Emerging Markets

Executive Summary The ultimate inflation anchor is unit labor costs. If relative price shocks cause employees to demand higher wages from their employers, and if they are granted wage increases above and beyond their productivity advances, inflation will become broad-based and persistent. US unit labor costs have been rising rapidly, which indicates that US inflation is becoming pervasive and entrenched (Chart of the week). The Fed is facing an acute dilemma that it has not encountered in the last 35 years or so: It either needs to slow growth materially to contain inflation or allow inflation to proliferate. The Fed will make a dovish pivot only after financial conditions tighten substantially, i.e., if the S&P 500 falls by 20% or more (from its peak) and credit spreads widen much more from the current levels. Rapid Rises In Unit Labor Costs Entail High Inflation Rapid Rises In Unit Labor Costs Entail High Inflation Rapid Rises In Unit Labor Costs Entail High Inflation Bottom Line: The Fed and equity markets are on a collision course: The Fed will not make a dovish pivot until markets sell off and markets cannot rally unless the Fed backs off. Feature In a report we published a year ago titled Riding A Tiger, we stated that “the enormous size of US stimulus and overflow of liquidity is creating a thrill akin to riding a tiger… Riding a tiger is fun. The hitch is that no one can safely get off a tiger. Similarly, US authorities are currently enjoying the exuberance from stimulus, but they will not be able to safely and smoothly dismount.” We also contended that “in any system where an explosive money/credit boom persists, the outcome will be one or a combination of the following: inflation, asset bubbles or capital misallocation… Odds are that the US will experience asset bubbles and inflation in the real economy.” Riding a tiger was indeed fun but now it is time for US policymakers to dismount. Yet, exiting the era of super easy monetary and fiscal policies will not be without costs and considerable financial market turbulence. Are the Fed and financial markets heading into a collision in the fog of inflation? Transitory Versus Persistent Inflation Chart 1US Inflation Is Broad Based, As Evidenced By Median And Trimmed-Mean CPIs US Inflation Is Broad Based, As Evidenced By Median And Trimmed-Mean CPIs US Inflation Is Broad Based, As Evidenced By Median And Trimmed-Mean CPIs US inflation has become broad-based.1 Not only is core CPI surging but also trimmed-mean, median and sticky core consumer price inflation have risen substantially (Chart 1).  Median and trimmed-mean price indexes would not be rocketing if inflation was limited to select goods or services. Particularly, the aforementioned measures exclude components with extreme price changes. What might have started as a narrow-based relative price shock has evolved into broad-based genuine inflation. The key to the transition from one-off inflation spikes to persistent genuine inflation is wages, more specifically unit labor costs. Unit labor cost are calculated as nominal wages divided by productivity (the latter is output per hour per employee). As long as unit labor costs are not rising considerably, sharp price increases in several types of goods do not entail genuine inflation and central banks should not tighten aggressively. However, when unit labor costs are escalating, odds are that higher inflation could become entrenched and persistent. The importance of wages stems from the fact that labor compensation makes up the largest share of costs for the majority of industries. Consequently, rising unit labor costs squeeze profit margins. When this transpires, businesses try to pass on rising costs to customers. Provided that robust wage growth propels consumer demand, companies often succeed in raising their prices. Chart 2US Wages Are Rising Rapidly US Wages Are Rising Rapidly US Wages Are Rising Rapidly In turn, inflation erodes the purchasing power of wages, and employees demand substantial pay raises. When revenues are strong, employers typically accommodate employees’ claims for higher compensation, and a wage-price spiral emerges. These dynamics are presently unfolding in the US. US wage growth has reached multi-decade highs of 4.5-5.5% (Chart 2). Plus, the high and climbing quit rate points to further wage acceleration (Chart 3). As US productivity cannot rise as fast as the current wage growth of 4.5-5.5% (Chart 4), the ratio of wages to productivity (unit labor costs) is escalating. Unit labor costs are rising faster than they have in the past 38-40 years. Historically, an acceleration in unit labor costs has often heralded higher inflation (Chart 5). Chart 3US Wages Will Continue Accelerating US Wages Will Continue Accelerating US Wages Will Continue Accelerating Chart 4Wage Growth Is Outpacing Productivity Gains Wage Growth Is Outpacing Productivity Gains Wage Growth Is Outpacing Productivity Gains   Chart 5Rapid Rises In Unit Labor Costs Entail High Inflation Rapid Rises In Unit Labor Costs Entail High Inflation Rapid Rises In Unit Labor Costs Entail High Inflation The only period when US core inflation fell despite rising unit labor costs was during the second half of the 1990s (Chart 5). During this period, EM currency devaluations from China to Mexico and then to Asia unleashed the deflation tsunami in goods prices. US imports prices from Asia collapsed allowing US inflation to drift lower despite rising unit labor costs. The current backdrop is different: US import prices from Asia, including China, are rising (Chart 6). Importantly, US wage growth is presently below headline and core CPI, i.e., real wages are contracting (Chart 7). Provided US employees have experienced a decline in their purchasing power in the past 12 months, they are keen to secure substantial pay raises in the coming months. Chart 6Unlike The Late 1990s, US Import Prices From Asia Are Rising Unlike The Late 1990s, US Import Prices From Asia Are Rising Unlike The Late 1990s, US Import Prices From Asia Are Rising Chart 7US Real Wages Are Shrinking US Real Wages Are Shrinking US Real Wages Are Shrinking   Employers facing strong demand cannot afford an employee exodus. Businesses will raise salaries and hike selling prices to preserve their profit margins, thereby giving rise to a wage-price spiral. Bottom Line: The ultimate inflation anchor is unit labor costs. This is why wages, more specifically unit labor costs, are the most important variable to monitor. If relative price shocks lead employees to demand higher wages from their employers, and if they are granted wage increases above and beyond their productivity advances, inflation will become broad-based and persistent. The Fed’s Dilemma When inflation becomes pervasive and entrenched, as it is now in the US, the only way to bring it down is to slow the economy. Unless demand decelerates meaningfully, US inflation will not go away because it has already spilled over into consumer and business expectations. Even though US headline and core CPI will likely drop in the coming months, core inflation will remain well above the Fed’s target of 2% (Chart 1 above). To maintain its credibility, the Fed should hike rates continually despite the potential rollover in headline and core CPI measures. Chart 8High Probability Of US Core Inflation Exceeding 4% In The Next 12 Months High Probability Of US Core Inflation Exceeding 4% In The Next 12 Months High Probability Of US Core Inflation Exceeding 4% In The Next 12 Months My colleague, Jonathan Laberge, Managing Editor of the Bank Credit Analyst, has quantitatively estimated that there is a almost 100% probability that in next 12 months core PCE inflation will be above 3%, and a 70% probability that it will be above 4% (Chart 8). All this means that if the Federal Reserve is serious about bringing core inflation closer to 2%, it will have to slow down the economy meaningfully. In short, the Fed cannot both achieve decent growth and bring inflation down to its 2% target in the next 1-2 years. The Fed seemed omnipotent over the past 35 years because inflation was falling or was very low. That allowed US monetary authorities during financial crises/deflationary shocks to cut rates aggressively and flood the system with liquidity. That playbook worked well in a disinflation context and the US central bank has prevented protracted debt deflation. When inflation – rather than deflation – is the problem, authorities can do little without slowing growth. In short, an inflation redux has made US policymakers’ jobs much more difficult. If the Fed tightens too much, the economy will slump. If policymakers drag their feet and do not raise interest rates rapidly and significantly, inflation will hover well above its target and inflation expectations will escalate with negative ramifications for the economy (more on this below). Bottom Line: The Fed is facing an acute dilemma. The Fed will not publicly acknowledge it, but financial markets are gradually waking up to the new reality that the era of an omnipotent Fed might be over, at least for a period of time. Why Not Allow Inflation To Proliferate? Why should authorities tighten policy and slow growth to reduce inflation? Why can’t the US operate with inflation in a range of 3.5-5%? First, there is no guarantee that core inflation will stabilize at 3.5-5% and not rise further. When higher consumer and business inflation expectations set in, they are not easily dislodged. Second, persistent inflation can damage growth itself. High price volatility increases business uncertainty as producers cannot properly plan their costs and selling prices. Higher uncertainty leads companies to abandon expansion projects and new investments. Consequently, economic growth, employment and ultimately productivity suffer. Lower productivity growth creates fertile ground for inflation to thrive. This can lead to stagflation whereby growth slows but inflation remains high. Finally, from a political perspective, inflation can be more damaging to a government’s popularity than modestly high unemployment. For example, if the unemployment rate is at 6-7%, there would be some unhappy voters, but the majority of the population would be employed and their real purchasing power would be rising. Hence, the majority of voters might be content about the incumbent government’s policies.  In an inflation scenario, however, everyone would be unhappy because inflation erodes the purchasing power of household income and wealth. The point is that moderately high unemployment affects a few families who do not have jobs while inflation affects everyone. US politicians and policymakers have forgotten the perils of inflation because rapidly rising prices have not been a problem for decades. Therefore, they have erred on the side of helicopter money assuming that deflationary pressures and higher unemployment are worse than inflation. They have forgotten that inflation is not only worse for the wider population but that it could cause growth to slump resulting in stagflation: a combination of high inflation and high unemployment. Inflation has already become a political problem in the US. With income growth lagging behind inflation, household purchasing power has declined, which has fueled dissatisfaction with the current government. Biden’s popularity has tanked in the past nine months along with the rise of inflation. If inflation is not quelled by this fall, chances are that the Democrats will lose Congress to the Republicans in the midterm elections. Further, if high inflation persists in the next two years, odds of a Republican candidate winning the 2024 presidential elections will be considerable. Recognizing this, the Biden administration will not oppose the Fed’s hawkish policy for now. While we are sympathetic to the view that the Fed will ultimately not raise rates too aggressively, they have no reason not to hike and cannot afford to appear dovish at the current juncture. Even as headline and core inflation measures start falling (which is very likely in the months ahead), the Fed has no excuse to turn dovish. The rationale is that the US core inflation rate, while dropping from 5.5-6%, will still be well above the central bank’s target of 2%. In our opinion, the Fed will make a dovish pivot only after financial conditions tighten substantially, i.e., if the S&P 500 falls by 20% or more (from its peak) and credit spreads widen much more from current levels. Bottom Line: Until panic selling occurs in the equity and credit markets or the economy is materially weaker, the Fed will hike interest rates at every meeting and will start quantitative tightening soon. Thus, US bond yields and the US dollar have more upside for the time being. Overall, the Fed and equity markets are on a collision course: the Fed will not make a dovish pivot until markets sell off and markets cannot rally unless the Fed backs off. Implications For Financial Markets Chart 9Second Half Of The 1960s: The S&P 500 And US Bond Yields Became Negatively Correlated Second Half Of The 1960s: The S&P 500 And US Bond Yields Became Negatively Correlated Second Half Of The 1960s: The S&P 500 And US Bond Yields Became Negatively Correlated As long as the Fed maintains its hawkish bias (which is very likely in the coming months), US bond yields will rise and/or the yield curve will flatten, the greenback will be firm, and stocks will struggle. The current environment will be more reminiscent of what occurred in the late 1960s than any other period of the past 40 years. In the second half of the 1960s, when US core CPI spiked, US share prices became negatively correlated with US bond yields (Chart 9). We discussed this topic at great length in a report from a year ago. Hawkish monetary policy amid the inflation overshoot means that the Fed appears to be credible, and this stance is positive for the US dollar. As soon as the Fed makes a dovish pivot however, the US dollar will tank. The basis is that by turning dovish earlier than warranted, odds are that inflation would remain well above its target, i.e., the Fed would fall behind the inflation curve. When a central bank is behind the inflation curve, the currency depreciates. Our US Equity Capitulation Indicator has fallen quite a bit but has not yet reached its 2018, 2016, 2011 and 2010 lows (Chart 10). We believe the macro backdrop is poor enough to justify a pullback on par with those selloffs (17-20% from the peak). In such an environment, EM stocks will outperform DM only if the US dollar weakens (Chart 11). Chart 10More Downside In The S&P 500? More Downside in The S&P 500? More Downside in The S&P 500? Chart 11EM Relative Equity Performance Moves With The US Dollar EM Relative Equity Performance Moves With The US Dollar EM Relative Equity Performance Moves With The US Dollar ​​ Chart 12Will The Current Episode Play Out Like Q4 2018? Will The Current Episode Play Out Like Q4 2018? Will The Current Episode Play Out Like Q4 2018? Alternatively, we might be witnessing a replay of Q4 2018 when the S&P 500 sold off hard led by tech stocks, but having underperformed earlier that year EM outperformed (Chart 12). While such a scenario is quite possible, we need to downgrade our view on the US dollar in order to upgrade EM stocks from underweight. We are not ready to do so because we believe the Fed’s hawkish bias will for now support the greenback. On the whole, we continue to recommend underweight allocations to EM equities and credit markets within their respective global portfolios. Absolute-return investors should stay cautious on EM risk assets. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     Please note this is the view of Emerging Markets Strategy team and does not reflect the view of other BCA services.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Executive Summary Russian Invasion Scenarios And Likely Equity Impact Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree The Ukraine crisis is escalating as predicted. We maintain our odds: 65% limited incursion, 10% full-scale invasion, 25% diplomatic de-escalation. Russia says it will take “military-technical” measures as its demands remain unmet, while the US says an invasion is imminent. Fighting has picked up in the Donbas region. Our Ukraine decision tree highlights that the key to a last-minute diplomatic resolution is a western renunciation of defense cooperation with Ukraine after a verified Russian troop withdrawal. The opposite is occurring as we go to press. Stay long gold, defensives over cyclicals, and large caps over small caps. Stay long cyber security stocks and aerospace/defense stocks relative to the broad market. Trade Recommendation Inception Date Return LONG GOLD (STRATEGIC) 2019-12-06 27.6% Bottom Line: Our 75% subjective odds of a partial Russian re-invasion of Ukraine appear to be materializing. At the same time, we are not as optimistic about an imminent solution to the US-Iran nuclear problem. A near-term energy price spike is negative for global growth so we recommend sticking with our defensive tactical trades. Feature Chart 1Ukraine: Don't Be Complacent Ukraine: Don't Be Complacent Ukraine: Don't Be Complacent Fears about a heightened war in Ukraine fell back briefly this week before redoubling. Russian President Vladimir Putin showed a willingness to pursue diplomacy but then western officials refuted Russian claims that it was reducing troops around Ukraine. US President Biden said Russia is highly likely to invade Ukraine in the next few days. The Russian foreign ministry sent a letter reiterating Russia’s earlier threat that it will take unspecified “military-technical” actions given that its chief demands have not been met by the United States. A worsening security outlook as we go to press will push the dollar up against the euro, the euro up against the ruble, will lead to global equities falling (with US not falling as much as ex-US), and global bond yields falling (Chart 1). To assess the situation we need to weigh the signs of escalation against those of de-escalation. What were the signs of de-escalation? First, the Russian Defense Ministry claimed it is reducing troop levels near Ukraine, although NATO and the western powers have not verified any drawdown. An unspecified number of troops were said to return to their barracks in the Western and Southern Military Regions, according to Russian Defense Ministry spokesman General Igor Konashenkov. A video showed military units and hardware pulling back from Crimea. Officials claimed all troops would leave Belarus after military drills ended on February 20.1 Second, the Kremlin signaled that diplomacy has not been exhausted. In a video released to the public, Putin met with Foreign Minister Sergei Lavrov. He asked whether there was still a chance “to reach an agreement with our partners on key issues that cause our concern?” Lavrov replied, “there is always a chance.” Putin replied, “Okay.” Then, after speaking with German Chancellor Olaf Scholz in Moscow, Putin said: "We are ready to work further together. We are ready to go down the negotiations track.”2 Third, the Ukrainians are supposedly restarting efforts to implement the 2015 Russia-imposed ceasefire, under pressure from Germany and France. Ukraine’s ruling party is expected to introduce three bills to the Rada (parliament) that would result in implementing the terms of the Russian-imposed 2015 ceasefire, the so-called Minsk II Protocols. Ukraine is supposed to change its constitution to adopt a more federal system that grants autonomy to the two Russian separatist regions in the Donbas, Donetsk and Luhansk. Ukraine is also supposed to hold elections.3 The caveats to these three points are already clear: The US said Russia actually added 7,000 troops to the buildup on the Ukrainian border. Without Russia’s reducing troops, the US and its allies cannot offer major concessions. The US cannot allow itself to be blackmailed as that would encourage future hostage-taking and blackmail. Putin’s offer of talks is apparently separate from its “military-technical” response to the West’s failure to meet its three core demands on NATO. Russia’s three core demands are no further NATO enlargement, no intermediate-range missiles within threatening range, and withdrawal of NATO forces from eastern Europe to pre-1997 status. Putin reiterated that these three demands are inseparable from any negotiation and that Russia will not engage endlessly without resolution. Yet the West has consistently rejected these demands. Then came the Foreign Ministry statement pledging Russia’s military-technical response. So talks that focus on other issues – like missile defense and military transparency – are a sideshow. Ukraine is reiterating its desire to join NATO and will struggle to implement the Minsk Protocol. The Minsk format is not popular in Ukraine as it grants influence and recognition to the breakaway ethnic Russian regions. Ostensibly President Volodymyr Zelenskiy has sufficient strength in the Rada to change the constitution, given the possibility of assistance from opposition parties that oppose war or favor Russia. But passage or implementation could fail. The Russian Duma has also advised Putin to recognize the Donetsk and Luhansk People’s Republics as independent countries, which Putin is not yet ready to do, but could do if Ukraine balks, and would nullify the Minsk format.4 Of Russia’s three core demands, investors should bear in mind the following points: Ukraine is never going to join NATO. One of the thirty NATO members will veto its membership to prevent war with Russia. Therefore Russia is either making this demand knowing it will fail to justify military action, or driving at something else, such as NATO defense cooperation with Ukraine. Even if NATO membership is practically unrealistic, the US and NATO are providing Ukraine with arms and training, making it a de facto member. The quality and quantity of western defense cooperation is not sufficient to threaten Russia’s military balance so far but it could grow over time and Russia is insisting that it stop. While there is also a broader negotiation over Europe’s entire security system, immediate progress depends on whether the US and its allies stop trying to turn Ukraine into a de facto NATO ally. NATO is not going to sacrifice all of the strategic, territorial, and military-logistical gains it has made since 1997. Especially not when Russia is attempting to achieve such a dramatic pullback by military blackmail. But NATO could reduce some of the most threatening aspects of its stance if Russia reciprocates and there is more military transparency. Similarly, the US and Russia have a track record of negotiating missile defense deals so this kind of agreement is possible over time. The problem, again, hinges on whether agreement can be found over Ukraine. The opposite looks to be the case. Based on the above points, Diagram 1 provides a “Decision Tree” that outlines the various courses of action, our subjective probabilities, and the sum of the conditional probabilities for each final scenario. Diagram 1Russia-Ukraine Decision Tree, February 9, 2022 Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree We start with the view that there is a 55% chance that the status quo continues: the West will not rule out Ukraine’s right to join NATO and will not halt defense cooperation. If this is true, then the new round of talks will fail because Russia’s core security interests will not be met. However, we also give a 25% chance to the scenario in which Ukraine is effectively barred from NATO but not defense cooperation. This may be the emerging scenario, given Chancellor Scholz’s point that Ukrainian NATO membership is not on the agenda and the White House’s claim that it will not pressure states to join NATO. Basically, western leaders could provide informal assurances that Ukraine will never join. But then the matter of defense cooperation must be resolved in the next round of talks. Given that the US and others have increased arms transfers to Ukraine in recent months and years (with US providing lethal arms for the first time in 2018), it seems more likely (60/40) that they will continue with arms transfers. After all, if they halt arms, Russia can invade anyway, but Ukraine will have less ability to resist. We allot a 15% chance to a scenario in which the US and its allies halt defense cooperation, even if they officially maintain NATO’s “open door” policy. If the Russians withdraw troops in this scenario, then a lasting reduction of tensions will occur. Again, while allied defense cooperation has been limited so far, it is up to Russia whether it poses a long-term threat. Finally, we give a 5% chance that the US and NATO will bar Ukraine from membership and halt defense cooperation. This path would mark a total capitulation to Russia’s demands. So far the allies have done nothing like this. They have insisted on NATO’s open door policy and have continued to transfer arms. No one should be surprised that tensions are escalating. De-escalation could still conceivably occur if Russia verifiably withdraws troops, if Ukraine moves to implement the Minsk II protocol, and if the US and its allies pledge to halt defense cooperation with Ukraine. The first step is for Russia to reduce troops, since that enables the US and allies to make major concessions when they are not under duress. If the US and NATO guarantee they will halt defense cooperation, given that Ukraine is practically unlikely to join NATO, then Russia may not be as concerned with Ukraine’s implementation of Minsk. As we go to press, none of these conditions are falling into place. The security situation is deteriorating rapidly. Bottom Line: Russia is likely to stage a limited military intervention into Ukraine (75%). The odds of a diplomatic resolution at the last minute are the same (25%). A full-scale invasion of all of Ukraine remains unlikely (10%). Market Reaction To Re-Escalation Chart 2 highlights the global equity market response to the Russian invasion of Crimea in 2014, which should serve as the baseline for assessing the market reaction to any renewed attack today. Stocks fell and moved sideways relative to bonds for several months, cyclicals (except energy) underperformed defensives, small caps briefly rose then collapsed against large caps, and value stocks rose relative to growth stocks. The takeaway was to stay invested over the cyclical time frame, prefer large caps, and prefer value. The difference today is that cyclicals and small caps are already performing worse against defensives and large caps than in 2014, while value has vastly outstripped growth (Chart 3). The implication is that once war breaks out, cyclicals and small caps have less room to fall whereas value has limited near-term upside. Chart 2Market Response To Crimea Invasion, 2014 Market Response To Crimea Invasion, 2014 Market Response To Crimea Invasion, 2014 ​​​​​​ Chart 3Market Response 2022 Versus 2014 Market Response 2022 Versus 2014 Market Response 2022 Versus 2014 ​​​​​​ If we look closely at global equity gyrations over the past week – when the Ukraine story moved to front and center – we see that stocks are falling relative to bonds, cyclicals are flat relative to defensives, small caps are rising relative to large caps, and value is flat relative to growth but may have peaked (Chart 4). In the short term the geopolitical dynamic will move markets so we expect cyclicals, small caps, and value to underperform. Commodity prices and the energy sector are initially benefiting from tensions as expected – oil prices and energy equities spiked amid the tensions (Chart 5). But assuming war materializes, Russia will at least cut off natural gas flowing through Ukraine, cutting off about 20% of Europe’s natural gas supply and triggering a bigger price shock. Ultimately, however, this price shock will incentivize production, destroy global demand, and drive energy prices down. Chart 4Global Equities Just Woke Up To Ukraine Global Equities Just Woke Up To Ukraine Global Equities Just Woke Up To Ukraine ​​​​​​ Chart 5Global Energy Sector Just Woke Up To Ukraine Global Energy Sector Just Woke Up To Ukraine Global Energy Sector Just Woke Up To Ukraine ​​​​​ Thus we expect energy price volatility. Russia will keep shipping energy to Europe to finance its military adventures. Europe will be loath to slap sanctions on critical energy supplies, assuming Russia’s military action is limited. The Saudis may or may not increase production to prevent demand destruction – in past Russian invasions they have actually reduced production once prices started to fall. A temporary US-Iran nuclear deal could release Iranian oil to the market, though that is not what we expect in the short run (discussed below). Bottom Line: Tactically investors should favor bonds over stocks, the US dollar and US equities over global currencies and equities (especially European), defensive sectors over cyclicals, large caps over small caps, and growth over value stocks. Is Ukraine Already Priced? Not Yet. Chart 6Crisis Events And Peak-To-Trough Market Drawdown Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree The peak-to-trough equity drawdown – in geopolitical crises that are comparable to a Russian invasion of Ukraine – range from 11%-14% going back to 1931. The following research findings are derived from a list of select events, from the Japanese invasion of China to the German invasion of Poland to lesser invasions, all the way down to Russia’s seizure of Crimea in 2014. We used the S&P 500 as it is the most representative stock index over this long period of time. The fully updated and broader list of geopolitical crises can be found in Appendix 1. Geopolitical crises tend to trigger an average 10% equity decline, smaller than economic crises or major terrorist attacks (Chart 6). The biggest geopolitical shocks to the equity market occur when an event is a truly global event, as opposed to regional shocks. Interestingly Europe-only shocks have seen some of the smallest average drawdowns at around 8% (Chart 7). An expanded Ukraine war would be limited to Europe. The average equity selloff is largest, at 14%, if both the US and its allies are directly involved in the geopolitical event. But the range is 11%-14% regardless of whether the US or its allies are involved (Chart 8). Ukraine is not an official ally, which is one reason the markets will tend to play down a larger war there. However, the market is underrating the fact that Ukraine’s neighbors are NATO members and will have a powerful interest in supporting the Ukrainian militant insurgency, which could lead to unexpected conflicts that involve NATO member-state’s citizens. Chart 7Geopolitical Crises And Markets: Where Is The Crisis? Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree ​​​​​​ Chart 8Geopolitical Crises And Markets: Who Are The Players? Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree ​​​​​​ Chart 9Russian Invasion Scenarios And Likely Equity Impact Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree The Russians have as many as 150,000 troops on the border with Ukraine, according to President Biden’s latest speech. The Ukrainian active military numbers 215,000. This ratio is not at all favorable for a full-scale invasion. The Russians are contemplating a limited action directed at teaching Ukraine a lesson or encroaching further onto Ukrainian territory, especially coastal territory. History suggests that a limited incursion will produce a 10% total equity drawdown, whereas a full-scale invasion would produce 13% or more (Chart 9). Still, investors should view 11%-14% as the appropriate range for a geopolitically induced crisis. The S&P has fallen by 9% since its peak on January 3, 2022. But Russia has not invaded yet. If war breaks out, there is more downside, given high uncertainty. Markets could still be surprised by the initial force of any Russian military action. The US will impose sweeping sanctions immediately. The Europeans will modify their sanctions according to Russia’s actions, a key source of uncertainty. If a diplomatic resolution is confirmed – with Russia withdrawing troops and the US and its allies cutting defense cooperation with Ukraine – then the market may continue to rally. However, there are other reasons to be cautious: especially inflation and monetary policy normalization, with the Federal Reserve potentially lifting rates by 50 basis points in March. Bottom Line: Stocks can fall further given that investors do not yet know the magnitude of the Russian military action or the US and European sanctions response. However, a buying opportunity is around the corner once this significant source of global uncertainty is clarified. New Iran Deal Is Neither Guaranteed Nor Durable A short note is necessary on the situation with Iran, another major risk this year, which falls under our third 2022 key view: oil-producing states gain geopolitical leverage. The implication is that the Iran risk will not be resolved quickly or easily. The global economy could suffer a double whammy of energy supply shock from Ukraine and energy supply risk in the Middle East this year. The US-Russia showdown is connected to the US-Iran nuclear negotiation. Russia took Crimea in 2014 in part because it saw an opportunity to exact a price from the United States, which sought Russia’s assistance in negotiating the 2015 nuclear deal with Iran. Today a similar dynamic is playing out, in which Russian diplomats cooperate on Iranian talks while encroaching on Ukraine. The Russians do not have an interest in Iran achieving a deliverable nuclear weapon and thus will offer some limited cooperation to this end. Their pound of flesh is Ukraine. According to media reports, the Iranian negotiations have seen some positive developments over the past month. US interest in rejoining the 2015 deal: The Biden administration has an interest in preventing Iran from reaching “breakout” levels of uranium enrichment and triggering a conflict in the region that would drive up oil prices ahead of the midterm election. It is going to be hard for Biden to remove sanctions in the context of Russian aggression but it is likely he would do it if the Iranians recommit to complying with the 2015 restrictions on their nuclear program. Iranian interest in rejoining the 2015 deal: The Iranians have an interest in convincing President Biden to remove sanctions to improve their economy and reduce the risk of social unrest. They are demanding the removal of all sanctions, not only those levied by President Trump. They also know that rejoining the 2015 deal itself is not so bad, since it starts expiring in 2025 and does not limit their missile production or support of militant proxies in the region. However, note that the Iranian regime has suppressed domestic instability since Trump’s “maximum pressure” sanctions, and the economy is improving on oil prices, so the threat of social unrest is not forcing Iran to accept a deal today. Also note that Iran is making demands that cannot be met: Iranian Foreign Minister Hossein Amirabdollahian is asking the US to provide guarantees that the US will not renege on the deal again, for example if the Republicans return to the White House in 2025. President Biden cannot provide these guarantees. The voting margins are too thin for a “political statement,” promising that the US will not renege on a deal, to pass Congress. While House Speaker Nancy Pelosi might be willing to provide such a statement to the Iranians, Senate Majority Leader Chuck Schumer probably will not – he opposed the originally 2015 deal. Even if Congress gave Iran guarantees, the fact remains that the GOP could win the White House in 2025, so the current, hawkish Iranian leadership cannot be satisfied on this front. Furthermore, even if Biden pulls back sanctions and Iran complies with the 2015 deal for a brief reprieve, Iran’s underlying interest is to obtain a deliverable nuclear weapon to achieve regime survival in the future. Iran faces a clear distinction between Ukraine, which gave up nukes and is now being dismembered (like Libya and Iraq), and North Korea, which now has a deliverable nuclear arsenal and commands respect from the US on the national stage. Moreover if the Republicans take back power in 2025, Iran will want to have achieved or be close to achieving a deliverable nuclear weapon. The Biden administration is weak at home and facing a crisis with Russia, which may present a window of opportunity for Iran to make a dash for the nuclear deterrent. Still, we acknowledge the short-term risk to our pessimistic view: It is possible that Iran will rejoin the deal to gain sanctions relief. In this case about 1-1.2 million barrels per day of Iranian crude will hit the global market. The implication, depending on the size of the energy shock, is that Brent crude prices will fall back to the $80 per barrel average that our Commodity & Energy Strategy expects. We also agree with our Commodity & Energy Strategist that global oil production will pick up in the face of supply risks that threaten to destroy demand. Bottom Line: We doubt Iran will rejoin the 2015 nuclear deal quickly. We expect energy prices to continue spiking in the short term due to Ukraine and any setbacks in the Iran negotiations. Yet we also expect oil producers around the world to increase production, which will sow the seeds for an oil price drop. Our tactical trade recommendations rest on falling oil prices and bond yields in the short run. Investment Takeaways Stay long gold. Stay long global defensive equity sectors over cyclicals. Favor global large caps over small caps. Stay long cyber security stocks and aerospace/defense stocks relative to the broad market. Stay long Japanese industrials relative to German and long yen. Stay long British stocks relative to other developed markets excluding the US, and long GBP-CZK. Favor Latin American equities within emerging markets, namely Mexican stocks and Brazilian financials relative to Indian stocks.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1      See "Russia Announces Troop Withdrawal," Russia Today, February 15, 2022, rt.com; "Ukraine crisis: Russian claim of troop withdrawal false, says US," BBC, February 17, 2022, bbc.com. 2     David M. Herszenhorn, “On stage at the Kremlin: Putin and Lavrov’s de-escalation dance,” Politico, February 14, 2022, politico.eu. 3     "Scholz says Zelensky promised to submit bills on Donbass to Contact Group," Tass, February 15, 2022, tass.com; "Scholz in Kyiv confirms Germany won’t arm Ukraine, stays mum on Nord Stream 2," February 15, 2022, euromaidanpress.com. 4     "Kiev makes no secret Minsk-2 is not on its agenda — Russian Foreign Ministry," Tass, February 17, 2022, tass.com; Felix Light, "Russian Parliament Backs Plan To Recognize Breakaway Ukrainian Regions," Moscow Times, February 15, 2022, themoscowtimes.com. Appendix 1: Geopolitical Events And Equity Market Impact Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Executive Summary Oil-Price Risk Skewed Upward Scenarios For Oil Prices Scenarios For Oil Prices The $10-$15/bbl risk premium in Brent prices will dissipate over the next month. Russia's best outcome is to follow the off-ramp offered by the US. President Biden's call to KSA's King Salman last week will result in higher oil output from the Kingdom, the UAE and Kuwait, in return for deeper US defense commitments. The Biden administration and Iran are in a hurry to get a deal done: The US wants lower oil prices, and Iran needs the revenue. Our Brent forecasts for 2022 and 2023 are revised slightly to $81.50 and $79.75/bbl, respectively, reflecting supply-demand adjustments. Price risks are tilted to the upside: A miss on any of the above assumptions will keep prices above $90/bbl, and push them higher. Bottom Line: Oil demand will remain robust this year and next.  To keep prices from surging from current levels into demand-destruction territory, additional supply is needed.  Most of this will come from KSA, the UAE and the US shale-oil producers.  We expect prices to fall from current prompt levels this year and next.  This will support sovereign budgets and oil producers' free cashflow goals.  We remain long the XOP ETF. Feature The $10-$15/bbl risk premium in Brent crude oil prices will dissipate, as the following supply-side events are ticked off: 1)   Russia gets on the off-ramp offered by the US last week to de-escalate the threat of another invasion of Ukraine by withdrawing its troops from the border;1 2)   OPEC 2.0's core producers – the Kingdom of Saudi Arabia (KSA), the United Arab Emirates (UAE), and Kuwait – increase supply in return for deeper US security commitments; 3)   Iran restores its remaining 1.0 – 1.2mm b/d of production to the market, following the restoration of its nuclear deal with Western powers; and 4)   US shale-oil producers step up production in response to higher WTI prices. Politics, Then Economics The first three assumptions above are political in nature, requiring a bargain be struck among contending interests to resolve. We do not believe Russia's endgame is to jeopardize its future oil and gas exports to the West, particularly to the EU (Chart 1). The US is warning that another invasion of Ukraine will put the use of the Nord Stream 2 pipeline to deliver gas to Germany at risk.2 It also is worthwhile noting NATO is aligned with the US on this stance. Russia derived 40-50% of its budget revenues from oil and gas production, and ~ 67% of its export revenue from oil and gas over the decade ended in 2020.3 Of course, only President Putin can determine whether oil and gas sales can be diversified enough – e.g., via higher shipments to China – to offset whatever penalties the West imposes. But, in a game-theoretic sense, the stakes are very high, and taking the US off-ramp is rational. Chart 1Russia's Critical Exports: Oil + Gas Lower Oil Prices On The Way Lower Oil Prices On The Way We expect the second assumption to play out in the near term, following US President Joe Biden's call to KSA's King Salman last week. The outreach stressed the US commitment to defend KSA and, presumably, its close allies in the Gulf (the UAE and Kuwait).4 KSA already has increased its production to 10.15mm b/d under the OPEC 2.0 agreement to restore 400k b/d beginning in August 2021. We estimate the coalition had fallen behind on this effort by ~ 1mm b/d, as only KSA, the UAE and Kuwait presently have the capacity to lift production and sustain it (Table 1). KSA's reference production level agreed at OPEC 2.0's July 2021 meeting will rise to 11.5mm b/d in June, up 500k b/d from its current level (Table 2). This means KSA could flex into another 850k b/d between now and the end of May; and another 500k b/d after that. The UAE's and Kuwait's reference production levels will rise 330k and 150k b/d in June to 3.5mm b/d and 3.0mm b/d, respectively. Markets will need these incremental volumes as demand continues to recover and non-core OPEC 2.0 production continues to fall (Chart 2). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Lower Oil Prices On The Way Lower Oil Prices On The Way Table 2Baseline Increases For Core OPEC 2.0 Lower Oil Prices On The Way Lower Oil Prices On The Way Our third assumption reflects our reading of the signaling by Iran over the past few weeks, which indicate growing confidence a deal with the US to restore the Joint Comprehensive Plan of Action (JCPOA) is in the offing.5 The politics here converge with the economics: the Biden Administration wants to increase oil supply ahead of mid-term elections in the US to keep gasoline prices under control; Iran needs to increase its revenues. Both sides get an immediate need satisfied. However, the risks to KSA and its Gulf allies will increase as Iran's revenues grow, because it will be able to fund proxy-war operations against the Gulf states. This is why deepening the US defense commitment to the region is critical to KSA and its allies. The last assumption reflects our view US E+P companies are being incentivized to lift production by high prompt and deferred prices. We continue to expect these companies – particularly those in the US shales, where the majority of the production increase will occur – to husband their capital resources closely, and to continue to prioritize shareholder interests. As capital availability declines – primarily due to reduced investor interest in investing in hydrocarbon production – these firms will have to focus on reducing operating costs and increasing productivity over the next decade to fund growth. Relative to 2021, we expect US oil production to increase 0.85mm b/d this year and by 0.53mm b/d in 2023 relative to this year, as producers respond to higher prices (Chart 3). Chart 2Increased Core OPEC 2.0 Production Becoming Critical Lower Oil Prices On The Way Lower Oil Prices On The Way Chart 3US Oil Production Will See Another Up Leg US Oil Production Will See Another Up Leg US Oil Production Will See Another Up Leg Supply-Demand Balances Are Tight Global oil demand growth this year is reduced slightly in our balances – going to 4.5mm b/d from 4.8mm b/d, mostly reflecting our assessment of slowing growth as central banks remove monetary accommodation. We lifted next year's growth estimate slightly, to 1.7mm b/d. These estimates still leave our growth expectations above the major data providers, the highest of which is OPEC's 4.2mm b/d estimate. We continue to expect DM demand to level off this year and next, and EM demand to retake its position as the global demand growth engine (Chart 4). The supply side remains tight, with average global crude oil and liquid fuels production estimated at 101.5mm b/d for 2022 and 102.8mm b/d for next year. With demand expected to average 101.5mm b/d this year and 103.2mm b/d next year, markets will remain balanced but tight (Chart 5). This means inventories will continue to be strained, leaving little in the way of a cushion to absorb unexpected supply losses (Chart 6).  Chart 4EM Demand Retakes Growth-Engine Role EM Demand Retakes Growth-Engine Role EM Demand Retakes Growth-Engine Role Chart 5Markets Remain Balanced But Tight... Markets Remain Balanced But Tight... Markets Remain Balanced But Tight... Chart 6...Keeping Pressure On Inventories ...Keeping Pressure On Inventories ...Keeping Pressure On Inventories Markets Remain Balanced But Tight Our supply-demand analysis indicates markets will remain balanced but tight, with inventories under pressure until supply increases. This will predispose markets to higher price volatility, as low inventories force prices to ration supply. This will increase the backwardation in the Brent and WTI curves, which will bolster the convenience yield in both of these markets (Chart 7).6 We expect implied volatility to remain elevated, as a result (Chart 8). Chart 7Backwardation Will Keep Convenience Yield Elevated Lower Oil Prices On The Way Lower Oil Prices On The Way Chart 8High Volatility Will Persist High Volatility Will Persist High Volatility Will Persist Because of these low inventory values, Brent prices for 2022 are higher than our previous estimate. By 2023, the effects of increased supply from KSA, UAE, Kuwait – albeit a marginal increase – and the US kick in to reduce prices. As supply increases, the risk premium currently embedded in Brent prices will decline, pushing them to our forecasted levels for 2022 and 2023 of $81.50/bbl and $79.75/bbl, respectively. For 1H22, we expect Brent prices to average $87.20/bbl, and in 2H22 we're forecasting a price of $75.80/bbl on the back of increased production. Next year, higher output will keep prices close to $80/bbl, with 1H23 Brent averaging $79.85 and 2H23 averaging $79.70/bbl. Word Of Caution Our analysis is predicated on strong assumptions regarding the incentives of oil producers taking a rational view of the need for stability and supply in markets. The bottom panel of Chart 9 provides an indication of how tenuous markets are if our assumptions are mistaken, and core OPEC 2.0 does not increase production, Iranian barrels are not returned to the market, or the US shale supply response is less vigorous than we expect. The highest price trajectory occurs when all of our assumptions prove wrong, which takes Brent prices above $140/bbl by the end of 2023. It goes without saying this is non-trivial. But we'll say it anyway: This is non-trivial. We can reasonably expect feedback loops in such a case – e.g., US and Canadian production kicks into high gear, and once-idled North Sea are brought back into service. However, this takes time, and will cause demand destruction on a global scale. Chart 9Scenarios For Oil Prices Scenarios For Oil Prices Scenarios For Oil Prices   Investment Implications Oil markets will remain tight and volatile until additional supplies are forthcoming. We are expecting core OPEC 2.0 to lift output by 3.2mm b/d this year, and for the US Lower 48 production to average 9.8mm b/d. The US production increase will be led by higher shale-oil output, which we expect to average 7.4mm b/d this year and 7.8mm b/d in 2023. Given the tight markets we expect, we remain long the XOP ETF, and commodity index exposure in the form of the S&P GSCI and the COMT ETF, an optimized version of the S&P GSCI.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish Marketed volumes of US natural gas are expected to hit a record high of just under 107 Bcf/d next year as prices stabilize close to $4/MMBtu, in the EIA's latest estimate. This is up from just over 104 Bcf/d of marketed production this year, which itself was a 3 Bcf/d increase over 2021 levels. Almost all of this will come from the Lower 48 (97%). We expect US LNG exports to increase on the back of rising production and further investment in export terminals. Most of this will be shipped to Europe, in our estimation, as EU states seek to diversify LNG sources in the wake of the Russia-Ukraine standoff currently underway. LNG imports accounted for roughly one-fifth of all natural gas supplied to the UK and EU-27 in 2020, according to the EIA, which notes, "Growing volumes of flexible LNG supplies, primarily from the United States, contributed to the notable increases in LNG imports to Europe from 2019 to 2021." Wide price differentials can be expected to support the flow of LNG to Europe from the US (Chart 10). Base Metals: Bullish Iron ore prices took a hit after China’s National Development and Reform Commission (NDRC) stated its intentions to stabilize iron ore markets, crack down on speculation and false price disclosures after prices in 2022 rallied sharply last week.  Authorities believe price strength is coming from speculation and hoarding, which is adding to inflationary pressures.  However, fundamental factors have been, and likely will keep iron ore prices buoyed.  Based on past steel inventory levels and seasonal patterns, steel production will increase and more than double current inventory levels by end-March. Monetary policy easing, and the push by China’s steel industry to become carbon-neutral over the next five years are additional fundamental factors supporting iron ore prices. Precious Metals: Bullish The January print for US CPI jumped 7.5% year-on-year, beating estimates as headline inflation rose to a 40-year high.  Markets are expecting around five interest increases this year (Chart 11).  BCA’s US Bond Strategy expects rate hikes will be around 100 – 125 bps this year.  Gold prices initially fell on the possibility of increasing rate hikes and a hawkish Fed, but in the second half of last week settled at subsequently higher prices on each day.  Apart from increased inflation demand, this was likely due to markets’ fear of the possibility of an ultra-hawkish Fed, which could tighten US financial conditions and see a rotation out of US equity markets into safe-haven assets or into other markets ex-US, both of which will be bullish for gold. Chart 10 Lower Oil Prices On The Way Lower Oil Prices On The Way Chart 11 US Policy Rate Expectations Going Up US Policy Rate Expectations Going Up         Footnotes 1     Please see Background Press Call by a Senior Administration Official on the President’s Call with Russian President Vladimir Putin, released by the US White House on February 12, 2022. 2     Please see Long-Term EU Gas Volatility Will Increase, which we published on February 3, 2022 for further discussion.  The EU is a huge market for Russia supplies Germany with 65% of its gas.  Approximately 78% of total natural gas exports (pipeline + LNG) from Russia went to the EU in 2020. 3    Please see Russia’s Unsustainable Business Model: Going All In on Oil and Gas, published on January 19, 2021 by the Hague Centre for Strategic Studies (HCSS). 4    Please see Readout of President Joseph R. Biden, Jr.’s Call with King Salman bin Abdulaziz Al-Saud of Saudi Arabia, released on February 7, 2022. The readout noted, " issues of mutual concern, including Iranian-enabled attacks by the Houthis against civilian targets in Saudi Arabia." Energy security also was discussed, which we read as code for a deal to increase production in return for a deepening of US defense commitments. This line is followed closely by Gulf media – e.g., It took Biden a year to realize Saudi Arabia’s vital regional role, published by arabnews.com on February 13, 2022, which notes: "If Putin decides to invade Ukraine, the Saudis are the only ones who could help relieve the unsteady oil markets by pumping more crude, being the largest crude exporter in the OPEC oil production group. The White House emphasized that both leaders further reiterated the commitment of the US and Saudi Arabia in ensuring the stability of global energy supplies. 5    Please see Iran 'is in a hurry' to revive nuclear deal if its interests secured -foreign minister, published by reuters.com on February 14, 2022. 6    Please see our November 4, 2021 report entitled Despite Weaker Prices Crude Oil Backwardation Will Persist for additional discussion of convenience yields and volatility.   Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image  

Executive Summary China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 The pace of credit creation in January increased sharply over December. However, the jump was less than meets the eye compared with previous easing cycles and adjusted for seasonality. Our calculation suggests that a minimum of approximately RMB35 trillion of new credit, or a credit impulse that accounts for 29% of this year's nominal GDP, will be needed to stabilize the economy. January’s credit expansion falls short of the RMB35 trillion mark on a six-month annualized rate of change basis. Our model will provide a framework for investors to gauge whether the month-over-month credit expansion data is on track to meet our estimate of the required stimulus. Despite an improvement in January's credit growth from December, it is premature to update Chinese stocks (on- and off-shore) to overweight relative to global equities. Bottom Line: Approximately RMB35 trillion in newly increased credit this year will probably be needed to revive China’s domestic demand.  Any stimulus short of this goal would mean that investors should not increase their cyclical asset allocation of Chinese stocks in a global portfolio. Feature January’s credit data for China exceeded the market consensus. The aggregate total social financing (TSF) more than doubled in the first month of 2022 from December last year. However, on a year-over-year basis, the increase in January’s TSF was smaller than in previous easing cycles, such as in 2013, 2016 and 2019. Furthermore, underlying data in the TSF reflects a prolonged weak demand for bank loans from both the corporate and household sectors. While January’s uptick in credit expansion makes us slightly more optimistic about China’s policy support, economic recovery and equity performance in the next 6 to 12 months, we are not yet ready to upgrade our view. An estimated RMB35 trillion in newly increased credit this year will likely be necessary to revive flagging domestic demand. In the absence of seasonally adjusted TSF data in China, our framework will help investors determine whether incoming stimulus is on course to meet this objective. Interpreting January’s Credit Numbers Chart 1A Sharp Increase In Credit Creation In January A Sharp Increase In Credit Creation In January A Sharp Increase In Credit Creation In January January’s credit creation beat the market consensus to reach RMB6.17 trillion, pushed up by a seasonal boost and a frontloading of government bond issuance (Chart 1). However, the composition of the TSF data reflects an extended weakness in business and consumer credit demand. On the plus side, net government bond financing, including local government special purpose bonds, rose to RMB603 billion last month, more than twice the amount from January 2021 (Chart 1, bottom panel). Corporate bond issuance also picked up, reflecting cheaper market rates and more accommodative liquidity conditions (Chart 2). Furthermore, shadow credit (including trust loans, entrust loans and bank acceptance bills) also ticked up in January compared with a year ago. The increase in informal lending sends a tentative signal that policymakers may be willing to ease the regulatory pressure on shadow bank activities (Chart 3). Chart 2Corporate Financing Through Bond Issuance Also Increased Corporate Financing Through Bond Issuance Also Increased Corporate Financing Through Bond Issuance Also Increased Chart 3Shadow Banking Activity Ticked Up For The First Time In A Year Shadow Banking Activity Ticked Up For The First Time In A Year Shadow Banking Activity Ticked Up For The First Time In A Year Meanwhile, several factors suggest that the surge in January’s credit expansion may be less than what it appears to be at first glance. First, credit growth is always abnormally strong in January. Banks typically increase lending at the beginning of a year, seeking to expand their assets rapidly before administrative credit quotas kick in. In recent years loans made during the first month of a year accounted for about 17% - 20% of total bank credit generated for an entire year. Secondly, the credit flow in January, although higher than in January 2021, was weaker than in the first month of previous easing cycles. Credit impulse – measured by the 12-month change in TSF as a percentage of nominal GDP – only inched up by 0.6 percentage points of GDP in January this year from December, much weaker than that during the first month in previous easing cycles (Chart 4). TSF increased by RMB980 billion from January 2021, lower than the RMB1.5 trillion year-on-year jump in 2019 and the RMB1.4 trillion boost in 2016 (Chart 4, bottom panel). Chart 4The Magnitude Of Increase In January’s Credit Impulse Less Than Meets The Eye Takeaways From January’s Credit Data Takeaways From January’s Credit Data Chart 5Corporate Demand For Bank Credit Remains Soft Corporate Demand For Bank Credit Remains Soft Corporate Demand For Bank Credit Remains Soft Furthermore, China’s households and private businesses have significantly lagged in their responses to recent policy easing measures and their demand for credit remained soft in January (Chart 5). Bank credit in both short and longer terms to households were lower than a year earlier due to downbeat consumer sentiment (Chart 6A and 6B). Chart 6AConsumption Was Unseasonably Weak During Chinese New Year Consumption Was Unseasonably Weak During Chinese New Year Consumption Was Unseasonably Weak During Chinese New Year Chart 6BHouseholds' Propensity To Consume Continues Trending Down Households' Propensity To Consume Continues Trending Down Households' Propensity To Consume Continues Trending Down How Much Stimulus Is Necessary? Our calculation suggests that China will probably need to create approximately RMB35 trillion in new credit, or 29% of GDP in credit impulse, over the course of this year to avoid a contraction in corporate earnings. In our previous reports, we argued that the state of the economy today is in a slightly better shape than the deep deflationary period in 2014/15, but the magnitude of the property market contraction is comparable to that seven years ago. Chart 7 illustrates our approach, which uses a model of Chinese investable earnings growth. The model is designed to predict the likelihood of a serious contraction in investable earnings in the coming 12 months. It includes variables on credit, manufacturing new orders and forward earnings momentum. The chart shows that the flow of TSF as a share of GDP needs to reach a minimum of 28.5% in order that the probability of a major earnings contraction falls below 50%. The size of the credit impulse necessary is 2 percentage points higher than that achieved last year, but still lower than the scope of the stimulus rolled out in 2016. Assuming an 8% growth rate in nominal GDP in 2022, the credit flow that should to be originated this year would be about RMB35 trillion, as illustrated in Chart 8. The chart also shows that this amount would exceed a previous high in credit flow reached in late-2020. Chart 7China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession Chart 8China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 Based on a 3-month annualized rate of change, January’s credit growth appears that it will achieve the RMB35 trillion mark. However, the jump in TSF largely reflects a one-month leap in frontloaded local government bond issuance and it is not certain if private credit will accelerate in the months ahead. For now, we contend the stimulus have been insufficiently provided during the past six months (Chart 8, bottom panel). Chance Of A Stimulus Overshoot? We will closely monitor whether the month-to-month pace of credit growth is consistent with the scope of the reflationary policy response required to revive China’s domestic demand. Despite a sharp improvement in January’s headline credit number, we view the policy signal from January’s credit data as neutral. China’s unique cyclical patterns and the lack of official seasonally adjusted data make monthly credit figures difficult to interpret. Charts 9 and 10 represent an approach that we previously introduced to help gauge whether the pace of credit creation is on track to meet the stimulus called for to stabilize the economy. Chart 9Jan Credit Growth Looked To Be Stronger Than A “Half-Strength” Credit Cycle… Takeaways From January’s Credit Data Takeaways From January’s Credit Data Chart 10…But It Is Too Early To Conclude It Is In Line With What Is Needed Takeaways From January’s Credit Data Takeaways From January’s Credit Data The charts show an average cumulative amount of TSF as the year advances, along with a ±0.5 standard deviation, based on data from 2010 to 2021. The thick black line in both charts shows the progress in new credit creation this year, assuming an 8% annual nominal GDP growth rate. Chart 9 shows the cumulative progress in credit, assuming a 27% new credit-to-GDP ratio for the year, whereas Chart 10 assumes 30%. The 27% ratio scenario shown in Chart 9, which is slightly higher than the magnitude of stimulus in 2019, would correspond to a very measured credit expansion. If the thick black line continues to trend within this range, it would suggest that policymakers are reluctant to allow credit growth to surge. Consequently, global investors should continue an underweight stance on Chinese stocks. In contrast, Chart 10 represents a 30% rate of TSF as a share of this year’s GDP; this would be the adequate stimulus needed for a recovery in domestic demand. A cumulative amount of TSF that trends within or above this range would provide more confidence that a credit overshoot similar to 2015/16 and 2020 would occur.   Investment Conclusions It is premature to upgrade Chinese stocks to an overweight cyclical stance (i.e. over 6-12 months) within a global portfolio. For now, we recommend investors stay only tactically overweight in Chinese investable equities versus the global benchmark, given their cheap relative valuations. Meanwhile, the increase in January’s TSF, while registering an improvement relative to previous months, does not signal that the pace of credit growth will be strong enough to overcome the negative ramifications of the ongoing deceleration in housing market activity. Therefore, in view of policymakers’ steadfast desire to avoid another major credit overshoot, our cyclical recommendation to underweight Chinese stocks remains unchanged.   Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (February 15 at 10:00 AM EST, 15:00 PM GMT, 16:00 PM CET). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Best regards, Ryan Swift, US Bond Strategist

Executive Summary Brazil: Are Political & Macro Risks Priced-In? Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Presidential elections are due in Brazil on October 2, 2022. While the left-of-center former President Lula da Silva will likely win, the road to his victory will not be as smooth as markets expect. Incumbent President Jair Bolsonaro will make every effort to cling to power, including fiscal populism and attacks on Brazil’s institutions. These moves may roil Brazil’s equity markets as they may provide a fillip to Bolsonaro’s popularity. Bolsonaro’s institutional attacks have triggered down moves in the market before and any fiscal expansion may worry investors as it could prove to be sticky. We urge investors to take-on only selective tactical exposure in Brazil. Equities appear cheap but political and macro risks abound. To play the rally yet stave-off political risk in Brazil, we suggest a tactical pair trade: Long Brazil Financials / Short India. Tactical Recommendation Inception Date Long Brazil Financials / Short India 2022-02-10   Bottom Line: On a tactical timeframe we suggest only selective exposure to Brazil given the latent political and macro risks. On a strategic timeframe, we are neutral on Brazil given that its growth potential coexists with high debt and low proclivity to structural reform. Feature Chart 1Brazil Underperformed Through 2020-21, Is Cheap Today Brazil Underperformed Through 2020-21, Is Cheap Today Brazil Underperformed Through 2020-21, Is Cheap Today Brazil’s equity markets underperformed relative to emerging markets (EMs) for a second consecutive year in 2021 (Chart 1). But thanks to this correction, Brazilian equities now appear cheap (Chart 1). With Brazil looking cheap, China easing policy, and Lula’s return likely, is now a good time to buy into Brazil? We recommend taking on only selective exposure to Brazil on a tactical horizon for now. Brazil in our view may present a near-term value trap as markets are under-pricing political and economic risks. Lula Set For Phoenix-Like Return Luiz Inácio Lula da Silva (or popularly Lula) of the Worker’s Party (PT) appears all set to reclaim the country’s presidency in the fall of 2022. The main risk that Lula’s presidency may bring is a degree of fiscal expansion. Despite this markets may ultimately welcome his victory at the presidential elections as Lula is in alignment with the median voter, is expected to be better for Brazil’s institutions, will institute a superior pandemic-control strategy, and may also undertake badly needed structural reforms in the early part of his tenure. Despite these points we urge investors to limit exposure to Brazil for now and turn bullish only once the market corrects further. Whilst far-right President Jair Bolsonaro managed to join a political party (i.e., the center-right Liberal Party) late last year, he is yet to secure something more central to winning elections i.e., a high degree of popularity. To boost his low popularity ratings (Chart 2), we expect Bolsonaro to leverage two planks: populism and authoritarianism. These measures will bump up Bolsonaro’s popularity enough to shake up Brazil’s markets with renewed uncertainty, but not enough to win him the presidency. Chart 2Lula Is Ahead But His Lead Has Narrowed Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Lula is a clear favorite to win. After spending more than a year in jail on corruption charges, Lula is back in the fray and has maintained a lead on Bolsonaro for the first round of polling (Chart 2). Even if a second-round run-off election were to take place, Lula would prevail over Bolsonaro or other key candidates (Chart 3). By contrast, Bolsonaro’s lower popularity means that in a run-off situation he stands a chance only if pitted against center-right candidates like Sergio Moro (his former justice minister) or João Doria (i.e., the center-right Governor of São Paulo) (Chart 4). Chart 3Lula Leads Run-Off Vote Against All Potential Candidates Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 4In A Run-Off, Bolso Stands Best Chance Of Winning If Pitted Against Moro Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ What has driven the swing to the left in Brazil? After the pandemic and some stagflation, Brazil’s median voter’s priorities have changed. In specific: Brazil’s median voter’s top concerns in 2018 were centered around improving law and order (Chart 5). A right-of-center candidate with concrete law-and-order credentials like Bolsonaro was well placed to tap into this public demand. Chart 5In 2018-19, Law And Order Issues Dominated Voters’ Concerns Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Now, however, Brazil’s voters’ top concerns are focused around improving the economy and controlling the pandemic, where Bolsonaro’s record is dismal (Chart 6). Given this change of priorities, a left-of-center candidate with a solid economic record like Lula is best placed to address voters’ concerns. Lula had the fortune to preside over a global commodity bull market and Brazilian economic boom in the early 2000s (Chart 7). Regarding pandemic control, almost any challenger would be better positioned than Bolsonaro, who initially dismissed Covid-19 as “a little flu” and lacked the will or ability to set up a stable public health policy. Chart 6In 2022, Median Voter Cares Most About Economic Issues, Pandemic-Control Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 7Lula’s Presidency Overlapped With An Economic Boom Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ A left-of-center candidate like Lula, or even Ciro Gomes (Chart 8), is more in step with the median voter today for two key reasons: Inflation Surge, Few Jobs: Inflation has surged, and the increase is higher than that seen under the previous President Michael Temer (Chart 7). Transportation, food, and housing costs have all taken a toll on voter’s pocketbooks (Chart 9). The cost of electricity has also shot up. For 46% of Brazilian families, expenditure on power and natural gas is eating into more than half of their monthly income, according to Ipec. Chart 8Left-Of-Center Candidates Stand A Better Chance In Brazil In 2022 Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 9Under Bolso Inflation Has Surged Across Key Categories Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​ Distinct from inflation, unemployment too has been high under Bolsonaro (Chart 10). Chart 10Unemployment Too Has Surged Under Bolsonaro Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 11Brazil’s Per Capita Income Growth Has Lagged That Of Peers Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 12Since 2018, Brazil's Economic Miseries Have Grown More Than Those Of Peers Since 2018, Brazil's Economic Miseries Have Grown More Than Those Of Peers Since 2018, Brazil's Economic Miseries Have Grown More Than Those Of Peers Stagnant Incomes: Despite a strong post-pandemic fiscal stimulus, GDP growth in Brazil has been low (Chart 7). In a country that is structurally plagued with high inequalities, the slow growth in Brazil’s per capita income (Chart 11) under a right-wing administration is bound to trigger a leftward shift. It is against this backdrop of rising economic miseries (Chart 12) that Latin America’s largest economy is seeing its ideological pendulum swing leftwards. This phenomenon has played out before too - most notably when Lula first assumed power as the president of Brazil in 2002. Brazil’s GDP growth was low, inflation was high and per capita incomes had almost halved under the presidency of Fernando Henrique Cardoso (or popularly FHC) over 1995-2002. This economic backdrop played a key role in Lula’s landslide win in 2002. Brazil’s political differences are rooted in regional as well as socioeconomic disparities. In the 2018 presidential elections, left-of-center candidates like Fernando Haddad generated greatest traction in the economically backward northeastern region of Brazil. On the other hand, Bolsonaro enjoyed higher traction in the relatively well-off regions in southern and northern Brazil (Maps 1 & 2). Now Bolsonaro has faltered under the pandemic and Lula can reunite the dissatisfied parts of the electorate with his northeastern base. Map 1Brazil’s South, Mid-West And North Supported Bolso In 2018 Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Map 2Left-Of-Center 2018 Presidential Candidate Haddad Had Greatest Traction In Regions With Low Incomes Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Bottom Line: The stage appears set for Lula’s return to Brazil’s presidency. But will the road be smooth? We think not. Investors should gird for downside risks that Brazilian markets must contend with as President Bolsonaro fights back. Brace For Bolso’s Fightback The road to Bolsonaro’s likely loss will be paved with market volatility and potentially a correction. Interest rates have surged in Brazil as its central bank combats inflation (Chart 13). Even as BCB’s actions will lend some stability to the Brazilian Real (Chart 13), political events over the course of 2022 will spook foreign investors. Bolsonaro will leverage two planks in a desperate attempt to retain control: Plank #1: Populism Brazil’s financial markets experienced a major correction in the second half of 2021. This was partially driven by the fact that Brazilian legislators approved a rule that allows the government to breach its federal spending cap. Given Bolsonaro’s low popularity ratings today and given that his fiscal stance has been restrained off late, Bolsonaro could well drive another bout of fiscal expansion in the run up to October 2022. Such a move will bump up his popularity but at the same time worry markets given Brazil’s elevated debt levels (Chart 14). Bolsonaro can technically pass these changes in the Brazilian national assembly given that in both houses the government along with the confidence and supply parties has more than 50% of seats. Chart 13Brazil’s Central Bank Has Hiked Rates Aggressively Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 14Brazil Is One Of The Most Indebted Emerging Markets Today Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Plank #2: Institutional Attacks To rally his supporters, the former army captain could also sow seeds of doubt in Brazil’s judiciary and electoral process. Given the strong support that Bolsonaro enjoys amongst conservatives, he may even mobilize supporters to stage acts of political violence in the run up to the elections. Bolsonaro could make more dramatic attempts to stay in power than former US President Trump, whose rebellion on Capitol Hill did not go as far as it could have gone to attempt to seize power for the outgoing president. Last but not the least, there is a possibility that the Brazilian judiciary presents an unexpected roadblock to Lula’s candidacy. Given the unpredictable path of Brazil’s judicial decisions, investors should be prepared for at least some kind of official impediments to Lula’s rise. Even if Lula is ultimately allowed to run, any ruling that casts doubt on his candidacy or corruption-related track record will upset financial markets. Global financial markets rallied through the Trump rebellion on January 6 last year. But US institutions, however flawed, are more stable than Brazil’s. Brazil only emerged from military dictatorship in 1985. Bolsonaro has fired up elements of the populace that are nostalgic for that period, as we discuss below. Bottom Line: Brazil’s equities look cheap today, but political risks have not fully run their course. President Bolsonaro may launch his fightback soon, which could drive another down-leg in Brazil’s markets. His institutional attacks have triggered down moves before and any potential fiscal expansion that Bolsonaro pursues may worry investors, as this expansion could stick under the subsequent administration. In addition, there is a chance that civil-military relations undergo high strain in the run-up to or immediately after Brazil’s elections. Is A Self-Coup By Bolso Possible? “One uncomfortable fact of the dictatorship is that its most brutal period of repression overlapped with what Milton Friedman called an economic miracle.… Brazil’s economy, nineteenth largest in the world before the coup, grew into the eighth largest. Jobs abounded and the regime then was actually popular.” – Alex Cuadros, Brazillionaires: Wealth, Power, Decadence, and Hope in an American Country (Spiegel & Grau, 2016) It is extremely difficult for President Bolsonaro to win the support of a majority of the electorate. But given his open admiration for Brazil’s dictatorship, is a self-coup possible in 2022? The next nine months will be tumultuous. A coup attempt could occur. However, we allocate a low probability to a successful self-coup because: Bolsonaro’s Popularity Is Too Low: Even dictators need to have some popular appeal. Bolsonaro has lost too much support (Chart 15), he never had full control of any major institutions (including the military), and few institutional players will risk their credibility for his sake. If he somehow clung to power, his subsequent administration would face overwhelming popular resistance. Chart 15Bolsonaro’s Low Approval Ratings - A Liability Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Bolsonaro’s Economy Is Too Weak: The dictatorship in Brazil managed to hold power for more than two decades partially because this period of authoritarianism was accompanied by a degree of economic well-being. Currently the public is shifting to the left because low growth and high inflation have dented the median voter’s purchasing power. The weak economy would make an authoritarian government unsustainable from the start. Lack Of American Support: Some military personnel may be supportive of a coup and several retired military officers are occupying civilian positions in the Brazilian federal government, thanks to Bolsonaro. So why can’t Brazil slip right back into a military dictatorship led by Bolsonaro, say if the election results are narrow and hotly contested? The coup d'état in Brazil in 1964 was a success to a large extent because this regime-change was supported by America. Back then communism was a threat to the US and Washington was keen to displace left-leaning heads of states in Latin America, such as Brazilian President João Goulart. But America’s strategic concerns have now changed. America today is attempting to coalesce an axis of democracies and the Biden administration has no incentive whatsoever to muddy its credentials by supporting dictatorship in Latin America’s largest country. Even aside from ideology, any such action would encourage fearful governments in the region to seek support from America’s foreign rivals, thus inviting the kind of foreign intervention that the US most wants to prevent in Latin America. The Brazilian Military Has Not Been Suppressed Or Sidelined: History suggests that coups are often triggered by a drop in the military’s importance in a country. However, the military’s power in Brazil has remained meaningful through the twenty-first century. Brazil has maintained steady military spends at around 1.5% of GDP over the last two decades. Thus, top leaders of Brazil’s military have no reason to feel aggrieved or disempowered. Having said that, it is not impossible that an extreme faction of junior officers might try to pull off a fantastical plot, even if they have little hope of succeeding, which is why we highlight that markets can be rudely awakened by the road to Brazil’s election this year. In Turkey in July 2016, an unsuccessful coup attempt caused Turkish equities to decline by 9% over a four-day period. Bottom Line: Investors must gird for the very real possibility of civil-military relations undergoing high degrees of strain in Brazil, particularly if a contested election occurs. While Bolsonaro’s supporters and disaffected elements of the Brazilian military could resist a smooth transition of power away from Bolsonaro, the transition will eventually take place because two powerful constituencies – Brazil’s median voter and America – will not support a coup in Brazil. Will Lula Be Good For Brazil’s Markets? Looking over Bolsonaro’s presidency, from a market-perspective, some policy measures were good, some were bad, and some were downright ugly. In specific: The Good: Pension Reforms And Independent Monetary Policy In Bolsonaro’s first year in power, he delivered pension sector reforms. The law increased the minimum retirement age and also increased workers’ pension contributions thereby resulting in meaningful fiscal savings. Bolsonaro passed a law to formalise the BCB’s autonomy and the BCB has been able to pursue a relatively independent monetary policy. BCB has now lifted the benchmark Selic rate by 725bps over 2021 thereby making it one of the most hawkish central banks amongst EMs (Chart 13). This is in sharp contrast to the situation in EMs like Turkey where the central bank cut rates owing to the influence of a populist head of state. The Bad: Poor Free Market Credentials And Fiscal Expansion In early 2021, President Bolsonaro fired the head of Petrobras (the state-owned energy champion) reportedly for raising fuel prices. Bolsonaro then picked a former army general (with no relevant work experience) to head the company. Although Bolsonaro positioned himself as a supporter of privatization in the run up to his presidency, he failed to follow through. Another area where the far-right leader has disappointed markets is with respect to Brazil’s debt levels. Under his presidency, a constitutional amendment to raise a key government spending cap was passed. Shortly afterwards came the creation of the massive welfare program Auxílio Brasil. Bolsonaro embraced fiscal populism to try to save his presidency after the pandemic. Consequently Brazil’s public debt to GDP ratio ballooned from 86% in 2018 to a peak of 99% in 2020. The Ugly: Poor Pandemic Response And Institutional Attacks The darkest hour of Bolsonaro’s presidency came on September 7, 2021, i.e., Brazil’s Independence Day. During rallies with his supporters, Bolsonaro levelled attacks on the Brazilian judiciary and sowed seeds of doubt in Brazil’s electoral process. More concretely, the greatest failing of the Bolsonaro administration has been its lax response to the pandemic. Bolsonaro delayed preventive measures, and this has meant that Brazil was one of the worst hit major economies of the world. The pandemic has claimed more than 630,000 lives in Brazil i.e., the second highest in the world. In relative terms too, Brazil has experienced a high death rate of about 2,960 per million which is even higher than the US rate of 2,720 per million. President Bolsonaro’s poor handling of the pandemic will cost the President in terms of votes in 2022 as the highest Covid-19-related death rates were seen in Southern Brazil (Map 3) i.e., a region that had voted in large numbers for Bolsonaro in 2018 (see Map 1 above). Map 3The Pandemic Has Had A Devastating Impact In Brazil’s South, Mid-West And North Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Given this backdrop, a Lula presidency will be welcomed by global financial markets, potentially for three reasons: Superior Pandemic-Control: An administration headed by Lula will bring in a more scientific and cohesive pandemic-control strategy thereby saving lives and benefiting the economy. Alignment With Institutions: Lula will act in alignment with Brazil’s institutions. He stands to benefit from the existing electoral system, the civil bureaucracy, academia, and the media. He may have rougher relations with the judiciary and parts of the military, but he is a known quantity and not likely to attempt to be a Hugo Chavez. Possibility Of Some Structural Reform: Given Brazil’s unstable debt dynamics, and the “lost decade” of economic malaise in the 2010s, there is a chance that Lula could pursue some structural reforms. Lula is more popular than his Worker’s Party, which is still tainted by corruption, so his strength in Congress will not be known until after the election. But Brazilian parties tend to coalesce around the president and Lula has experience in managing the legislative process. The probability of Lula pushing through some bit of structural reform will be the greatest in 2021. Back in 2019, it is worth recounting that only 4% of the Brazilian public supported pension reforms. Despite this Bolsonaro managed the passage of painful pension reforms in 2019 because market pressure forced the parties to cooperate. Faced with inflation and low growth, Lula may be forced to push through some piecemeal structural financial sector and economic reforms. However, if commodity prices and financial markets are cheering his election, he may spend his initial political capital on policies closer to his base of support, which means that a market riot may be necessary to force action on structural reforms. This dynamic will have to be monitored in the aftermath of the election. Assuming Lula does pursue some structural reforms while he has the political capital, and therefore that his first year is positive for financial markets, there is a reason to be positive on Brazil selectively on a tactical basis. However, electoral compulsions could cause Lula to pursue left-wing populism, fiscal expansion, and to resist privatization over the remaining three years of his presidency. Given Brazil’s already elevated debt levels (Chart 14), such a policy tilt would be market negative. It is against this backdrop that we expect a pro-Lula market rally to falter after the initial excitement. Bottom Line: Once the power transition is complete, a relief rally may follow as markets factor in the prospects of institutional stability and possibly a dash of structural reform in the first year of Lula’s presidency. But given Brazil’s elevated inequalities, even a pro-Lula rally will eventually fade as the administration will be constrained to switch back to the old ways and pursue an expansionary fiscal policy when elections loom. Investment Conclusions Brazil Presents A Value Trap, Fraught with Politico-Economic Risks From a strategic perspective, we are neutral on Brazil. A decade of bad news has been priced in but there is not yet a clear and sustainable trajectory to improve the country’s productivity. History suggests that both left-wing and right-wing presidents are often forced to backtrack on structural reforms and resort to cash-handouts in the run up to elections. This tends to add to Brazil’s high debt levels, prevents the domestic growth engine from revving up, and adds to inflation. Low growth and high inflation then set the wheels rolling for another bout of fiscal expansion (Chart 16). Chart 16The Vicious Politico-Economic Cycle That Brazil Is Trapped In Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Exceptions to this politico-economic cycle occur when a commodity boom is underway or if China, which is Brazil’s key client state, is booming. China today buys a third of Brazil’s exports (Chart 17) and is Brazil’s largest export market. The other reason we remain circumspect about Brazil’s strategic prospects is because of the secular slowdown underway in China. China is not in a position today to recreate the commodity and trade boom that buoyed Lula during his first presidency. China’s policy easing is a tactical boon at best, which can coincide with a Lula relief rally, but afterwards investors will be left with Chinese deleveraging and Brazilian populism. Political Risks Are High, Selective Tactical Exposure Brazil Will Be Optimal We urge investors to buy into Brazilian assets only selectively, even as Brazilian equities appear cheap (Chart 18). Political risks and economic risks such as low growth in GDP and earnings (Chart 19) could contribute to another correction and/or volatility in Brazilian equities. Chart 17China Buys A Third Of Brazil’s Exports Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​ ​​​​​Chart 18Brazil: Are Political & Macro Risks Priced-In? Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Chart 19Brazil's EPS Growth Tracks China's Total Social Financing Growth With A Lag Brazil's EPS Growth Tracks China's Total Social Financing Growth With A Lag Brazil's EPS Growth Tracks China's Total Social Financing Growth With A Lag China’s policy easing is an important macro factor playing to Brazil’s benefit. As we highlighted in our “China Geopolitical Outlook 2022,” Beijing is focused on ensuring stability over the next 12 months. But history suggests that Brazil’s corporate earnings respond to a pick-up in China’s total social financing with a lag of more than six months (Chart 19). Thus, even from a purely macro perspective it may make sense to turn bullish on Brazil after the election turmoil concludes. Given that politically sensitive sectors account for an unusually high proportion of Brazil’s market capitalization (Chart 18), and given the political risks in the offing for Brazil, we suggest taking-on selective exposure in Brazil. To play the rally yet mitigate political risks (that can be higher for capital-heavy sectors), we suggest a pair trade: Long Brazil Financials / Short India. We remain positive on India on a strategic horizon. However, in view of India approaching the business-end of its five-year election cycle, when policy risks tend to become elevated, we reiterate our tactical sell on India. India currently trades at a 81% premium to MSCI EM on a forward P-E ratio basis versus its two year average of 56%. A Quick Note On The Nascent EM Rally Investors should gradually look more favorably on emerging markets, but tactical caution is warranted. MSCI EM and MSCI World are down YTD 1.1% and 4.6% respectively. Despite the dip, we are not yet turning bullish on EM as a whole, owing to both geopolitical and macroeconomic factors. Global geopolitical risks in the new year are high. We recently upgraded the odds of Russia re-invading Ukraine from 50% to 75%. Besides EM Europe, we also see high and underrated geopolitical risks in the Middle East in the short run. Both the Russia and Iran conflicts raise a non-negligible risk of energy shocks that undermine global growth. Once these hurdles are cleared, we will turn more positive toward risky assets. Macroeconomically, the current EM rally can be sustained only if China delivers a substantial stimulus, and the US dollar continues to weaken. The former is likely, as we have argued, but the dollar looks to be resilient and it will take several months before China’s credit impulse rebounds. Hence conditions for a sustainable EM rally do not yet exist. Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Executive Summary Rising TIPS Yields = Equity Multiples Compression Rising TIPS Yields = Equity Multiples Compression Rising TIPS Yields = Equity Multiples Compression Equity sector and style rotations could prevent the broad equity indexes from plunging, but these rotations will not be sufficient to propel the overall stock indexes to new highs. Rising US bond yields remain the key risk to US growth stocks in both absolute and relative terms. As US growth stocks drift lower in absolute terms, the S&P 500 will stay in a trading range but is unlikely to make new highs. Equity leadership rotations typically occur during or after bear markets and/or major corrections in global share prices. Hence, a major selloff in global stocks is likely before EM, commodities, global cyclicals and value stocks move toward a period of secular outperformance (i.e., a multi-year bull market in absolute and relative terms). Recommendation   Inception Date Return Underweight EM Relative To DM Stocks (In Common Currency) 2021-03-25 15.8% Bottom Line: Continue underweighting EM in a global equity portfolio. Cyclically, continue favoring value versus growth stocks. Feature We expect US bond yields to continue to rise, and global growth stocks to continue to underperform global value stocks in the months ahead. This prompts the question: What does this scenario mean for overall global share prices, EM markets, and EM relative equity performance? Equity Rotation And Overall Market Performance Can the S&P 500 or global equity index advance in absolute terms when US and global growth stocks sell off in absolute terms? Our hunch is as follows: As US growth stocks drift lower, the S&P 500 will stay in a trading range, but is unlikely to make new highs. A review of past episodes of sector and style rotation is in order. We recall two episodes of major rotation: 1. The closest historical comparison is in the year 2000. The top panel of Chart 1 illustrates US value stocks were resilient even after the Nasdaq bubble started bursting in March 2000. Besides, the S&P 500 index held up well in the first half of that year even though Nasdaq stocks were plummeting (Chart 1, bottom panel). Nevertheless, despite the rotation, value/old economy stocks failed to break out of their previous highs (Chart 1, top panel). We would expect a similar pattern to emerge in the current cycle as the Nasdaq index wobbles. Despite the Nasdaq selloff, oil prices continued to rise until October 2000, and the US median stock had a bumpy ride but made a new high in early 2002 (Chart 2). Chart 1US Equity Rotation In 2000 US Equity Rotation In 2000 US Equity Rotation In 2000 Chart 2Rotation In 2000: The Nasdaq, Oil And The Median Stock Rotation In 2000: The Nasdaq, Oil And The Median Stock Rotation In 2000: The Nasdaq, Oil And The Median Stock   Overall, as rising US interest rates weigh on growth stocks, the rest of the market can stay in a trading range. Segments with very good fundamentals and cheap valuations could even make new marginal highs. Nevertheless, given the sheer weight of growth stocks in the broad US equity index, it will be hard for the S&P 500 to make new highs when growth stocks wobble. However, a key difference between now and the 2000-2002 market is that back then, US bond yields were falling. Thus, the bear market in the US equity market in general and Nasdaq stocks in particular, occurred alongside falling US bond yields (Chart 3). Currently, the Fed is in a tightening mode and US bond yields are climbing. A rising discount factor is negative for all stocks (Chart 4): It is more negative for high-multiples stocks and less negative for low multiples companies. Chart 3The Nasdaq Bubble Burst Despite Falling Interest Rates The Nasdaq Bubble Burst Despite Falling Interest Rates The Nasdaq Bubble Burst Despite Falling Interest Rates Chart 4Rising TIPS Yields = Equity Multiples Compression Rising TIPS Yields = Equity Multiples Compression Rising TIPS Yields = Equity Multiples Compression   Another interesting observation about the 2000-2002 bear market is that it occurred despite resilient US consumer spending, and a very robust housing market and credit growth (Chart 5, top two panels). Remarkably, corporate profits collapsed by about 60% even though real GDP barely contracted at all (Chart 5, bottom two panel). We do not predict a similar equity bust this time around. Instead, we are highlighting that US equity valuations and corporate profits can shrink even if US consumer spending does not contract. What happens to costs, profit margins, inflation and interest rates are as important as the consumer spending outlook. To sum up, when the Nasdaq’s bubble began bursting in March of 2000, investors rotated into old economy stocks and the S&P 500 held up well until July of that year. From July onward, the selloff broadened, and the overall US equity indexes entered a bear market. The latter lasted until March 2003. 2. Another episode of extended market rotation occurred in the lead up to and during the 2008 bear market. The US financial/credit crisis in 2007-08 commenced with the selloff in sub-prime securities in March 2007. Corporate spreads began widening, and bank share prices rolled over in June 2007. Next, the S&P 500 and EM stocks peaked in October 2007 (Chart 6). Despite these developments, commodity prices and EM currencies continued to rally until the summer of 2008 when they finally collapsed in the second half of that year (Chart 6, bottom panel). Chart 5US Profits Recession In 2001 Occurred Despite No Economic Recession US Profits Recession In 2001 Occurred Despite No Economic Recession US Profits Recession In 2001 Occurred Despite No Economic Recession Chart 6Domino Effect In 2007-08 Domino Effect in 2007-08 Domino Effect in 2007-08 Clearly, what was initially a rotation out of US cyclicals and financials into commodities and EM eventually proved to be nothing more than part of a domino effect. Again, we are not making the case that the US economy and financial markets are headed into a financial crisis. Our point here is that rotations do occur and can last for a while. Yet, a sustainable bull market in aggregate equity indexes does not emerge until there is a broad-based selloff during which the majority of sectors and bourses drop in absolute terms. Bottom Line: Rotation episodes can last several months. Equity sector and style rotations could prevent the broad equity indexes from plunging but these rotations will not be sufficient to propel the overall stock indexes to new highs. Equity Leadership Changes Occur Around Major Selloffs Having examined these rotation episodes, we can now take a step back and see the big picture: equity leadership rotations typically occur during or after bear markets and/or major corrections in global share prices. Chart 7 illustrates EM relative stock prices versus DM along with the global equity index. Over the past 25 years, there have been several major leadership changes between EM and DM, and all of them coincided with, or were preceded by, either a bear market or a substantial drawdown in global share prices. Chart 7EM Versus DM: Equity Rotations EM Versus DM: Equity Rotations EM Versus DM: Equity Rotations EM Versus DM: Equity Rotations EM Versus DM: Equity Rotations Similarly, the relative performance of global growth versus value stocks often experiences trend reversals during or after selloffs (Chart 8). Chart 8Global Growth Versus Value: Leadership Rotations Global Growth Versus Value: Leadership Rotations Global Growth Versus Value: Leadership Rotations Global Growth Versus Value: Leadership Rotations Global Growth Versus Value: Leadership Rotations Finally, secular trend changes in the relative performance of the global tech sector, energy stocks and materials have also occurred during or after drawdowns in global share prices (Chart 9). Chart 9Global Technology, Energy And Materials: Leadership Rotations Global Technology, Energy And Materials: Leadership Rotations Global Technology, Energy And Materials: Leadership Rotations Global Technology, Energy And Materials: Leadership Rotations Global Technology, Energy And Materials: Leadership Rotations A word on commodity prices is warranted. We are surprised that industrial metal prices have so far held up well and oil prices have been surging despite China’s slowdown. The culprits behind the rally in resource prices are strong DM demand for commodities and investor purchases of commodities as an inflation hedge. Therefore, it might take investor concerns about US demand and/or a slowdown in global manufacturing to trigger a relapse in commodity prices. Rising US interest rates and a continued US dollar rally will eventually lead to a meaningful drawdown in commodity prices. Yet, the precise timing of this shift is uncertain. Critically, among financial markets, oil prices are often the last to fall and/or rally. Hence, investors should not use oil as a leading indicator for other markets. As to share prices of commodity producers, global materials have rolled over at their previous high (Chart 10, top panel), while energy stocks have surged through multiple technical resistances. However, they now face another technical hurdle (Chart 10, bottom panel). If oil share prices decisively break above this long-term moving average, it would likely signal that they have entered a multi-year bull market. Chart 10Global Energy Stocks And Materials: A Long-Term Profile Global Energy Stocks And Materials: A Long-Term Profile Global Energy Stocks And Materials: A Long-Term Profile Bottom Line: Major equity leadership rotations normally occur around bear markets or major corrections. Hence, a major selloff in global stocks is likely before EM, commodities, global cyclicals and value stocks move toward a period of secular outperformance (i.e., a multi-year bull market in absolute and relative terms). Investment Considerations Chart 11EM And US Stocks Relative To The Global Benchmark: No Change In Trend EM And US Stocks Relative To The Global Benchmark: No Change In Trend EM And US Stocks Relative To The Global Benchmark: No Change In Trend We will contemplate upgrading EM if a broad selloff transpires. In such an equity drawdown, there is a 50% chance that EM may outperform the S&P 500 if the selloff is led by growth stocks, as occurred during the carnage in global stocks in January this year or in the fourth quarter of 2018 (Chart 11, top panel). Yet, the EM overall equity index will underperform Europe and Japan in such a broad-based drawdown. A weaker dollar is essential for EM outperformance. For now, we remain positive on the dollar for the next several months and are hence underweight EM stocks and credit markets versus their DM peers. As to US stocks, the jury is still out on whether their secular outperformance is over. Notably, US share prices relative to the global equity index have rebounded from their 200-day moving average (Chart 11, bottom panel). When such a technical pattern occurs, odds are high that US stocks will make new highs in relative terms. US equities outperforming the rest of the world is not consistent with growth stocks underperforming value ones. Hence, a potential US outperformance represents a risk to our core view that growth stocks will continue underperforming value stocks. How do we reconcile these inconsistencies? It might be that US growth stocks’ recent rebound persists for the next several weeks and they outperform value stocks during this window. In such a case, our equity leadership rotation theme will be delayed. Yet, in this scenario EM stocks will continue underperforming DM ones. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations