart 17). Chart 16The Yen Remains A Good Hedge Chart 17Go Short CHF/JPY Strategically, we were stopped out of our short USD/JPY position at 128, initiated at 124. Our 2022 target for the yen is 110. Our sense is that most of the downside risks are well understood by markets, while upside surprises are much underappreciated. Tactically, we will wait for the consolidation phase we outlined earlier in this report, before initiating fresh positions.   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

Special Report

Executive Summary The Declining Value Of An Old Friendship India may buy cheap oil from Russia, but oil alone cannot expand this partnership. India needs to maintain a balance of power against China and Pakistan. With Russia’s heft set to decline, India will be compelled to explore a configuration with America. India will slowly yet surely move into America’s sphere of influence. Strong geopolitical as well as economic incentives exist for both sides to develop partnership. The US’s grand strategy will continue to collide with that of Russia and China. China will increasingly align with Russia and is doomed to stay entangled in a strategic conflict with India. With India a promising emerging market set to cleave to America, we reiterate our strategic buy call on India. Tactically however we are bearish on India. We also recommend investors go strategically long Indian tech / short Chinese tech. This pair trade is likely to keep rising on a secular basis. Trade Recommendation Inception Date Return LONG INDIAN TECH / CHINESE TECH EQUITIES 2022-04-21   Bottom Line: For reasons of geopolitics as well as macroeconomics, we maintain our constructive view on India and our negative view on China on a strategic time frame. On a tactical timeframe, we remain sellers of India given cyclical political and macro risks. Feature Russia’s invasion of Ukraine has forced all players at the global geopolitical table to show their hand. The one major player at the table who is yet to show her cards is India. Which side India choses matters. Its geopolitical rise is one of the many reasons we live in a brave new multipolar world. India will gain influence in the global economy as a large buyer of oil and guns and as a user of tech platforms and capital. Related Report  Geopolitical StrategyFrom Nixon-Mao To Putin-Xi The situation is complicated by mixed signals. India has played a geopolitically neutral or “non-aligned” role for most of its time since independence in 1947. Those who believe India will stay neutral point to the fact that India has continued buying oil from Russia and has abstained from voting on both anti-Russia and anti-Ukrainian resolutions at the United Nations. Those who predict that India will side with Russia have trouble explaining how India will get along with China, which committed to a “no limits” strategic partnership with Russia prior to the invasion. Those who speculate that India will align with the US have trouble explaining India’s persistent ties with Russia and the Biden administration’s threat of punishment for those who help Russia circumvent US sanctions. In this report we argue that the Indo-Russian friendship is destined to fade over a long-term, strategic horizon. The reason is simple: Russia’s geopolitical power is fading and hence it can no longer help India meet its regional security goals. The growing Russia-China alignment will only alienate India further. Hence, we expect the relationship between India and Russia to be reduced to a transactional status – mainly trade in oil and guns over the next few years, while strategic realities will drive India to tighten relations with the US and its Asian allies. Three geopolitical forces will break down the camaraderie between India and Russia, namely: (1) A collision in the grand strategies of America with that of both China and Russia, (2) India’s need to align with the US to underwrite its own regional security, and (3) China’s rising distrust of India as India aligns with the US and its allies. In fact, we expect China and India to stay embroiled in a strategic conflict over the next few years. Any thaw in their relations will be temporary at best. The rest of this report explains and quantifies these forces. We conclude with actionable investment conclusions. Let’s dive straight in. US Versus China-Russia: A Grand Strategy Collision “For the enemy is the communist system itself – implacable, insatiable, unceasing in its drive for world domination … For this is not a struggle for supremacy of arms alone – it is also a struggle for supremacy between two conflicting ideologies: freedom under God versus ruthless, Godless tyranny. “ – John F. Kennedy, Remarks at Mormon Tabernacle, Utah (September 1960) Chart 1China’s Is An Export-Powered Economic Heavyweight It’s been six decades since these words were spoken and today the quotation is more relevant than at any time since the Cold War ended in 1991. The excerpt captures how the Biden administration has positioned itself with respect to Russia and China, only replacing “communist” with “autocratic” in Russia’s case. The Ukraine war helps America advance its grand strategy with respect to Russia. The Ukraine war is steadily draining Russia’s already limited economic might. Western sanctions aim to weaken Russia further. Russia’s military capabilities are now in greater doubt than before, so that its only remaining geopolitical strengths are nuclear weapons and, significantly, its leverage as an energy supplier. With Russia weakened, yet capable of reinforcing China, America will focus more intensely on China over the coming years and the breakdown in US-China relations will only accelerate. China is a genuine economic competitor to the United States (Chart 1). Its strategic rise worries America. To make matters worse, America poses a unique threat to China. China relies heavily on energy imports (Chart 2) from the Middle East (Chart 3). This is a source of great vulnerability as China’s fuel imports must traverse seas that America controls (Map 1). During peace time, and periods of robust US-China strategic engagement, this vulnerability is not an issue. But China is acutely aware that America has the capability to choke China’s energy access at will in the event of hostilities, just as it did to Japan in World War II. Russia has managed to wage war in Ukraine, against US wishes, since it is a net energy supplier to Europe and the global economy. Chart 2China And India Rely On Imports For Energy​​​​​ Chart 3India And China Both Depend On Middle East For Oil​​​​​​ Map 1US Military Footprint In Middle East Threatens China … Yet US Presence In South Asia Is Weak Atop China’s fuel-supply related insecurities, America has begun a strategic pivot to Asia in recent years. For instance, America has pulled troops out of Iraq and Afghanistan, declared a trade war on China, and strengthening strategic alliances and partnerships with regional geopolitical powers like India and Australia (Table 1). The US has retained its alliance with the Philippines despite an adverse government there, while South Korea has just elected a pro-American president again. With Japan, South Korea and Australia aligned militarily with the US, China’s naval power pales in comparison (Chart 4). Table 1America’s Influence In Asia Is Rising Chart 4China’s Naval Power Pales Versus US Allies In Asia Now China cannot watch America refurbish its grand strategy in Asia silently. Given China’s need for supply security, geopolitical independence, and regional influence, Beijing will double down on building its influence in Asia and in the eastern hemisphere. Against this backdrop of US-China competition, military conflict becomes increasingly likely, especially in the form of “proxy wars” involving China’s neighbors but conceivably even in the form of US-China naval warfare. China’s plans to modernize and enhance its economic prowess will add to America’s worries (Chart 5). A bipartisan consensus of American lawmakers is focused on reviving America’s economic strength but simultaneously limiting China’s benefit by restricting Chinese imports and American high-tech exports (Chart 6). Since Beijing cannot afford to base its national strategy on the hope of lingering American engagement, US-China trade relations will weaken regardless of which party controls the White House. Chart 5China’s Growing Might Worries America​​​​​​ Chart 6US Growth Does Not Equal Growth In Imports From China ​​​​​​ The consensus in global financial media (which we never bought) held that the Biden administration would reduce tensions with China – but the détente never occurred and the remaining window for détente is limited by the uncertainty of the 2024 election. The US is currently occupied with Russia but threatening to impose secondary sanctions on China if it provides military assistance or circumvents sanctions. The Russo-Ukrainian war has led to an energy price shock that hurts an industrial economy like China’s. For the rest of this year China’s leaders will be consumed with managing the energy shock, a nationwide Covid-19 outbreak, and the important political reshuffle this fall. Only in 2023 will Beijing have room for maneuver when it comes to the US. But the US cannot return to engagement, which strengthens China’s economy, while China cannot open up to the US economy and become more exposed to future US sanctions. Bottom Line: A grand strategy collision between the US and China is certain. US dominance of sea routes that China uses for energy imports necessarily intimidates China. America’s pivot to Asia threatens China’s regional influence. This will prompt China to restrict American advances in strategic geographies —and not only the Taiwan Strait but also, as we will see, in South Asia. US-India Strategic Alignment: Only A Matter Of Time “If they [nation states] wish to survive, they must be willing to go to war to preserve a balance against the growing hegemonic power of the period.” – Nicholas J. Spykman, America's Strategy in World Politics (Harcourt, Brace and Co, 1942) For reasons of strategy, China will continue to build its influence in South Asia. South Asia offers prospects of sea access to the Indian Ocean, namely via Pakistan. This factor could ease China’s fuel supply insecurities. Also, penetrating northern India helps China set up a noose around India’s neck, thus neutralizing a potential enemy and US ally. In short China will pursue a two-pronged strategy of Eurasian development and naval expansion, both of which threaten India. Against this backdrop, India needs US support to counter Pakistan to its west, China’s latest intrusions into its eastern flank (Map 2), and China’s maritime challenge. India has historically spent generously on defense, but its military might pales in comparison to that of China. Even partial support from America would help India make some progress toward a balance of power in South Asia (Chart 7). Map 2China’s Newfound Interest In India’s Eastern Flank Chart 7America Can Provide Military Heft To India​​​​​​ Chart 8US Is A Key Trading Partner For India​​​​​​ There’s another reason why US alignment makes sense for India. Much like China, India is highly import-dependent for its fuel needs (Chart 2). Given India’s high reliance on the Middle East for energy, India stands to benefit from America’s solid military footprint in this region (Map 1). The US too has a motive in exploring this alliance. India can provide a strategic foothold on the Eurasian rimland. America will value this new access route to Eurasia because America knows that its military footprint in South Asia is surprisingly weak – a weakness it needs to address against the backdrop of China’s increasing influence in the region (Map 1). Meaningful economic interests also underpin the US-India relationship. India and the US appear like sparring partners from time to time. The US may raise issues of human rights violations in India and the two may bicker over trade. However there exist strong economic incentives for the two countries to keep their differences under check and develop a long-term strategic partnership. The US is a major user of India’s software services and buys nearly a fifth of India’s merchandise exports. The trading relationship that India shares with the US is far more developed than India’s trading relationship with China and Russia (Chart 8). Capital is a factor of production that India desperately needs to finance its high growth. America and its allies are also major suppliers of capital to India (Chart 9). India is averse to granting China the political influence that would go along with major capital infusions and direct investments. Chart 9US And Its Allies Are Major Suppliers Of Capital To India​​​​​​ Chart 10India Offers US Firms Access To High Growth​​​​​​ Chart 11India Is A Key Market For American Big Tech India on its part is a large marketplace which offers high growth prospects (Chart 10) and remains open and accessible to American corporations (unlike say Russia or China). The growth element is something that American firms will value more over time, as the American economy is mature and has a lower potential growth rate. Most importantly if the US imposes sanctions on India, then two key business lobbies are sure to mitigate the damage. In specific: Since India is a key potential market for American tech firms (Chart 11), Big Tech will always desire amicable Indo-US relations. Since India is the third largest buyer of defense goods globally, American defense suppliers will have similar intentions. In both cases, US policy planners will support these industries’ lobbying efforts due to the grand strategic considerations outlined above. Bottom Line: India will slowly yet surely move into America’s sphere of influence. Notwithstanding persistent differences, the Indo-US relationship will strengthen over a strategic timeframe. Strong geopolitical motives as well as notable economic incentives exist for both sides to develop this alignment. Indo-Russian Alignment: Destined To Fade The Indo-Russian friendship can be traced back to the second half of the 20th century. The fulcrum was the fact that Russia was a formidable land-based power and provided an offset against threats from China and Pakistan (Chart 12). The finest hour of this friendship perhaps came in 1971 when Russia sided with India in its war with Pakistan. India’s citizens hold an unusually favorable opinion of Russia (Chart 13). Chart 12The Declining Value Of An Old Friendship​​​​​​ Chart 13Indians Hold A Favorable Opinion Of Russians ​​​​​​ Despite this rich past, the Indo-Russia friendship is doomed to fade over a strategic timeframe. Even if  Russia’s share in Indian oil rises from current low levels of 2%, this glue alone cannot hold the Indo-Russian relationship together for one key reason: Russia’s geopolitical might has been waning and Russia can no longer help India establish a balance of power against China and Pakistan (Table 2). In fact, since 2006, the Russo-Indian partnership has been commanding lower geopolitical power than that of China (Chart 12). Table 2Russia’s Military Heft Is Of Limited Use To India Today Managing regional security is a key strategic concern for India. As Russia’s geopolitical power wanes so will India’s utility of Russia as an effective guarantor of India’s security. Russia’s war in Ukraine is ominous in this regard, as Russian armed forces were forced to retreat from Kyiv, while the country’s already bleak economic prospects have worsened under western sanctions. The solidification of the China-Russia axis will alienate India further (Chart 14). China is essential to Russia’s economy now while Moscow is essential to China’s Eurasian strategy of bypassing American naval dominance to reduce its supply insecurity. Russia holds the keys to Central Asia, from a military-security point of view, and hence also to the Middle East. Furthermore, limited economic bonds exist to prevent India and Russia from falling out. Russia accounts for a smidgen of India’s trade (Chart 8). India is Russia’s largest arms client (accounting for +20% of its arms sales) but this reliance could also decline over time: The Indian government has been pursuing a range of policies to increase the indigenous production of arms. This is a strategic goal that would also reinforce India’s economic need for more effective manufacturing capabilities. Russia’s own defense franchise had been coming under pressure, even before the Ukraine war (Chart 15). On the contrary, Western arms manufacturers’ franchise has been steadily growing. Chart 14China-Russia Axis Will Alienate India ​​​​​ Chart 15The Rise & Rise Of Western Arms Manufacturers ​​​​​​ While the US may look the other way in the short term when India buys arms from Russia, over a period of time the US is bound to pull India away by using a combination of sticks (mild sanctions) and carrots (heavy discounts). Two aforementioned external factors will also work against the Indo-Russia relationship namely (1) The Russo-Chinese alignment and its clash with US grand strategy and (2) The coming-to-life of a US-India strategic alignment. Bottom Line: India’s need for cheap oil will preserve basic Indo-Russian relations for some time. But oil alone cannot drive a deeper strategic alignment. Regional security concerns are paramount for India. Russia’s geopolitical decline will force India to explore an alignment with America, which will offer India security in the Indian Ocean and Persian Gulf in the face of China’s emergence in this region. Is A Realignment In Indo-China Relations Possible? But why should India not join the other Asian giants to balance against America’s threat of global dominance? Would such a bloc not secure India’s interests? And what if the US imposes harsh sanctions for India’s continued trade with Russia and strategic neutrality? Or what if a future US administration grows restless and attempts to force India to choose sides sooner rather than later? Even if the US offends India, it will only lead to a temporary improvement in India’s ties with the China-Russia alliance. This is because America stands to lose if India cleaves towards the Sino-Russian alliance and would thus quickly correct its policy. In specific: Security Interests: America will risk losing all influence in South Asia if India were to cleave towards China. India provides a key foothold for America to control China’s regional ascendance especially given that the US has now withdrawn from Afghanistan and its bilateral relations with Pakistan are weak. Business Interests: India’s movement into the China-Russia sphere of influence can have adverse business implications for American corporations and US allies, given that the US is abandoning the Chinese market over time, while India is a large and fast-growing consumer of American tech exports and services. India could emerge as a major buyer of American defense goods and will import more and more energy provided by the US and its partners in the Persian Gulf. These business groups will lobby for the withdrawal of US sanctions on India given India’s long-term potential. Meanwhile any improvement in Indo-Chinese relations will have a limited basis. In specific: Ascendant Nationalism In China And India: China’s declining potential GDP is motivating a rise in nationalism and an assertive foreign policy. Meanwhile India’s inability to create plentiful jobs for a young and growing population is also fuelling a wave of nationalism. A historic turn toward Sino-Indian economic engagement would require the domestic political ability to embrace and promote each other’s well-being. Pakistan Factor: India’s eastern neighbor Pakistan is controlled by its military. The military’s raison d'être is enforced by maintaining an aggressive stance towards India, while pursuing economic development through whatever other means are available. As long as Pakistan’s military stays influential its stance towards India will be hostile. And as long as Pakistan’s economy remains weak (Chart 16), its reliance on China will remain meaningful (Chart 17). Chart 16Pakistan: High Military Influence, Low Economic Vigor ​​​​​​ Chart 17China & Pakistan: Iron Brothers?​​​​​​ Chart 18Indians View China And Pakistan Negatively   China also benefits from its alliance with Pakistan because it provides an alternative entry point into India and access to the Indian Ocean. Fundamental Distrust: For reasons of history, Indians harbor a negative opinion of both Pakistan and China (Chart 18). This factor reinforces the first point that any Indian administration will see limited political dividends from developing a long-term alignment with China or with Pakistan. Bottom Line: If any Indo-Chinese détente materializes owing to harsh US sanctions, which we do not expect, the result will be temporary. America has limited incentives to push India towards the Sino-Russian camp. More importantly, China and India will stay entangled in a strategic conflict for reasons of both history and geography. Investment Conclusions Chart 19Sell India Tactically But Buy India On A Strategic Horizon The historic Indo-Russia relationship will weaken over the next few years as India and Russia explore new alignments with USA and China respectively. The relationship may not collapse entirely but has limited basis to grow given Russia’s declining geopolitical clout. Indo-American economic interests are set to deepen not just for reasons of security. India may consider looking for alternatives to Russian arms in the American defense industry while American Big Tech will be keen to grow their footprint in India. With India set to cleave to America, a country whose geopolitical power remains unparalleled today, we reiterate our constructive long-term investment view on India (Chart 19). However, tactically we remain worried about near-term geopolitical and macro headwinds that India must confront. China will strengthen relations with Russia over the next few years. It needs Russia’s help to execute its Eurasian strategy and to diversify its sources of fuel supply, over the long run. Given that the US and its allies will be engaged in a conflict with China over a strategic horizon, we reiterate our strategic sell call on China. Tactically we are neutral on Chinese stocks, given that they have already sold off sharply in accordance with our views over the past two years. In view of both these calls, we urge clients with a holding period mandate of more than 12 months to reduce exposure to Chinese assets and increase exposure to Indian assets. We also recommend investors go strategically long Indian tech / short Chinese tech. This pair trade is likely to keep rising on a secular basis.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com 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

Executive Summary Brent Stable As Demand + Supply Fall Oil demand growth will slow this year and next by 1.6mm b/d and 1mm b/d, respectively. These expectations are in line with sharp downgrades in World Bank and IMF economic forecasts, which cite pressures from the Ukraine War, COVID-19-induced lockdowns in China, and central-bank policy efforts to contain rising inflation. Lower oil demand will be offset by lower supply from Russia and OPEC 2.0, which now are ~ 1.5mm b/d behind on pledges to restore production taken from the market during the pandemic. In 2022, US production will increase ~750k b/d year-on-year. The strategic relationship between the US and core OPEC 2.0 producers Saudi Arabia and the UAE is fraying. The Core's unwillingness to increase production despite pleas from the Biden administration likely motivated the US’s record SPR release of 180mm barrels (1mm b/d over 6 months). This will be augmented by another 60mm-barrel release of refined products by IEA member states. The EU's threat to stop importing half of Russia's 5mm b/d of oil exports would, if realized, force Russian storage to fill, and lead to production shut-ins. Oil prices would surge to destroy enough demand to cover this loss. Our base-case Brent forecast is at $94/bbl this year and $88/bbl in 2023, leaving our forecast over the period mostly unchanged. Bottom Line: Despite major shifts in global oil supply and demand over the past month, oil markets have remained mostly balanced. We remain long commodity index exposure via the S&P GSCI index, and the COMT ETF. We also are long oil and gas producer exposure via the XOP, and base metals producers via the PICK and XME ETFs. Feature Related Report  Commodity & Energy StrategyDesperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma Oil demand and supply growth are weakening on the back of the Ukraine War, COVID-19-induced lockdowns in China, and central-bank efforts to contain rising inflation. We expect global demand growth to slow this year and next by 1.6mm b/d and 1mm b/d, respectively, in line with downgrades in IMF and World Bank global growth forecasts.1 Demand will fall to 100mm b/d on average this year, down from our earlier expectation of 101.5mm b/d published in March. For next year, we expect global oil consumption to come in at 102.2mm b/d, down from our March estimate of 103.2mm b/d (Chart 1). EM consumption, the engine of oil-demand growth, falls to 54.2mm b/d vs. 55.8mm b/d in last month's forecast for 2022 demand. We have been steadily lowering our estimate for 2022 Chinese demand this year due to its zero-tolerance COVID policy and its associated lockdowns, and again take it down 250k b/d in this month's balances to 15.7mm b/d on average. In our estimates, Chinese oil demand grows 2.6% from its 2021 level of 15.3mm b/d. We have been expecting DM oil consumption to flatten out this year, following massive fiscal and monetary stimulus fueling oil demand during and after the pandemic, and continue to expect it to come in at ~ 45.7mm b/d this year. Chart 1Sharply Lower Oil Demand Expected Oil Supply Gets Complicated Oil supply will continue to weaken along with demand this year, primarily due to sanctions imposed on Russia by Western buyers following its invasion of Ukraine. Russia's production reportedly was just above 10mm b/d. Estimates of Russian production losses over 2022-23 range from 1mm b/d to as much as 1.7mm b/d over at the US EIA. The outlier here is the IEA, which warns Russian production will fall 1.5mm b/d this month, then accelerate to 3mm b/d beginning in May. In our base-case modeling, we expect Russian output to average 9.8mm b/d in 2022 and 9.9mm b/d next year (Chart 2). Tracking Russia's production became more complicated, as the government this week announced it no longer would be reporting these data. Prices and satellite services will be needed to impute Russia's output in the future. Russia and the Kingdom of Saudi Arabia (KSA) are the putative leaders of OPEC 2.0 (otherwise known as OPEC+). In the wake of Russia's invasion of Ukraine, OPEC, the original cartel led by KSA, continues to maintain solidarity with Russia, referring in its Monthly Oil Market Report (MOMR), for example, to the "conflict between Russian and Ukraine," or the "conflict in Eastern Europe" – not the war in Ukraine. This would suggest KSA and its allies continue to place a high value in maintaining the OPEC 2.0 structure, which has shown itself to be an extremely useful organization for managing production and production declines among non-Core states – i.e., those states outside the Gulf that cannot increase output, or are managing declining production due to lack of capital, labor or both (Chart 3). Chart 2Brent Stable As Demand + Supply Fall Chart 3OPEC 2.0 Remains Useful To KSA And Russia The strategic relationship between core OPEC 2.0 producers capable of maintaining higher production – KSA and the UAE – and the US is fraying. Both states showed no interest in increasing production despite pleas from the Biden administration following Russia's invasion of Ukraine, and have shown a propensity to expand their diplomatic and financial relationships, e.g., exploring oil sales denominated in Chinese RMB, beyond their US relationships.2 This likely motivated the US’s record SPR release of 180mm barrels (1mm b/d over 6 months). This will be augmented by another 60mm-barrel release of refined products by IEA member states. Outside the OPEC 2.0 coalition, we continue to expect higher output from the US, led by shale oil production. According to Rystad Energy, horizontal drilling permits in the Permian basin hit an all-time high in March.3 If these permits are converted into new projects, oil supply growth will be boosted starting 2023. The US government’s recent announcement to lease around 144,000 acres of land to oil and gas companies – in a bid to bring down high US oil prices – also will spur supply growth towards the beginning of next year.4 These bullish factors are balanced out by nearer-term headwinds. Bottlenecks resulting from pent-up demand released following global lockdowns, the Russia-Ukraine crisis, and investor-induced capital austerity means US oil producers will not be able to turn on the taps as quickly this year as they've been able to do in days gone by. Given the near-term bearish factors and longer-term bullish factors, we expect total US crude production to grow slower this year and ramp up at a faster pace the next. US shale output (i.e., Lower 48 states (L48) ex Gulf of Mexico) is expected to average 9.73mm b/d in 2022 and 10.53mm b/d in 2023 (Chart 4). Total US crude supply is expected to average 11.92mm b/d and 12.74mm b/d, respectively, over this period. Additional production increases are expected from Canada, Brazil and Norway. Chart 4Shales Continue To Pace US Onshore Output Increases Upside Risk Remains KSA's and the UAE's strategy to hold off on production increases despite US entreaties upends one of our expectations – i.e., that these state would increase production as the deficit in OPEC 2.0 output being returned to the market widened. We are coming around to the idea this could represent a desire to diversify their exposure to USD payments and assets, which, as Russia's invasion of Ukraine demonstrated, can become liabilities in an economic war. This also would begin to reduce the heavy reliance KSA and the UAE place on the US vis-à-vis defending its interests.5 Lastly, we would observe KSA's and the UAE's spare capacity is being husbanded closely, given it constitutes most, if not all, of OPEC 2.0's 3.4mm b/d of spare capacity (Chart 5). There are multiple scenarios in which this spare capacity would be needed by global markets to address production outages. One of the most imposing is an EU embargo on Russian oil imports floated by France this week, which triggers a cut-off of natural gas supplies by Russia to the EU.6 An embargo of Russian oil imports by the EU is a very low-probability event, but it is not vanishingly small. The EU imports about 2.5mm b/d of Russia's crude oil exports. The EU's threat to stop importing half of Russia's 5mm b/d of oil exports would, if realized, force Russian pipelines and storage to fill, and would lead to production shut-ins. Oil prices would have to surge to destroy enough demand to cover this loss of supply, even after OPEC's spare capacity was released into the market. If realized, such an event also would throw the world into recession, in our view. The prospect of a cut-off of Russian oil imports by the EU was addressed last month by Energy Minister Alexander Novak, who said such an act would prompt Russia to shut down natural gas exports to the EU.7 If Russia follows through on such a threat, it would shut down much of the EU's industrial and manufacturing activity. The experience of this past winter – when aluminum and zinc smelters were forced to shut as natural gas prices surged and made electricity from gas-fired generation too expensive for their operations – remains fresh in the mind of the market. An oil-import ban by the EU followed by a cut-off of natgas exports by Russia almost surely would spike volatility in these markets (Chart 6). In addition, a global recession would be a foregone conclusion, in our view. Chart 5OPEC Spare Capacity Concentrated In KSA, UAE Chart 6Oil+ Gas Volatility Would Spike If EU Cuts Russian Oil Imports Markets Remain Roughly Balanced … For Now Our supply-demand modeling indicates production losses are roughly balanced by consumption losses at present (Chart 7). If anything, the lost demand slightly outweighs the loss of production, when we run our econometric models. However, we are maintaining a $10/bbl risk premium in our estimates for 2022-23 Brent prices, which keeps our current forecast close to last month's levels. Persistent strength in the USD, particularly in the USD real effective exchange rate, acts as a headwind on prices by making oil more expensive ex-US (Chart 8). We expect this to continue, given the Fed's avowed commitment to raise policy rates to choke off inflation, which, all else equal, will make USD-denominated returns attractive. Chart 7Markets Remain Mostly Balanced Chart 8Strong USD Restrains Oil Prices Investment Implications Despite the major shifts in oil supply and demand over the past month, markets have remained mostly balanced (Table 1). Falling Russian output and weak OPEC 2.0 production – where most states are managing production declines – is being exacerbated by falling Chinese demand and SPR releases from the US and IEA. The market does not yet need the 1.3mm b/d of Iranian output that is being held at bay due to a diplomatic impasse between the US and Iran, which we believe will persist. With overall economic output growth slowing – per the forecasts of the major supranational agencies (WTO, IMF, World Bank) – weaker demand can be expected to persist. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 This is not to say upside risk is non-existent. A move by the EU to ban Russian oil imports could set in motion sharply higher oil and gas prices and a deep EU recession, as discussed above. This could trigger an immediate need for OPEC spare capacity and those Iranian barrels waiting to return to export markets. We remain long commodity index exposure via the S&P GSCI index, and the COMT ETF. We also are long oil and gas producer exposure via the XOP, and base metals producers via the PICK and XME ETFs.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodity Round-Up Energy: Bullish Russia's concentration of exposure to OECD Europe – as customers for its energy exports – exceeds the latter's concentration of imports from Russia by a wide margin. Russia produced 10.1mm b/d of crude and condensates in 2021. Of the 4.7mm b/d of this Russia exported last year, OECD Europe was its largest customer, accounting for 50% of total oil exports, according to the US EIA (Chart 9). On the natgas side, more than one-third of the ~ 25 Tcf of natgas produced by Russia last year was exported via pipeline or as LNG, based on 2021 data from the EIA. This amounted to almost 9 Tcf. Most of this – 84% – was exported via pipeline to the OECD Europe, with the biggest customers being Germany, Turkey, Italy and France. As is the case with crude oil and liquids, OECD Europe is Russia's biggest natgas customer, accounting for ~ 75% of exports in either gaseous or liquid form. There is an argument to be made Russia needs OECD Europe as much or more than the latter needs Russia. Ags/Softs: Neutral Grains and vegetable oils are at multi-year or all-time highs, as a result of the war in Ukraine. This week, corn futures hit the highest since 2012, while wheat futures surged amid the ongoing war and unfavorable weather in U.S. growing areas. The U.N. Food and Agriculture Organization's Food Price Index rose 12.6% from February, its highest level since 1990. According to the FAO, the war in Ukraine was largely responsible for the 17.1% rise in the price of grains, including wheat and corn. Together, Russia and Ukraine account for around 30% and 20% of global wheat and corn exports. The cost of fertilizers has increased by almost 30% in many places due to the supply disruptions caused by the war and the tightening of natural gas markets, which is being driven by EU efforts to diversify away from Russian imports of the commodity.8 Planting is expected to be very irregular in the upcoming grain-sowing months, navigate through much higher prices for fuel and fertilizers (Chart 10). Chart 9 Chart 10     Footnotes 1     Please see the IMF's April 2022 World Economic Outlook report entitled War Sets Back the Global Recovery, and the World Bank's Spring Meetings 2022 Media Roundtable Opening Remarks by World Bank Group President David Malpass, posted on April 18, 2022. 2     Please see, e.g., Saudi Arabia Considers Accepting Yuan Instead of Dollars for Chinese Oil Sales published by wsj.com on March 15, 2022.   3    Please see Permian drilling permits hit all-time high in March, signaling production surge on the horizon, published by Rystad Energy on April 13, 2022. 4    Please see Joe Biden resumes oil and gas leases on federal land, published by the Financial Times on April 15, 2022. 5    Please see Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma, which we published on January 14, 2014. In that report, we noted, "… the U.S. has decided to stop micromanaging the Middle East. The latter policy sucked in too much of Washington's material resources, blood and treasure, at a time when regional powers like China and Russia were looking to establish their own spheres of influence in East Asia and Eurasia respectively." Building deeper commercial relationships with China also would bind both states together in terms of addressing KSA's security concerns, given China's existing relationships with Iran. This is a longer-term strategy, in our view. 6    Please see An EU embargo on Russian oil in the works - French minister, published by reuters.com on April 19, 2022. 7     Please see War in Ukraine: Russia says it may cut gas supplies if oil ban goes ahead, published by bbc.co.uk on March 8, 2022. 8    Please refer to Food prices soar to record levels on Ukraine war disruptions, published by abcNEWS on April 8, 2022.   Investment Views and Themes Strategic Recommendations Trades Closed in 2022

Executive Summary After having overspent on goods ex-autos over the past two years and experiencing contracting incomes in real terms, US and European households will reduce their purchases of goods ex-autos. Risks to global growth stemming from China remain to the downside. Leading indicators from Asia and global financial markets are signaling a contraction in global trade. Yet, US core inflation will not drop below 4% for the rest of this year. Consequently, the Fed will likely end up hiking rates and sounding hawkish amidst a major global trade slump. This will give rise to stagflation anxiety among investors and will be negative for global risk assets in general and EM equities, currencies and credit markets in particular. The yuan is breaking down versus the US dollar. A weaker RMB will pull down Emerging Asian as well as other EM currencies. Does This Divergence From A Historic Correlation Signify Stagflation? Bottom Line: Global equity and credit portfolios should remain defensive and continue underweighting EM. Currency investors should be positioned for another upleg in the US dollar and a downleg in EM currencies. Feature The volume of global trade is about to contract. Meantime, US inflation will remain well above the Fed’s target. This combination will produce stagflation anxiety among investors. It is impossible to know whether stagflation will be a long-lasting phenomenon in the real economy. In our view, the stagflation narrative will dominate global financial markets in the coming months. This heralds a cautious stance on global and EM risk assets. The slowdown in global manufacturing and trade will be pervasive and broad-based but will exclude auto production. The latter will in fact recover as chip/input shortages ease. The main drivers of the slowdown are (1) a mean reversion in US and European demand for goods ex-autos; (2) China’s economic woes and (3) moribund domestic demand in mainstream EM. Shrinking DM Household Demand For Goods ex-Autos Chart 1DM Household Demand For Goods ex-Autos Will Experience Mean Reversion After having overspent on goods ex-autos over the past two years and experiencing contracting income in real terms (after adjusting for inflation), US and European households will reduce their purchases of goods ex-autos. US and European consumption of goods ex-autos exploded at the onset of the pandemic two years ago and has stayed robust until now. Chart 1 illustrates that since mid-2020, the consumption of goods ex-autos was running well above its trend, which signifies excessive demand over the past two years. Such excessive demand has led to bottlenecks and shortages, giving producers an opportunity to hike prices. In a nutshell, inflation in tradable goods in the past 18 months was primarily driven by demand, not supply constraints. A portion of future goods consumption has been pulled forward, which implies that household demand for these goods has become saturated. Moreover, as the pandemic subsides, consumers are shifting their spending from goods to services. These dynamics could create an air pocket in the demand for certain goods. Chart 2DM Household Real Incomes Are Contracting Critically, US and European household income is contracting in real terms (Chart 2). Wage growth has not kept up with the surge in inflation. Due to shrinking disposable real income, consumers in advanced economies will curtail their consumption of discretionary items, primarily goods ex autos on which they have overspent during the past two years. Bottom Line: Demand for goods ex-autos will shrink in advanced economies in the next 6-12 months. This will weigh on global merchandise trade. China’s Trilemma Chinese authorities are facing an “impossible trinity” in their attempts to simultaneously achieve three objectives: (1) pursuing the dynamic zero-Covid policy, (2) delivering decent economic growth, and (3) not resorting to “irrigation-style” massive stimulus. We do not think all three objectives can be achieved. China’s economy was struggling prior to the recent lockdowns. The COVID-related restrictions have only made matters worse and have weighed heavily on economic activities and household income. Domestic orders for industrial enterprises plunged below 50, i.e., they are in contraction territory (Chart 3). These surveys, released on March 30-31, were not affected by the Shanghai lockdowns, which have proliferated since March 28. Exports orders are also contracting (Chart 4). Chart 3China: Domestic Orders Were Plunging Prior To Lockdowns Chart 4China: Exports Are Set To Contract   Further, China’s import and export volumes were contracting in January – prior to the Ukraine war and the recent lockdowns. Notably, Chart 5 highlights that prior to the recent lockdowns, import weakness was broad-based, including commodities, machinery and semiconductors. In particular, total imports in USD are flat in March compared to a year ago. With commodity prices up significantly, it is clear that import volumes in March have shrunken substantially. National disposable income per capita was growing at about 6% in nominal terms before the lockdowns (Chart 6, top panel). Household mortgage growth had decelerated considerably before lockdowns became widespread (Chart 6, bottom panel). Chart 5Chinese Imports Were Shrinking Before Lockdowns Chart 6China: Household Income And Mortgage Borrowing ​​​​​​​​​​​​​​​​​​​​​   As the lockdowns wreak havoc on the economy and household income, and with the government not providing direct transfers to the population, household consumption will be severely affected in the months ahead. The property market remains in the doldrums and is unlikely to recover soon. As we have highlighted in previous reports, structural headwinds, continue to weigh down on the property market. Since 2009, there has been no business cycle recovery in China without the real estate market playing the leading role. Residential floor space sold was down by 20% in Q1 from a year ago (Chart 7, top panel). House prices have begun deflating in tier-3 cities. Deflation will likely spread to tier-1 and -2 cities due to a pandemic-driven decline in income and confidence. Critically, the plunge in property developers’ financing entails shrinkage in housing completion (construction work) (Chart 7, bottom panel). The latter has so far held up as authorities have been forcing developers to use their limited financing to complete projects that they had already started. The massive issuance of local government bonds will spur an acceleration in infrastructure spending. China’s government gave the green light already this year to infrastructure projects worth nearly 70% of what was allowed for the whole of last year. Yet, this might be insufficient to produce a rapid business cycle recovery in an environment of rolling lockdowns and with other segments of the economy facing challenges. Related Report  Emerging Markets StrategyGlobal Semi Stocks: More Downside Given these negative forces, the Chinese economy requires massive government stimulus in the form of direct transfers to households and SMEs – as the US offered in the spring of 2020. Yet, it does not seem that the government is rushing to provide such direct and significant stimulus. In our opinion, the policy stimulus measures announced so far by the government fall short of what is required to lift the economy. Policymakers are neither ready to abandon the dynamic zero-Covid policy nor provide “irrigation-type” stimulus, especially for households and the property market. With these two constraints, economic growth in China is set to underwhelm. Bottom Line: Risks to global growth stemming from China remain to the downside. In EM ex-China, ongoing fiscal tightening, monetary tightening in LATAM and feeble household income growth in India and ASEAN will all cap consumer spending and business investment (Chart 8). Chart 7China: Property Construction Is Set To Shrink Chart 8EM ex-China: Domestic Demand Will Remain Sluggish Signs Of A Global Trade Contraction There is already evidence to suggest that a major relapse in global manufacturing and trade is beginning: Taiwanese shipments to China are dipping into negative territory, and they lead global exports (Chart 9). Taiwanese exports to China are a good leading indicator of global trade dynamics because mainland producers order inputs from Taiwan first before they produce final goods for export. When producers located in China order less inputs, they evidently expect less in the way of production and shipments. Korea’s business survey of exporting companies indicates a substantial deterioration in their business conditions in April (Chart 10). This points to a major slump in the nation’s exports and, hence, global trade. Chart 9Global Trade Is Set To Contract Chart 10Korean Exporters Are Downgrading Their Expectations Korean and Japanese non-financial share prices have plunged despite considerable currency depreciation, which is typically positive for their competitiveness. As many of these non-financial companies are major exporters, this development points to a major downtrend in global trade. Global cyclicals have been underperforming global defensives. This dynamic has historically been a good leading indicator for the global industrial downturn (Chart 11). Finally, early cyclical stocks in the US have sold off and have substantially underperformed domestic defensives (Chart 12). This also points to a slowdown in US growth. Chart 11Global Equity Sector Performance Points To A Relapse In Global Manufacturing Chart 12Beware Of A Relapse in US Early Cyclical Stocks   Bottom Line: Leading indicators from Asian economies and global financial markets are signaling that global trade will experience a contraction and global growth will slow. Inflation Amid A Global Trade Contraction? Chart 13US Wages Are Surging in Nominal Terms Yet Shrinking In Real Terms A natural question is why worry about inflation when global trade volumes will be contracting? The primary source of anxiety in this context is US inflation and the Fed’s tightening. A decline in global trade will not be enough to bring down US core inflation substantially. By contrast, China and Asia do not face an inflation problem. US inflation worries will persist, and the Fed will likely continue to hike rates and sound hawkish for the following reasons: First, US capital expenditures by companies and household spending on services will remain robust. US services make up a larger share of the American economy and employment than do goods-producing sectors. Hence, we do not expect a broad-based recession in the US this year. Second, as we have previously noted, the US has a genuine inflation problem. American wages are accelerating, and a tight labor market will push up wage growth above 5-6% (Chart 13, top panel). Importantly, real wages in the US have contracted (Chart 13, bottom panel). Faced with a decline in purchasing power, employees will demand higher wages. The tight labor market raises the odds that companies will likely accommodate higher wages. Chart 14Unit Labor Costs Are The Key To Core Inflation Given that US productivity growth is no more than 1.5-2%, wage growth over 5-6% means that unit labor costs will be rising by more than 3-4%. This will prevent core inflation from falling a lot. Unit labor costs have historically been the main driver of core inflation in the US (Chart 14). Finally, inflation is a lagging and inert phenomenon. It takes a long time (more than six to nine months) of sub-par growth for inflation to subside. Odds are that even though global trade volumes will be contracting, the Fed will continue hiking rates and sounding hawkish because US inflationary pressures will remain acute. Bottom Line: Annual core CPI inflation will drop in the US due to the base effect and a drop in some goods prices. Yet, we expect core CPI and PCE to remain above 4% for the rest of this year. Underlying inflationary pressures have spilled over into the labor market, and the wage-price spiral has probably unraveled. Therefore, inflation cannot be reduced meaningfully without bringing economic growth down below potential growth and weakening the labor market for a few quarters. Investment Implications Shrinking global trade volumes and a hawkish Fed are bearish for global risk assets in general and EM equities, currencies and credit markets in particular. Contracting exports and a hawkish Fed are negative for the Chinese yuan and other Asian currencies. The CNY/USD exchange rate has broken below its 200-day moving average and odds are that it will depreciate further (Chart 15). Our target for CNY/USD is 6.7. The broad trade-weighted US dollar has more upside and EM currencies will depreciate. Chart 16 illustrates that investors’ net long positions in ZAR, BRL and MXN are high. Chart 15The RMB Is Breaking Down Chart 16Investors Are Long EM Commodity Currencies   Our recommended currency shorts for now are ZAR, PHP, IDR, COP, HUF, PEN and PLN. Global equity and credit portfolios should continue underweighting EM. Notably, global defensive equity sectors have been outperforming non-TMT stocks despite rising US/global bond yields (Chart 17). This is a major departure from the historical relationship and likely signifies a period of slower global growth ahead but continuous Fed tightening. Global equity managers should favor defensive stocks. Chart 17Does This Divergence From A Historic Correlation Signify Stagflation? For EM equity managers, we also recommend favoring defensive sectors like consumer staples. Presently, our country overweights are Korea, Singapore, Chinese A-shares, Mexico and Brazil. Our underweights are India, Central Europe, Indonesia, Turkey, South Africa, Colombia and Peru. In local rates, we continue recommending receiving Chinese and Malaysian 10-year swap rates, a long position in Brazilian 10-year bonds, betting on yield curve flattening in Mexico and paying Polish 10-year swap rates while receiving Czech 10-year swap rates. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com​​​​​​​

Executive Summary In this first of a regular series of ‘no holds barred’ conversations with a concerned client we tackle the hot topic of inflation. Month-on-month US core inflation has already peaked, 12-month US core inflation is about to peak, and demand destruction will ultimately pull down headline inflation too. Given modest and slowing growth in unit labour costs, there is no imminent risk of a wage-price spiral. Surging inflation expectations are just capturing the frothiness in inflation protected bond prices that massive hedging demand is creating. This recent massive demand for inflation hedges such as inflation protected bonds and commodities will recede and take the frothiness out of their prices. On a 6-12 month horizon, underweight inflation protected bonds and commodities… …overweight conventional bonds and stocks… …and tilt towards healthcare and biotech. The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price Bottom Line: US core inflation is about to peak, demand destruction will ultimately pull down headline inflation, and there is no imminent risk of a wage-price spiral. On a 6-12 horizon, overweight stocks and conventional bonds versus commodities and inflation protected bonds. Feature Welcome to the first of a regular series of Counterpoint reports that takes the form of a ‘no holds barred’ conversation with a concerned client. Roughly once a month, our open and counterpoint conversations will address a major question or concern for investors. This inaugural conversation tackles the hot topic of inflation. On Peak Inflation Client: Thank you for addressing my worries. Like many people right now, I am concerned about inflation. My first question is, when is inflation going to peak? CPT: The good news is that, in an important sense, inflation has already peaked. Month-on-month core inflation in the US reached a high of 0.9 percent through April-June last year. In the more recent pickup through October-January it reached a ‘lower peak’ of 0.6 percent. And in March it dropped to 0.3 percent. Client: Ok, but inflation usually refers to the 12-month inflation rate – when will that peak? CPT: The 12-month inflation rate is just the sum of the last twelve month-on-month rates. So, when the big numbers of April-June of last year drop off to be replaced by the smaller numbers of April-June of this year, the 12-month inflation rate will fall sharply (Chart I-1). Chart I-1Month-On-Month Core Inflation Has Already Peaked, And 12-Month Core Inflation Is About To Peak Client: Even if the 12-month inflation rate does peak soon, it will still be far too high. When will it return to the 2 percent target? CPT: In the pandemic era, monthly core inflation has been non-linear. Meaning it has been either ‘high-phase’ of 0.5 percent and above, or ‘low-phase’ of 0.3 percent and below. In March it returned to low-phase. If it stays in low-phase, then as an arithmetic identity, the 12-month core inflation rate will be close to its target twelve months from now. Client: So far, you have just talked about core inflation which excludes energy and food prices. What about headline inflation? Specifically, isn’t the Ukraine crisis a massive supply shock for Russian and Ukrainian sourced energy and food? Demand destruction will ultimately pull down headline inflation too. CPT: Yes, headline inflation may take longer to come down than core inflation. But supply shocks ultimately resolve themselves through demand destruction. Client: Could you elaborate on that? CPT: Sure. With fuel and food prices surging, many people are asking: do I really need to make that journey? Do I really need to keep the heating on? Can I buy a cheaper loaf of bread? So, they will cut back, and to the extent that they can’t cut back on energy and food, demand for other more discretionary items will come down, and eventually weigh on prices. Client: At the same time, the pandemic is still raging – look at what’s happening in Shanghai right now. Won’t further disruptions to supply chains just add further fuel to inflation? CPT: Yes, but to repeat, inflation that is entirely due to a supply shock ultimately resolves itself through demand destruction. On The Source Of The Inflation Crisis Client: I am puzzled. If supply shock generated inflation resolves itself, then what has caused the post-pandemic inflation to be anything but ‘transitory’? CPT: The simple answer is the pandemic’s draconian lockdowns combined with massive handouts of government cash unleashed a massive demand shock. But it wasn’t a shock in the magnitude of demand, it was a shock in the distribution of demand (Chart I-2). Chart I-2The Pandemic's Draconian Lockdowns Combined With Massive Government Stimulus Unleashed A Massive Shock In The Distribution Of Demand Client: Could you explain that? CPT: Well, we were all locked at home and flush with government supplied cash, and we couldn’t spend the cash on services. So, we spent it on what we could spend it on – namely, durable goods. This created a massive shock in the distribution of demand, out of services whose supply could easily adjust downwards, and into goods whose supply could not easily adjust upwards. Client: Can you give me some specific examples? CPT: Sure. Airlines could cut back their flights, but auto manufacturers couldn’t make more cars. So, airfares didn’t collapse but used car prices went vertical! The result being the surge in inflation. Client: Do you have any more evidence? Inflation is highest in those economies where the cash handouts and furlough schemes were the most generous, like the US and the UK. CPT: Yes, the three separate surges in month-on-month core inflation all occurred after surges in durable goods demand (Chart I-3). Additionally, inflation is highest in those economies where the cash handouts and furlough schemes were the most generous – like the US and the UK. Chart I-3The Three Surges In Month-On-Month Core Inflation All Occurred After Surges In Durable Goods Demand Client: If we get more waves of Covid, what’s to stop all this happening again? CPT: Nothing, so we should be vigilant. That said, we now have coping strategies for Covid that do not necessitate massive handouts of government cash. Also, we have already binged on durable goods, making it much harder to repeat that trick. On Wages And Inflation Expectations Client: I am still worried that if workers can negotiate much higher wages in response to higher prices, then it would threaten a wage-price spiral. CPT: Agreed, but it is technically incorrect to focus on wage inflation. The correct metric to focus on is unit labour cost inflation – which is wage growth in excess of productivity growth. In the US, this was 3.5 percent through 2021, slowing to just a 0.9 percent annual rate in the fourth quarter. So, it is not flashing danger, at least yet. Client: Ok, but what about the surge in inflation expectations. Isn’t that flashing danger? CPT: We should treat inflation expectations with a huge dose of salt, as they simply track the oil price, and therefore provide a nonsensical prediction of future inflation! (Chart I-4) Chart I-4The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Nonsense Client: What can explain this nonsense? CPT: Simply that when the oil price is high, investors flood into inflation hedges such as inflation protected bonds. So, the surge in inflation expectations is just capturing the frothiness in inflation protected bond prices that this massive hedging demand is creating. We can see similar frothiness in some commodity prices. The recent massive demand for inflation hedges such as inflation protected bonds and commodities will recede and take the frothiness out of their prices. Client: How so? CPT: Well to the extent that commodity prices drive headline inflation, the apples-for-apples relationship should be between commodity price inflation and headline inflation, and this is what we generally see (Chart I-5). But recently, this relationship has broken down and instead we see a tighter relationship between headline inflation and commodity price levels (Chart I-6 and Chart I-7). The likely causality here is that, just as for inflation protected bonds, massive inflation hedging demand has created frothiness in some commodity prices. Chart I-5Commodity Price Inflation Usually Drives Headline Inflation, But Recently The Relationship Broke Down Chart I-6Recently, We See A Weak Relationship Between Commodity Price Inflation And Headline Inflation... Chart I-7...But A Tight Relationship Between Headline Inflation And Commodity Price Levels On The Investment Implications Client: To sum up your view then, month-on-month US core inflation has already peaked, 12-month US core inflation is about to peak, and demand destruction will ultimately pull down headline inflation. Given modest and slowing growth in unit labour costs, there is no imminent risk of a wage-price spiral, and surging inflation expectations are just capturing the frothiness in inflation protected bond prices that massive hedging demand is creating. What does this view mean for investment strategy? On a 6-12 horizon, overweight stocks and conventional bonds versus commodities and inflation protected bonds. CPT: Well given that inflation is peaking, one obvious implication is that the massive demand for inflation hedges will recede and take the frothiness out of their prices. On a 6-12 month horizon this means underweighting inflation protected bonds and commodities (Chart I-8). Chart I-8The Performance Of Inflation Protected Bonds Versus Conventional Bonds Just Tracks The Oil Price Client: What about the surge in bond yields – when will that reverse? CPT: Empirically, we have seen that bond yields turn just ahead of the turn in the 12-month core inflation rate. Hence, on a 6-12 month horizon this means overweighting bonds. Client: Finally, what does all this mean for stock markets? CPT: The weakness of stock markets this year has been entirely due to falling valuations, rather than falling profits. If the headwind to valuations from rising bond yields turns into a tailwind from falling bond yields, it will boost stocks – especially long-duration stocks with relatively defensive profits. On a 6-12 month horizon this means overweighting stocks, and our favourite sectors are healthcare and biotech. Client: Thank you very much for this open and counterpoint conversation. Fractal Trading Watchlist Due to the Easter holidays, there are no new trades this week. However, the full updated watchlist of 20 investments that are experiencing or approaching turning points is available on our website: cpt.bcaresearch.com Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Vulnerable To Reversal Chart 5Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart 17Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Is At A Potential Turning Point Chart 19Fractal Trading Watch List Chart 20Fractal Trading Watch List   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations