Energy

Listen to a short summary of this report.     Dear Client, In lieu of our weekly report next week, I will be hosting a webcast on Tuesday with my colleague Mathieu Savary, Chief European Strategist, on the implications of stagflation on European assets and global FX markets. I look forward to answering any questions you might have. Kind regards, Chester Executive Summary The Yen And Interest Rates The Yen And Interest Rates The Yen And Interest Rates The Japanese yen is in liquidation. The historical evidence suggests waiting for an exhaustion in selling pressure, before placing fresh bets. This exhaustion is likely to occur once global bond yields stabilize (Feature chart), and energy price inflation abates. A move lower in these two key variables would catalyze an explosive rebound in the yen, on the back of very cheap valuations and a large net short speculative position. The Bank of Japan will not meaningfully pivot soon. The reason is that downside risks to the Japanese economy supersede the risk of an inflation overshoot. What Japan needs is stronger fiscal spending, that would offset deficient domestic demand. That said, Japan is also one of the best candidates for generating non-inflationary growth, a bullish backdrop for the currency. Our 2022 target for the yen is 110. Our sense is that most of the downside risks are well understood by markets, while upside surprises are much underappreciated. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short chf/JPY 135 2022-04-21 - Bottom Line: The yen has undershot. According to our in-house PPP models, the Japanese currency is undervalued by 35%. Historically, an investor buying the yen at such undervalued levels has made 6% per year over the subsequent 5 years. Feature The yen’s move in recent weeks has been explosive. Since early March, the yen has collapsed by 11%, pushing USD/JPY from around 115 to a nudge below 130. Over the last year, the yen is down 16%. In retrospect, a chart formation since 1990 suggests this is a classic liquidation phase that is unlikely to reverse until fundamentals shift. The two key drivers of yen weakness have been higher global yields, and elevated energy prices. Chart 1 shows that the yen has been perfectly tracking the US 10-year Treasury yield. Yield curve control (YCC) is leading to a capitulation of both domestic and foreign investors, fleeing from Japanese bonds towards external bond markets. Looking out the curve, investors do not expect the Bank of Japan to lift rates higher than 50 bps until 2028 (Chart 2). Chart 1The Yen And Interest Rates The Yen And Interest Rates The Yen And Interest Rates Chart 2The BoJ Is Expected To Stay Dovish The BoJ Is Expected To Stay Dovish The BoJ Is Expected To Stay Dovish Meanwhile, higher energy costs are also putting selling pressure on the yen as merchants sell JPY to pay for more expensive imports in US dollars.    Is Selling Pressure Exhausted? Chart 3A Technical Profile Of The Japanese Yen A Technical Profile Of The Japanese Yen A Technical Profile Of The Japanese Yen The key question for investors is whether the carnage in the yen is in an apocalyptic phase. The answer depends on the time horizon. Daily traders, reconciling positions every few hours, should continue shorting the yen. Exhaustion in selling pressure is likely to manifest itself through a few technical patterns, most notably, a consolidation phase. Chart 3 suggests that reversals in the yen have tended to pass through a period of indigestion, allowing investors enough time to play on a reversal. We are not there yet.  That said, for longer-term investors, being contrarian could pay off handsomely. The 1-year drawdown in the yen is within the scope of historical capitulation phases (Chart 4). Since JPY became freely floating, selloffs have been around 15%-20% especially during major events (the Asian financial crisis or the manufacturing recession the last decade, for example). The last major selloff was around Abenomics in 2012, a pivotal event. Chart 4The Yen Drawdown Has Matched Previous Capitulation Phases The Yen Drawdown Has Matched Previous Capitulation Phases The Yen Drawdown Has Matched Previous Capitulation Phases Speculators are also very short JPY and sentiment is quite depressed. This is bullish from a contrarian perspective. Low rates in Japan have led to the proliferation of carry trades. While these are likely to persist, the bulk of investors have already jumped on this bandwagon. A stabilization and/or reversal in US Treasury yields could flush out stale shorts in the yen (Chart 5). If, as we expect, the greenback does weaken in the second half of this year, that will also support the yen. Chart 5Sentiment On The Yen Is Very Depressed Sentiment On The Yen Is Very Depressed Sentiment On The Yen Is Very Depressed Japan’s Economic Outlook The yen tends to appreciate when the Japanese economy is exiting a recession (Chart 6). Part of the reason why the yen has been so weak is because economic growth in Japan has been anemic. While the external sector has been benefiting from a global trade boom, the domestic sector has been under siege from the pandemic, until recently. Chart 6The Yen Tends To Rebound When The Japanese Economy Recovers The Yen Tends To Rebound When The Japanese Economy Recovers The Yen Tends To Rebound When The Japanese Economy Recovers It is notable that while goods spending has been picking up around the world, the personal consumption component of GDP in Japan remains 5% below the pre-pandemic trend. Shinkansen passenger volumes are still down 42% this year after an even bigger collapse last year. Inbound tourists, a meaningful source of demand, has collapsed from about 25% of the overall Japanese population before the pandemic to zero today. These dire statistics are likely to reverse. The manufacturing PMI is ticking higher. The number of daily new COVID-19 cases has dramatically rolled over. This will be a welcome fillip to much subdued consumer and business sentiment. 2% Inflation = Mission Impossible? The BoJ is likely to get its wish of 2% inflation in the coming months. However, it will prove fleeting. The overarching theme for Japan is an aging and declining population which has put a lid on consumer prices (Chart 7). This will support real interest rates. Inflation does not tend to accelerate on the island until the output gap is fully closed. That has yet to occur. Meanwhile, the political push to cut mobile phone prices has been a drag on CPI. Mobile phone charges alone have cut around 1.2%-1.5% from the core core measure of Japanese inflation, according to the BoJ. This has been a structural trend. As a result, long-term inflation expectations in Japan remain anchored near 1%, even though the rest of the world is seeing a price boom (Chart 8). The revealed preference is for low/stable prices. Chart 7Demographics Are Weighing On Japanese##br##Inflation Demographics Are Weighing On Japanese Inflation Demographics Are Weighing On Japanese Inflation Chart 8Long-Term Inflation Expectations In Japan Are Rising, But Muted Long-Term Inflation Expectations In Japan Are Rising, But Muted Long-Term Inflation Expectations In Japan Are Rising, But Muted Clearly, the Bank of Japan would like this to change, as it aims for a persistent 2% inflation target. That said, it will be unable to adjust monetary settings aggressively. The BoJ already owns over 50% of Japanese government bonds, and that has made the market very illiquid. As a result, ownership as a share of GDP is nearing attrition (Chart 9). Related Report  Foreign Exchange StrategyThe Yen In 2022 Arguably, the BoJ could widen the target band for yield curve control, while lowering short rates further below zero, but that is unlikely to do much for inflation expectations. It could also expand its 0% bank loan scheme beyond renewable industries, and/or small/medium-sized firms, but the problem in Japan is a lack of demand. The currency remains the sole policy lever for the BoJ. Unfortunately, for a small, open economy, the BoJ has less control over the currency. The Ministry of Finance last intervened to support the currency in 1998 (Chart 10). That helped the yen temporarily, but global factors dictated its longer-term trend. Intervention this time around will not assuage the whale of carry traders. Chart 9The BoJ Has Not Been Aggressively Buying Government Bonds The BoJ Has Not Been Aggressively Buying Government Bonds The BoJ Has Not Been Aggressively Buying Government Bonds Chart 10The MoF Could Soon ##br##Intervene The MoF Could Soon Intervene The MoF Could Soon Intervene A falling yen would allow some pass-through inflation, but this is unlikely to be sticky. The yen needs to fall 10% every year to generate 1% inflation in Japan (Chart 11). Meanwhile, a policy based on depreciating your currency could lead to a crisis of confidence, especially vis-à-vis Japanese trade partners. Our model for core core inflation suggests that all the weakness in the currency will only boost this print to 0.5% in the coming months (Chart 12). Chart 11Currency Weakness Will Only Temporarily Help Boost Inflation Currency Weakness Will Only Temporarily Help Boost Inflation Currency Weakness Will Only Temporarily Help Boost Inflation Chart 12Core CPI Will Not Meaningfully ##br##Recover Core CPI Will Not Meaningfully Recover Core CPI Will Not Meaningfully Recover What Japan needs is more fiscal spending. For a low-growth economy, with ultra-loose monetary settings, the fiscal multiplier tends to be much larger. Putting it all together, real rates are unlikely to fall very much in Japan. This is very positive for the yen in a world with deeply negative real rates. As demand recovers, and the Japanese economy generates non-inflationary growth, the currency should find a solid footing. Why Valuation Matters Chart 13The Yen Is Very Cheap The Yen Is Very Cheap The Yen Is Very Cheap Japan is running a big trade deficit on the back of high energy prices. A cheap currency at least increases Japan’s competitiveness. This is particularly the case since the boom in external demand has been a much welcome cushion for Japanese growth. According to our PPP models, the Japanese yen is the cheapest G10 currency, undervalued by around 35% (Chart 13). Why valuations matter is because an investor who buys the yen today can expect to make 6% a year over the next half decade, based on the historical correlation between valuation and subsequent currency returns (Chart 14). This will especially be the case if Japanese inflation keeps lagging inflation in the US. As we argued at the beginning of this report, US yields will need to stabilize before long yen positions make sense on a tactical basis (Chart 15). Chart 14Valuation Matters For The Japanese Yen Valuation Matters For The Japanese Yen Valuation Matters For The Japanese Yen Chart 15Global Yields Need To Stabilize For The Yen To Bounce Global Yields Need To Stabilize For The Yen To Bounce Global Yields Need To Stabilize For The Yen To Bounce The Yen As A Safe Haven The yen still appears to have the best correlation with a rising VIX (Chart 16). In a world of slowing global growth and the potential for equity market turbulence, this bodes well for long yen positions. That said, the carry on this position will be unbearable especially if the Federal Reserve continues to sound hawkish. The better play on potential yen strength is a short CHF/JPY position. Historically, these currencies have tended to move together. However, more recently, the CHF has risen substantially versus the JPY, suggesting some mean reversion is due (Chart 17). Chart 16The Yen Remains A Good Hedge The Yen Remains A Good Hedge The Yen Remains A Good Hedge Chart 17Go Short CHF/JPY Go Short CHF/JPY Go Short CHF/JPY Strategically, we were stopped out of our short USD/JPY position at 128, initiated at 124. Our 2022 target for the yen is 110. Our sense is that most of the downside risks are well understood by markets, while upside surprises are much underappreciated. Tactically, we will wait for the consolidation phase we outlined earlier in this report, before initiating fresh positions.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary The Declining Value Of An Old Friendship Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? India may buy cheap oil from Russia, but oil alone cannot expand this partnership. India needs to maintain a balance of power against China and Pakistan. With Russia’s heft set to decline, India will be compelled to explore a configuration with America. India will slowly yet surely move into America’s sphere of influence. Strong geopolitical as well as economic incentives exist for both sides to develop partnership. The US’s grand strategy will continue to collide with that of Russia and China. China will increasingly align with Russia and is doomed to stay entangled in a strategic conflict with India. With India a promising emerging market set to cleave to America, we reiterate our strategic buy call on India. Tactically however we are bearish on India. We also recommend investors go strategically long Indian tech / short Chinese tech. This pair trade is likely to keep rising on a secular basis. Trade Recommendation Inception Date Return LONG INDIAN TECH / CHINESE TECH EQUITIES 2022-04-21   Bottom Line: For reasons of geopolitics as well as macroeconomics, we maintain our constructive view on India and our negative view on China on a strategic time frame. On a tactical timeframe, we remain sellers of India given cyclical political and macro risks. Feature Russia’s invasion of Ukraine has forced all players at the global geopolitical table to show their hand. The one major player at the table who is yet to show her cards is India. Which side India choses matters. Its geopolitical rise is one of the many reasons we live in a brave new multipolar world. India will gain influence in the global economy as a large buyer of oil and guns and as a user of tech platforms and capital. Related Report  Geopolitical StrategyFrom Nixon-Mao To Putin-Xi The situation is complicated by mixed signals. India has played a geopolitically neutral or “non-aligned” role for most of its time since independence in 1947. Those who believe India will stay neutral point to the fact that India has continued buying oil from Russia and has abstained from voting on both anti-Russia and anti-Ukrainian resolutions at the United Nations. Those who predict that India will side with Russia have trouble explaining how India will get along with China, which committed to a “no limits” strategic partnership with Russia prior to the invasion. Those who speculate that India will align with the US have trouble explaining India’s persistent ties with Russia and the Biden administration’s threat of punishment for those who help Russia circumvent US sanctions. In this report we argue that the Indo-Russian friendship is destined to fade over a long-term, strategic horizon. The reason is simple: Russia’s geopolitical power is fading and hence it can no longer help India meet its regional security goals. The growing Russia-China alignment will only alienate India further. Hence, we expect the relationship between India and Russia to be reduced to a transactional status – mainly trade in oil and guns over the next few years, while strategic realities will drive India to tighten relations with the US and its Asian allies. Three geopolitical forces will break down the camaraderie between India and Russia, namely: (1) A collision in the grand strategies of America with that of both China and Russia, (2) India’s need to align with the US to underwrite its own regional security, and (3) China’s rising distrust of India as India aligns with the US and its allies. In fact, we expect China and India to stay embroiled in a strategic conflict over the next few years. Any thaw in their relations will be temporary at best. The rest of this report explains and quantifies these forces. We conclude with actionable investment conclusions. Let’s dive straight in. US Versus China-Russia: A Grand Strategy Collision “For the enemy is the communist system itself – implacable, insatiable, unceasing in its drive for world domination … For this is not a struggle for supremacy of arms alone – it is also a struggle for supremacy between two conflicting ideologies: freedom under God versus ruthless, Godless tyranny. “ – John F. Kennedy, Remarks at Mormon Tabernacle, Utah (September 1960) Chart 1China’s Is An Export-Powered Economic Heavyweight Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? It’s been six decades since these words were spoken and today the quotation is more relevant than at any time since the Cold War ended in 1991. The excerpt captures how the Biden administration has positioned itself with respect to Russia and China, only replacing “communist” with “autocratic” in Russia’s case. The Ukraine war helps America advance its grand strategy with respect to Russia. The Ukraine war is steadily draining Russia’s already limited economic might. Western sanctions aim to weaken Russia further. Russia’s military capabilities are now in greater doubt than before, so that its only remaining geopolitical strengths are nuclear weapons and, significantly, its leverage as an energy supplier. With Russia weakened, yet capable of reinforcing China, America will focus more intensely on China over the coming years and the breakdown in US-China relations will only accelerate. China is a genuine economic competitor to the United States (Chart 1). Its strategic rise worries America. To make matters worse, America poses a unique threat to China. China relies heavily on energy imports (Chart 2) from the Middle East (Chart 3). This is a source of great vulnerability as China’s fuel imports must traverse seas that America controls (Map 1). During peace time, and periods of robust US-China strategic engagement, this vulnerability is not an issue. But China is acutely aware that America has the capability to choke China’s energy access at will in the event of hostilities, just as it did to Japan in World War II. Russia has managed to wage war in Ukraine, against US wishes, since it is a net energy supplier to Europe and the global economy. Chart 2China And India Rely On Imports For Energy Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​ Chart 3India And China Both Depend On Middle East For Oil Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Map 1US Military Footprint In Middle East Threatens China … Yet US Presence In South Asia Is Weak Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? Atop China’s fuel-supply related insecurities, America has begun a strategic pivot to Asia in recent years. For instance, America has pulled troops out of Iraq and Afghanistan, declared a trade war on China, and strengthening strategic alliances and partnerships with regional geopolitical powers like India and Australia (Table 1). The US has retained its alliance with the Philippines despite an adverse government there, while South Korea has just elected a pro-American president again. With Japan, South Korea and Australia aligned militarily with the US, China’s naval power pales in comparison (Chart 4). Table 1America’s Influence In Asia Is Rising Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? Chart 4China’s Naval Power Pales Versus US Allies In Asia Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? Now China cannot watch America refurbish its grand strategy in Asia silently. Given China’s need for supply security, geopolitical independence, and regional influence, Beijing will double down on building its influence in Asia and in the eastern hemisphere. Against this backdrop of US-China competition, military conflict becomes increasingly likely, especially in the form of “proxy wars” involving China’s neighbors but conceivably even in the form of US-China naval warfare. China’s plans to modernize and enhance its economic prowess will add to America’s worries (Chart 5). A bipartisan consensus of American lawmakers is focused on reviving America’s economic strength but simultaneously limiting China’s benefit by restricting Chinese imports and American high-tech exports (Chart 6). Since Beijing cannot afford to base its national strategy on the hope of lingering American engagement, US-China trade relations will weaken regardless of which party controls the White House. Chart 5China’s Growing Might Worries America Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 6US Growth Does Not Equal Growth In Imports From China Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ The consensus in global financial media (which we never bought) held that the Biden administration would reduce tensions with China – but the détente never occurred and the remaining window for détente is limited by the uncertainty of the 2024 election. The US is currently occupied with Russia but threatening to impose secondary sanctions on China if it provides military assistance or circumvents sanctions. The Russo-Ukrainian war has led to an energy price shock that hurts an industrial economy like China’s. For the rest of this year China’s leaders will be consumed with managing the energy shock, a nationwide Covid-19 outbreak, and the important political reshuffle this fall. Only in 2023 will Beijing have room for maneuver when it comes to the US. But the US cannot return to engagement, which strengthens China’s economy, while China cannot open up to the US economy and become more exposed to future US sanctions. Bottom Line: A grand strategy collision between the US and China is certain. US dominance of sea routes that China uses for energy imports necessarily intimidates China. America’s pivot to Asia threatens China’s regional influence. This will prompt China to restrict American advances in strategic geographies —and not only the Taiwan Strait but also, as we will see, in South Asia. US-India Strategic Alignment: Only A Matter Of Time “If they [nation states] wish to survive, they must be willing to go to war to preserve a balance against the growing hegemonic power of the period.” – Nicholas J. Spykman, America's Strategy in World Politics (Harcourt, Brace and Co, 1942) For reasons of strategy, China will continue to build its influence in South Asia. South Asia offers prospects of sea access to the Indian Ocean, namely via Pakistan. This factor could ease China’s fuel supply insecurities. Also, penetrating northern India helps China set up a noose around India’s neck, thus neutralizing a potential enemy and US ally. In short China will pursue a two-pronged strategy of Eurasian development and naval expansion, both of which threaten India. Against this backdrop, India needs US support to counter Pakistan to its west, China’s latest intrusions into its eastern flank (Map 2), and China’s maritime challenge. India has historically spent generously on defense, but its military might pales in comparison to that of China. Even partial support from America would help India make some progress toward a balance of power in South Asia (Chart 7). Map 2China’s Newfound Interest In India’s Eastern Flank Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? Chart 7America Can Provide Military Heft To India Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 8US Is A Key Trading Partner For India Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ There’s another reason why US alignment makes sense for India. Much like China, India is highly import-dependent for its fuel needs (Chart 2). Given India’s high reliance on the Middle East for energy, India stands to benefit from America’s solid military footprint in this region (Map 1). The US too has a motive in exploring this alliance. India can provide a strategic foothold on the Eurasian rimland. America will value this new access route to Eurasia because America knows that its military footprint in South Asia is surprisingly weak – a weakness it needs to address against the backdrop of China’s increasing influence in the region (Map 1). Meaningful economic interests also underpin the US-India relationship. India and the US appear like sparring partners from time to time. The US may raise issues of human rights violations in India and the two may bicker over trade. However there exist strong economic incentives for the two countries to keep their differences under check and develop a long-term strategic partnership. The US is a major user of India’s software services and buys nearly a fifth of India’s merchandise exports. The trading relationship that India shares with the US is far more developed than India’s trading relationship with China and Russia (Chart 8). Capital is a factor of production that India desperately needs to finance its high growth. America and its allies are also major suppliers of capital to India (Chart 9). India is averse to granting China the political influence that would go along with major capital infusions and direct investments. Chart 9US And Its Allies Are Major Suppliers Of Capital To India Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 10India Offers US Firms Access To High Growth Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 11India Is A Key Market For American Big Tech Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? India on its part is a large marketplace which offers high growth prospects (Chart 10) and remains open and accessible to American corporations (unlike say Russia or China). The growth element is something that American firms will value more over time, as the American economy is mature and has a lower potential growth rate. Most importantly if the US imposes sanctions on India, then two key business lobbies are sure to mitigate the damage. In specific: Since India is a key potential market for American tech firms (Chart 11), Big Tech will always desire amicable Indo-US relations. Since India is the third largest buyer of defense goods globally, American defense suppliers will have similar intentions. In both cases, US policy planners will support these industries’ lobbying efforts due to the grand strategic considerations outlined above. Bottom Line: India will slowly yet surely move into America’s sphere of influence. Notwithstanding persistent differences, the Indo-US relationship will strengthen over a strategic timeframe. Strong geopolitical motives as well as notable economic incentives exist for both sides to develop this alignment. Indo-Russian Alignment: Destined To Fade The Indo-Russian friendship can be traced back to the second half of the 20th century. The fulcrum was the fact that Russia was a formidable land-based power and provided an offset against threats from China and Pakistan (Chart 12). The finest hour of this friendship perhaps came in 1971 when Russia sided with India in its war with Pakistan. India’s citizens hold an unusually favorable opinion of Russia (Chart 13). Chart 12The Declining Value Of An Old Friendship Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 13Indians Hold A Favorable Opinion Of Russians Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Despite this rich past, the Indo-Russia friendship is doomed to fade over a strategic timeframe. Even if  Russia’s share in Indian oil rises from current low levels of 2%, this glue alone cannot hold the Indo-Russian relationship together for one key reason: Russia’s geopolitical might has been waning and Russia can no longer help India establish a balance of power against China and Pakistan (Table 2). In fact, since 2006, the Russo-Indian partnership has been commanding lower geopolitical power than that of China (Chart 12). Table 2Russia’s Military Heft Is Of Limited Use To India Today Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? Managing regional security is a key strategic concern for India. As Russia’s geopolitical power wanes so will India’s utility of Russia as an effective guarantor of India’s security. Russia’s war in Ukraine is ominous in this regard, as Russian armed forces were forced to retreat from Kyiv, while the country’s already bleak economic prospects have worsened under western sanctions. The solidification of the China-Russia axis will alienate India further (Chart 14). China is essential to Russia’s economy now while Moscow is essential to China’s Eurasian strategy of bypassing American naval dominance to reduce its supply insecurity. Russia holds the keys to Central Asia, from a military-security point of view, and hence also to the Middle East. Furthermore, limited economic bonds exist to prevent India and Russia from falling out. Russia accounts for a smidgen of India’s trade (Chart 8). India is Russia’s largest arms client (accounting for +20% of its arms sales) but this reliance could also decline over time: The Indian government has been pursuing a range of policies to increase the indigenous production of arms. This is a strategic goal that would also reinforce India’s economic need for more effective manufacturing capabilities. Russia’s own defense franchise had been coming under pressure, even before the Ukraine war (Chart 15). On the contrary, Western arms manufacturers’ franchise has been steadily growing. Chart 14China-Russia Axis Will Alienate India Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​ Chart 15The Rise & Rise Of Western Arms Manufacturers Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ While the US may look the other way in the short term when India buys arms from Russia, over a period of time the US is bound to pull India away by using a combination of sticks (mild sanctions) and carrots (heavy discounts). Two aforementioned external factors will also work against the Indo-Russia relationship namely (1) The Russo-Chinese alignment and its clash with US grand strategy and (2) The coming-to-life of a US-India strategic alignment. Bottom Line: India’s need for cheap oil will preserve basic Indo-Russian relations for some time. But oil alone cannot drive a deeper strategic alignment. Regional security concerns are paramount for India. Russia’s geopolitical decline will force India to explore an alignment with America, which will offer India security in the Indian Ocean and Persian Gulf in the face of China’s emergence in this region. Is A Realignment In Indo-China Relations Possible? But why should India not join the other Asian giants to balance against America’s threat of global dominance? Would such a bloc not secure India’s interests? And what if the US imposes harsh sanctions for India’s continued trade with Russia and strategic neutrality? Or what if a future US administration grows restless and attempts to force India to choose sides sooner rather than later? Even if the US offends India, it will only lead to a temporary improvement in India’s ties with the China-Russia alliance. This is because America stands to lose if India cleaves towards the Sino-Russian alliance and would thus quickly correct its policy. In specific: Security Interests: America will risk losing all influence in South Asia if India were to cleave towards China. India provides a key foothold for America to control China’s regional ascendance especially given that the US has now withdrawn from Afghanistan and its bilateral relations with Pakistan are weak. Business Interests: India’s movement into the China-Russia sphere of influence can have adverse business implications for American corporations and US allies, given that the US is abandoning the Chinese market over time, while India is a large and fast-growing consumer of American tech exports and services. India could emerge as a major buyer of American defense goods and will import more and more energy provided by the US and its partners in the Persian Gulf. These business groups will lobby for the withdrawal of US sanctions on India given India’s long-term potential. Meanwhile any improvement in Indo-Chinese relations will have a limited basis. In specific: Ascendant Nationalism In China And India: China’s declining potential GDP is motivating a rise in nationalism and an assertive foreign policy. Meanwhile India’s inability to create plentiful jobs for a young and growing population is also fuelling a wave of nationalism. A historic turn toward Sino-Indian economic engagement would require the domestic political ability to embrace and promote each other’s well-being. Pakistan Factor: India’s eastern neighbor Pakistan is controlled by its military. The military’s raison d'être is enforced by maintaining an aggressive stance towards India, while pursuing economic development through whatever other means are available. As long as Pakistan’s military stays influential its stance towards India will be hostile. And as long as Pakistan’s economy remains weak (Chart 16), its reliance on China will remain meaningful (Chart 17). Chart 16Pakistan: High Military Influence, Low Economic Vigor Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 17China & Pakistan: Iron Brothers? Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis? ​​​​​​ Chart 18Indians View China And Pakistan Negatively Indo-Russian Relations: Quo Vadis? Indo-Russian Relations: Quo Vadis?   China also benefits from its alliance with Pakistan because it provides an alternative entry point into India and access to the Indian Ocean. Fundamental Distrust: For reasons of history, Indians harbor a negative opinion of both Pakistan and China (Chart 18). This factor reinforces the first point that any Indian administration will see limited political dividends from developing a long-term alignment with China or with Pakistan. Bottom Line: If any Indo-Chinese détente materializes owing to harsh US sanctions, which we do not expect, the result will be temporary. America has limited incentives to push India towards the Sino-Russian camp. More importantly, China and India will stay entangled in a strategic conflict for reasons of both history and geography. Investment Conclusions Chart 19Sell India Tactically But Buy India On A Strategic Horizon Sell India Tactically But Buy India On A Strategic Horizon Sell India Tactically But Buy India On A Strategic Horizon The historic Indo-Russia relationship will weaken over the next few years as India and Russia explore new alignments with USA and China respectively. The relationship may not collapse entirely but has limited basis to grow given Russia’s declining geopolitical clout. Indo-American economic interests are set to deepen not just for reasons of security. India may consider looking for alternatives to Russian arms in the American defense industry while American Big Tech will be keen to grow their footprint in India. With India set to cleave to America, a country whose geopolitical power remains unparalleled today, we reiterate our constructive long-term investment view on India (Chart 19). However, tactically we remain worried about near-term geopolitical and macro headwinds that India must confront. China will strengthen relations with Russia over the next few years. It needs Russia’s help to execute its Eurasian strategy and to diversify its sources of fuel supply, over the long run. Given that the US and its allies will be engaged in a conflict with China over a strategic horizon, we reiterate our strategic sell call on China. Tactically we are neutral on Chinese stocks, given that they have already sold off sharply in accordance with our views over the past two years. In view of both these calls, we urge clients with a holding period mandate of more than 12 months to reduce exposure to Chinese assets and increase exposure to Indian assets. We also recommend investors go strategically long Indian tech / short Chinese tech. This pair trade is likely to keep rising on a secular basis.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

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

Executive Summary Copper Will Remain Tight Even In Recession Copper Will Remain Tight Even In Recession Copper Will Remain Tight Even In Recession Supply-chain disruptions arising from Russia's invasion of Ukraine and demand hits from lockdowns in Shanghai are increasing the odds of a global recession, which can be seen in the WTO's latest economic forecast. Cyclical base-metals demand, particularly copper's, will slow in a recession. Still, markets will remain physically short and well bid, as incremental demand from the global renewable-energy and defense buildouts gathers strength. Global GDP growth will return to trend in 2024. Renewables and defense-related demand will continue to power ahead. Physical deficits will persist. Copper-supply growth increasingly is tied to local political risk – e.g., Chile's government sued miners over water-use disputes this month. Miners now are seeking assurances investment will be protected before committing to higher capex. The environmental stain arising from the global competition for metals will redound to the benefit oil and gas E+Ps involved in natural gas and hydrogen production. Bottom Line: A higher likelihood of a global recession will not diminish the drive to secure base metals critical to renewables and defense, particularly copper. This will keep metals bid and inventories strained. Stagflation likely ensues. We remain long commodity-index exposure expecting longer-term backwardation, and ETFs with exposures to the equity of miners. We continue to expect copper prices to average $5/lb on the COMEX this year, and $6/lb in 2023. Feature The World Trade Organization (WTO) released a sharply lower expectation for global growth this week – from a robust 5.7% rate in 2021 to 2.8% this year and 3.2% next year.1 This effectively translates into a global recession arriving this year. The WTO forecast also calls for global merchandise trade volume to grow 3.0% in 2022 and 3.4% in 2023, which also will dampen cyclical aluminium demand. Related Report  Commodity & Energy StrategyCopper Will Grind Higher The WTO's forecast is one of the first among major agencies to incorporate the impact of the Ukraine war and supply-chain disruptions arising from lockdowns in Shanghai. If the WTO's forecast is realized, cyclical copper and base metals demand will slow, but markets will remain physically short – i.e., in deficit – and well bid, in our view (Chart 1). Incremental demand from the global renewable-energy and defense buildouts in the Big 3 military-industrial blocs – the EU, US and China – will gather strength and keep metals markets tight over the course of this decade (Chart 2). Chart 1Copper Will Remain Tight Even In Recession Copper Will Remain Tight Even In Recession Copper Will Remain Tight Even In Recession Chart 2Copper Inventories Will Remain Tight Copper Demand Will Ignore Recession Copper Demand Will Ignore Recession Global refined copper demand is highly sensitive to GDP growth: While not exactly a 1-for-1 correspondence, a 1% increase in global GDP translates into a 0.76% increase in refined copper demand. A 1% increase in EM GDP translates into a 0.54% increase in refined copper demand in these economies (Chart 3). Interestingly, our modeling finds DM GDP growth has had little if any effect on global refined copper demand, most likely because, historically, DM economies were not building infrastructure to the extent EM economies, particularly China and the Asian Tigers, has been building over past decades. Chart 3World, EM GDP Drive Copper Demand World, EM GDP Drive Copper Demand World, EM GDP Drive Copper Demand Estimating New Incremental Copper Demand The DM base metals demand profile – particularly for copper – is set to change dramatically following the Russian invasion of Ukraine. Russian aggression prompted the EU to double-down on its renewable energy build-out, and to restore a credible military to protect its borders and the safety of its citizens. Both of these efforts will be funded by new bond-issuance programs from the EU. Practically, this means the EU will join the US and Chinese military-industrial complexes in the global competition for critical materials required for the renewable-energy and defense buildouts. The EU and China already were active on the renewables side; it is the US that will be joining that race on a larger scale following the passage of legislation by the Biden administration to fund and incentivize renewables.2 The US and China have been in an intense competition to build military capacities; now the EU joins that race. None of these military-industrial complexes will provide actual spending estimates for these buildouts, which means markets have to continually revise their supply-demand estimates for base metals as data becomes available. Copper markets provide the best data for such an exercise – it is the bellwether market for base metals, with useful data to estimate supply and demand. As a starting point for our estimation of copper balances going forward, we assume global cyclical demand will remain a function of global GDP; EM demand also can be modelled using EM GDP as an explanatory variable. We also assume that the 10 years ending in 2030 will require refined copper production to double in order to meet demand for renewable-energy and from the military-industrial complex globally. We make some reasonable first approximations of what this will look like initially, and then will iterate as actual data becomes available. Chart 1 shows the evolution we expect for global consumption as a function of cyclical and incremental demand. On the supply side, we use estimated annual production for refined copper production from the Australian government's Department of Industry, Science, Energy and Resources, and the World Bureau of Metals Statistics. We note there are a few noteworthy projects due to come on line – e.g., Canada (Kena Gold-Copper project; Blue Cove Copper Project); Congo (Kamoa-Kakula project ramping up); Peru (Quellaveco) and Chile (Pampa Norte). We again note that copper supply in critically important states accounting for huge shares of global production – e.g., Chile (30% of global mining output) and Peru (10%) – increasingly is vulnerable to local political risks.3 Chile, in particular, is facing environmental and political challenges on the mining side: It is in the 13th year of a drought, which forced the government to institute water rationing in the capital Santiago this week. In addition, last week the federal government sued major mining companies over water-rights disputes. Our price view will evolve as we get data on cyclical and incremental demand, and supply additions.We would note in this regard major miners already are sounding the alarm on how difficult it will be to lift supply over the next 10 years given the likely demand markets will be pricing in. For now, we are maintaining our expectation COMEX copper prices will average $5/lb this year and $6/lb next year, and that markets will remain backwardated with inventories remaining under pressure (Chart 2).4 Investment Implications Base metals markets – copper included – are facing a moment of reckoning in terms of being able to support the global push for renewable energy. While the odds of a global recession in the wake of Russia's invasion of Ukraine and China's lockdowns to address the COVID-19 outbreak in Shanghai are higher – which ordinarily would point to inventory accumulation, all else equal – we believe markets will remain tight. A recession will cause cyclical demand to soften, which, along with marginal new supply, will keep the COMEX forward curve relatively flat over the short term (3-9 months). However, over the next two years and beyond, supply will not be coming on fast enough to offset cyclical and incremental demand from the global renewables and defense buildouts (Chart 3). This will keep copper markets in physical-deficit conditions, and inventories will have to draw to meet demand (Chart 4). We expect this will translate into renewed backwardation in the COMEX forward curve. Chart 4Global Inventories Will Continue To Draw Copper Demand Will Ignore Recession Copper Demand Will Ignore Recession Chart 5Backwardation Will Re-emerge Backwardation Will Re-emerge Backwardation Will Re-emerge We remain bullish copper over the medium and longer terms, and remain long commodity index exposure expecting a return of backwardation in COMEX copper, and the XME ETF, which gives us exposure to base metals miners (Chart 5).   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodity Round-Up Energy: Bullish US LNG exports hit record highs again in March, continuing a streak that began in December 2021. Exports averaged 11.9 Bcf/d for the month, on the back of new liquefaction capacity coming on line at the beginning of March. The US EIA is expecting LNG exports to average 12.2 Bcf/d this year, which would represent a 25% increase in shipments abroad. This US is accounting for the bulk of European LNG exports at present. European storage ended March at 26% of capacity, vs. a five-year average capacity of 34% at end-March. Separately, China became the largest importer of LNG in the world in 2021, displacing Japan for the top spot. According to the EIA, China’s LNG imports averaged 10.5 Bcf/d last year, which was close to 20% above 2020 levels. China's LNG imports exceeded Japan's , a 1.7 Bcf/d (19%) increase over its 2020 average, and 0.8 Bcf/d more than Japan’s imports. Base Metals: Bullish The Fraser Institute released a report assessing states’ and countries’ mining investment attractiveness for 2021. Investment attractiveness is measured by accounting for the mineral availability in the region and the effect of government policy on exploration investment. Western Australia topped the charts, while the copper-rich nations of Chile and Peru ranked 38th and 49th. This is telling of the policy adversity and uncertainty towards mining in these two countries and resonates with a BHP executive’s remarks a few weeks ago. Last week, the Chilean government sued mines operated by BHP, Albemarle, and Antofagasta over alleged environmental damage. One of the mines sued is BHP’s Escondida, the world’s largest copper mine. Precious Metals: Bullish According to Impala Platinum, palladium and rhodium prices are expected to rally for the next four-to-five years on tight market fundamentals. Low palladium supply coupled with an increase in the metal’s demand for catalytic converters, as pollution control regulations tighten, are causing the supply squeeze. On April 8 London’s Platinum and Palladium Market suspended Russian refiners from minting platinum and palladium for the London market, boosting the price of both metals (Charts 6 and 7). Russia supplies 10% and 40% of global mined platinum and palladium respectively. Depending on the period of the suspension, Europe may need to substitute Russian imports of the metals from South Africa. Chart 6 Copper Demand Will Ignore Recession Copper Demand Will Ignore Recession Chart 7 Copper Demand Will Ignore Recession Copper Demand Will Ignore Recession       Footnotes   1     Please see the WTO's "TRADE STATISTICS AND OUTLOOK: Russia-Ukraine conflict puts fragile global trade recovery at risk," released by the WTO on April 12, 2022. Revisions are subject to the evolution of the war in Ukraine following Russia's invasion in February 2022. 2     Worthwhile noting here the Biden Administration in the US invoked the Defense Production Act (DPA) to "to support the production and processing of minerals and materials used for large capacity batteries – such as lithium, nickel, cobalt, graphite, and manganese." In addition, the US Department of Defense will be tasked in implementing this authority. Lastly, the White House readout notes, "The President is also reviewing potential further uses of DPA – in addition to minerals and materials – to secure safer, cleaner, and more resilient energy for America." Practically, the US and China are treating access to critical materials as a defense issue. The EU likely joins this club in the very near future. 3    Please see our report from February 24, 2022 entitled Copper Will Grind Higher for additional discussion. It is available at ces.bcaresearch.com. 4    Please see, e.g., Bigger investment in mining needed to meet climate goals, says LGIM, published by ft.com on  April 5, 2022. The article summarizes a study done by Legal & General Investment and BHP, which notes that without a significant increase in mining activity – which is itself a hydrocarbon-intensive undertaking – there will not be sufficient supplies to achieve the IEA's 2050 net-zero goals.     Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image  

Dear client, In lieu of April 18 publication, I will be hosting our quarterly webcast. Our regular weekly publication will resume Monday, April 25. Kind Regards, Irene Tunkel Chief Strategist, US Equity Strategy   Executive Summary R&D Is Paying Off Is It Time To Invest In "Green And Clean"? Is It Time To Invest In "Green And Clean"? What Is Renewable Energy: It consists of  new utilities companies that generate electricity using clean technologies including wind, solar, hydro, biomass, geothermal, nuclear and other. Currently, renewables are becoming a dominant source of new power generation as their costs becoming comparable to the ones of traditional fossil fuels.  Industry Breakthroughs: Increased renewables adaptation is possible due to several technological advancements including improved battery storage, implementation of smart grid networks, and an increase in carbon capture activities. Renewables And Cleantech Investment Characteristics: The majority of renewable energy and cleantech companies tend to be smaller than established utilities. As a result, they are highly correlated with the small-cap growth indices. Key Macroeconomic Drivers: Just like small caps, renewables are highly sensitive to economic growth and monetary conditions. Currently, rolling over global PMIs as well as tightening liquidity conditions spell trouble for the sensitive green-tech stocks. Fundamentals Overview: The industry is characterized by extremely volatile fundamental data, once again underscoring its small-cap growth-like nature. That said, margins are healthy, capex growth is in the positive territory, while valuations are on the expensive side. The policy backdrop is also favorable, as we will show in a sequel to this report. Bottom Line: On a structural basis, renewable energy and cleantech companies are at the core of the global push to diversify energy sources and mitigate climate change. They enjoy a temporary tailwind from the US administration and a more lasting tailwind from the geopolitical need for energy security. However, over the near term, renewables face headwinds from tighter monetary policy and slowing growth. Feature Introduction Climate change is at the forefront of many investors’ minds. BCA Research has covered some of the key trends and challenges in the Climate Change Special Report, published three years ago, and in its coverage of the Biden administration. But this subject is just as relevant today. For much of the past decade, renewable energy and clean technology companies have flourished, enjoying tailwinds from a secular push towards green and renewable energy (Chart 1). However, in February 2021, the group collapsed with many clean energy stocks down more than 50% off-peak. Recently, renewables have rebounded on the back of the war in Ukraine and the surge in energy prices and diversification (Chart 2). Chart 1The Industry's Performance... The Industry's Performance... The Industry's Performance... Chart 2...Is Very Volatile Is It Time To Invest In "Green And Clean"? Is It Time To Invest In "Green And Clean"? In this report, we conduct a “deep dive” into various types of renewable energy and clean technologies, to gauge their commercial potential and investment attractiveness. We will try to get to the bottom of the question of whether “green and clean” is a lucrative investment theme, and when may be a good entry point. What Is “Green And Clean”? According to International Renewable Energy Agency (IRENA), 90% of all decarbonization in 2050 will involve renewable energy through a direct supply of low-cost power, efficiency, electrification, bioenergy with carbon capture, and green hydrogen. All of these technologies fall into one of the two intertwined tracks: Renewables and Cleantech. Renewable Energy Companies Are The New Utilities Renewable energy is mostly represented by the companies in the Utilities sector that generate power from sustainable sources, such as solar photovoltaic (PV), wind, hydropower, and renewable hydrogen in fuel cells. These companies then sell that electricity at either market or contracted rates. Despite the novel technologies they leverage, from an investment standpoint, these companies are not much different than traditional utilities in terms of their business model. However, a whole ecosystem has developed around solar and wind energy-producing companies: Producers of raw materials, manufacturers of solar batteries, wind turbines, and systems and components, along with companies that offer installation and maintenance services. Many of these companies may be described as Cleantech. Cleantech Is A High Tech Take On Solving Climate Change Cleantech uses nascent technologies to reduce the carbon footprint of mundane human activities, such as heating homes, driving, and growing food supplies. Technologies being developed are energy storage batteries, smart grid implementation, carbon capture, energy efficiency, and many others. In addition, the Cleantech sector includes renewable energy equipment manufacturers that produce such components as wind turbines, solar panels and cells, and solar inverters. Clearly, Cleantech has a broad reach and spans a wide range of sectors, such as Technology, Material, and Industrials (Table 1). Cleantech offers more tech-like higher-risk, higher-reward potential payoffs than renewable energy production. Let’s take a close look at these technologies. Table 1Renewables Performance Statistics Versus S&P Sectors Is It Time To Invest In "Green And Clean"? Is It Time To Invest In "Green And Clean"? Renewable Energy Renewable Energy Sources Are Replacing Fossil Fuels Over the past 20 years, this country has made significant strides in shifting its energy generation toward renewable sources away from fossil fuels, increasing the share of clean energy from 3.7%  in 2000, to 10% in 2020 (Chart 3). Non-hydro renewable generation, which includes wind, solar, geothermal, and biomass sources of power, accounted for 65% of US renewable electricity production in 2020. Chart 3A Structural Trend Is It Time To Invest In "Green And Clean"? Is It Time To Invest In "Green And Clean"? New Installations Are Dominated By Renewables Chart 4Share Of New Electricity Capacity Is It Time To Invest In "Green And Clean"? Is It Time To Invest In "Green And Clean"? Renewables are becoming a dominant source of new power generation. In terms of new electricity capacity installations, over 80% in the US and 72% globally are renewables, and their share is growing steadily over time (Chart 4). In terms of growth, wind and solar dominate the category, with production increasing nearly exponentially over the past decade (Chart 5). Chart 5USA Renewable Energy Sources Breakdown Is It Time To Invest In "Green And Clean"? Is It Time To Invest In "Green And Clean"? Power Generated By Renewables Is Cheaper Than Power Generated By Fossil Fuels The key reason for the proliferation of green energy generation is that renewable electricity is becoming cheaper than electricity produced by fossil fuels – according to IRENA, 62% of the added renewable power generation capacity had lower electricity costs than the cheapest source of new fossil fuel-fired capacity. Costs for renewable technologies continued to fall significantly over the past year:1 Concentrating solar power (CSP) fell by 85 percent Onshore wind by 56 percent Solar PV by 85 percent Offshore wind by 48 percent  This trend is bolstering the economic case for transitioning to cleaner energy resources (Chart 6). Chart 6R&D Is Paying Off Is It Time To Invest In "Green And Clean"? Is It Time To Invest In "Green And Clean"? Higher Production Translates Into Lower Prices Why are the prices of renewable alternatives falling so fast? Like traditional utilities, renewables require a massive upfront investment and, as a result, enjoy substantial operating leverage. However, with such high upfront costs, to achieve profitability, these companies need high production volumes. In addition, high production levels help these relatively young industries move up the experiential learning curve towards operational efficiencies. From 2010 to 2020, capacity increased nearly 4x for wind, 17.5x for solar PV,2 and 22x for lithium-ion batteries. With the rapid scaling of these technologies, cost declines range between 65-and 90%.3 Solar PV cumulative capacity vs price dynamic is a perfect illustration (Chart 7). Chart 7Solar PV Module Prices Versus Cumulative Capacity Is It Time To Invest In "Green And Clean"? Is It Time To Invest In "Green And Clean"? Key Challenges Of Solar And Wind While solar and wind are the fastest growing and most promising renewable technologies, they are also facing some significant challenges, which imperil their wider adoption. There are limitations in grid connection and flexibility, fluctuations in amounts of energy these sources generate, and a dire need for technological innovation in battery storage and digital tools for demand-side management. Outlook For The Renewables Industry IRENA expects renewables to scale up from 14% of total energy today to around 40% in 2030. Global annual additions of renewable power would triple by 2030 as recommended by the Intergovernmental Panel on Climate Change (IPCC). Solar and wind power will attract a lion’s share of investments (Chart 8). Chart 8Renewable Energy Investment Breakdown Is It Time To Invest In "Green And Clean"? Is It Time To Invest In "Green And Clean"? Breakthroughs In Cleantech Over the past few years, we have seen broad-based commercialization of novel climate-friendly technologies for fueling—no, charging our cars; warming our homes; and cleaning up greenhouse gases resulting from human activities. The following are just a few of the most prominent ones. Battery Storage Renewables like wind and solar are considered variable energy sources as the amount of energy they generate fluctuates over time. Energy supplies could be stabilized if excess supplies of energy could be stored quite literally for a rainy day. Utility-scale lithium-ion battery storage, which has gotten cheaper over time with battery prices decreasing on average by 18% annually from 2010 to 2019, is emerging as a viable option for storing excess energy for future use. Pairing lithium-ion batteries with nearby solar plants is known as “solar plus storage.” The dollar value of the US energy storage market is expected to grow more than twentyfold to nearly $11.5 billion by 2026, from an estimated $513 million in 2018, according to Wood Mackenzie, a global research and consultancy firm. Hydrogen Fuel Hydrogen is a clean fuel that, when consumed in a fuel cell, produces only water. Hydrogen can be produced from a variety of domestic resources, such as natural gas, nuclear power, biomass, and renewable power such as solar and wind. These qualities make it an attractive fuel option for transportation and electricity generation applications. It can be used in cars, in houses, for portable power, and in many more applications. Hydrogen is an energy carrier that can be used to store, move, and deliver energy produced from other sources.4 Today, hydrogen fuel can be produced through several methods. The most common methods are natural gas reforming (a thermal process), and electrolysis. Other methods include solar-driven and biological processes. A hydrogen fuel cell combines hydrogen and oxygen to produce electricity, heat, and water. As hydrogen is high in energy and produces almost no pollution, it can be used as fuel. Fuel cells are similar to batteries in that they produce electricity without combustion or emissions. Unlike batteries, fuel cells do not run down or need to recharge—as long as there’s a constant source of fuel and oxygen. Carbon Capture And Storage Carbon capture and storage (CCS) is the process of capturing carbon dioxide (CO2) before it enters the atmosphere, transporting it, and storing it (carbon sequestration) for centuries. Usually, the CO2 is captured from large point sources, such as a coal-fired power plant, a chemical plant, or a biomass power plant, and then stored in an underground geological formation. The aim is to prevent the release of CO2 from heavy industry with the intent of mitigating the effects of climate change.5 CCS efforts are targeted to neutralize emissions from manufacturing and power generation industries, which together account for about 70% of the world’s emissions.6 Companies like ExxonMobil are exploring direct air capture technology to scrub emissions out of the air and carbonate fuel cells to capture industrial emissions from flue gas streams of power plants or manufacturing facilities. Once considered fringe climate change mitigation methods, these processes are seeing wider acceptance as effective complements to conventional interventions. Smart Grid The smart grid is a planned nationwide network that uses information technology to deliver electricity efficiently, reliably, and securely. It's been called "electricity with a brain," "the energy internet," and "the electronet." Unlike today's grid, which primarily delivers electricity in a one-way flow from generator to outlet, the smart grid will permit the two-way flow of both electricity and information.7 Smart grid development will require investment across a wide range of technologies (Chart 9). Chart 9Smart Grid Investments Breakdown Is It Time To Invest In "Green And Clean"? Is It Time To Invest In "Green And Clean"? Renewables And Cleantech Investment Characteristics The majority of renewable energy and cleantech companies tend to be smaller market cap-wise than established utilities or industrial companies and tend to inhabit small-cap and mid-cap indices. Life span-wise, these are younger companies, many of which are commercializing novel technologies and have high growth potential. It is not surprising that they are highly correlated with the small-cap growth indices (Chart 10). As quintessential growth companies, they reinvest aggressively into their business: Capex growth, while volatile, is high (Chart 11). As a result, many of these companies are highly indebted, although recently many of them have cleaned up their balance sheets (Chart 12). Chart 10Renewables Often Behave Like Small-cap Growth Stocks Renewables Often Behave Like Small-cap Growth Stocks Renewables Often Behave Like Small-cap Growth Stocks Chart 11Volatile Capex Volatile Capex Volatile Capex Chart 12Improving Balance Sheets Improving Balance Sheets Improving Balance Sheets And it is worthwhile to point out that while many renewable energy companies fit squarely into the “utilities” category, don’t expect them to be boring, i.e., be a low volatility investment, or to pay dividends. Sales And Profitability Renewable energy generation and cleantech are good businesses with companies in the Wind index enjoying double-digit margins (Chart 13). Their earnings are also expected to grow at more than 30% per annum, which is consistent with IRENA’s high growth rate forecasts for the industry. Chart 13Steady Margins Steady Margins Steady Margins Valuations Chart 14Cheaper, Yet Still Pricey Cheaper, Yet Still Pricey Cheaper, Yet Still Pricey Valuations have come down substantially from the peak (Chart 14) but remain elevated. Trailing PEs for all renewable ETFs look rich (Table 2). High expected earnings growth and elevated valuations are highly consistent with the small-cap growth profile of these stocks.​​​​Table 2Cheaper, Yet Still Pricey Is It Time To Invest In "Green And Clean"? Is It Time To Invest In "Green And Clean"? Therefore, we believe that fundamentals are unlikely to be a driver of the performance of these stocks, while macroeconomic and political backdrops are truly important. Key Macroeconomic Drivers As we have established, renewable energy and cleantech stocks are small-cap growth and, like the rest of their brethren, must be highly sensitive to economic growth and monetary conditions. As providers of alternative energy, they are also highly sensitive to the price of oil. Economic growth The pursuit of new technologies requires deep pockets. Without a benefactor, such as the government, renewables need strong economic growth that translates into strong sales and earnings growth to pursue lucrative new projects and develop their business (Chart 15). However, lately, global PMIs have turned down, signaling growth deceleration, which does not bode well for the industry. Chart 15Global Growth Headwinds Coupled With... Global Growth Headwinds Coupled With... Global Growth Headwinds Coupled With... Monetary Conditions The survival and prosperity of renewable energy stocks are also tied to their ability to access cheap capital. As a result, their market performance is closely linked to liquidity (Chart 16). The industry is still in the early stages of its innovation cycle and requires significant Capex outlays to develop its offerings. As financial conditions tighten and liquidity shrinks, renewable companies can no longer access cheap funding and may have to postpone projects. Many of these companies are heavily indebted and may struggle to meet their financial obligations without cheap funding. As a result, these companies’ growth prospects and immediate bottom line may take a hit. Withdrawal of liquidity will also hurt highly inflated multiples of the group. Since the US is in the early innings of a steep tightening cycle, we consider monetary conditions a major headwind for renewables. Chart 16...A Liquidity Drought Spells Trouble ...A Liquidity Drought Spells Trouble ...A Liquidity Drought Spells Trouble Cost of Oil And Alternative Energy Sources Oil and other fossil fuels are substitute goods from a renewable energy standpoint, providing customers with alternatives (Chart 17). Since resulting electricity is highly commoditized, customers are inclined to choose a cheaper option. Also, at times of shortages, either type of energy provider may be able to step in and pick up the slack. A recent spike in the performance of alternative energy stocks on the back of an energy crisis triggered by the war is a case in point. As long as supply disruptions in the energy space continue, renewables will outperform. However, the price of oil is a geopolitical gamble, and the probability of a downside move is higher than the probability of an upside move. Especially if geopolitical tensions are reduced or resolved faster than the market expects. Chart 17Keep An Eye On Energy When Investing In Renewables Keep An Eye On Energy When Investing In Renewables Keep An Eye On Energy When Investing In Renewables How To Invest In Cleantech? There is a host of ETFs that offer investors a wide range of choices for access to renewable energy and cleantech themes (Table 3). These ETFs differ in geographic span, industry focus, liquidity, and cost, but all are viable investment options. Table 3Clean Tech ETFs Is It Time To Invest In "Green And Clean"? Is It Time To Invest In "Green And Clean"? Investment Implications Renewable energy and cleantech companies are at the core of the global push to increase energy security and contain climate change. They enjoy a substantial tailwind from China and the EU, as well as a temporary tailwind from the Biden administration, which has put its weight behind a goal of swift transition of the economy to clean sources of energy. However, stocks of these companies fall squarely into the small-cap growth style bucket, and the macroeconomic backdrop characterized by slowing growth and tightening monetary conditions is highly unfavorable for the group. The surging price of oil is the only pillar supporting the recent outperformance of the group – however, a change in a geopolitical backdrop may send the price of oil spinning, taking renewables with it. While we believe that on a structural basis, renewables and cleantech present a tremendous opportunity to partake in a monumental energy transition, we also believe that over the short investment horizon, the probability of downside risk in performance is elevated. Bottom Line: “Green and Clean” are at the forefront of the global transition to renewable energy and clean technology and expected growth rates are unparalleled. However, over the near term, the group faces headwinds from tighter monetary policy and slowing growth, while the price of energy is a hostage to geopolitics and presents a downside risk if geopolitical tensions are reduced faster than expected.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Appendix: Types Of Renewable Energy Solar Energy Photovoltaics (PV), also called solar cells, are electronic devices made of semiconducting material that convert sunlight directly into electricity. Solar panels were invented in the US in 1954 at Bell Labs. Today, PV is one of the fastest-growing renewable energy technologies. Solar PV installations can be combined to provide electricity on a commercial scale or arranged in smaller configurations for mini-grids or personal use. The cost of manufacturing solar panels has plummeted dramatically in the last decade, making them not only affordable but often the cheapest form of electricity. Concentrated solar power (CSP) uses mirrors to concentrate solar rays, which heat fluid into steam to drive a turbine and generate electricity. One of the main advantages of a CSP power plant over a solar PV power plant is that it can be equipped with molten salts in which heat can be stored, allowing electricity to be generated after the sun has set. Looking at solar power, the installed capacity of solar energy sources increased by 17.6x (1,763%) between 2010 and 2020 and is expected to increase sevenfold by 2030. The lifetime costs of solar modules are continuing to fall as innovations in PV cells continue to improve efficiency, which has improved by about 200% since the 1950s to around 15-16% today for commercially available panels. Lab results show cells can achieve efficiencies of over 40%. Wind energy is when the wind is harnessed to produce electricity using the kinetic energy created by air in motion. This is transformed into electrical energy using wind turbines or wind energy conversion systems. The output is proportional to the dimensions of the rotor and to the cube of the wind speed. Wind turbine capacity has increased over time. According to IRENA, global installed onshore and offshore wind generation capacity has tripled in the past decades. In 2016, wind energy accounted for 16% of the electricity generated by renewables. The wind will be one of the largest generation sources by 2030, supplying 24% of total electricity needs.8  Much of this recent growth can be attributed to innovation and the rapidly decreasing costs of underlying technologies. In 2019, 75% of the new onshore wind projects commissioned had a Levelized Cost Of Electricity (LCOE)9 lower than the cheapest new source of fossil fuel-fired power generation as, over the past 10 years, the LCOE of wind power decreased by 55%. Growth of wind power generation is expected to continue as economies of scale, greater investment, supportive policies, and market forces further reduce the cost of components, installation, and operation of wind energy sources. Hydropower The basic principle of hydropower is using water to drive turbines. Hydroelectric sources like dams and run-of-the-river power generators represented the lion’s share of renewable power generation. Hydroelectric power represented 82% of all renewable power generation in 2010; however, this share has contracted in recent years. The installed capacity of hydro has remained flat over the past decade, largely because energy sources are restricted by location and an already-prominent reliance on hydroelectric power limits its growth. This is the slowest growing renewable energy segment. Other Renewables Over the longer-term, bioenergy, geothermal, and ocean energy may also be important sources of renewable energy. Yet, at present these technologies account for no more than 5% of the renewables market; strong R&D efforts will be needed in the coming decades to bring their costs down and expand their share. IRENA expects these technologies to grow sixfold by 2030.     Footnotes 1     IRENA, “World Energy Transitions Outlook 2022” 2     IRENA, “Installed Capacity Trends” 3    European Commission, “Lithium-ion batteries for mobility and stationary storage applications,” 2018. 4    Hydrogen Fuel Basics | Department of Energy 5    Carbon capture and storage - Wikipedia 6    Helping decarbonize industry with carbon capture and storage – Energy Factor (exxonmobil.com) 7     Smart Grid: A Beginner's Guide | NIST 8    Ibid 9    LCOE refers to the revenue required to build and operate a power source over a specified cost recovery period   Recommended Allocation   Recommended Allocation: Addendum Sector Chart Pack Commentary Sector Chart Pack Commentary  

Executive Summary The Ukraine war reinforces our key view that commodity producers will use their geopolitical leverage this year. The market is growing complacent again about Russian risks. Iran is part of the same dynamic. If US-Iran talks fail, as we expect, the Middle East will destabilize and add another energy supply risk on top of the Russian risk. The Ukraine war also interacts with our other two key views for 2022: China’s reversion to autocracy and the US’s policy insularity. Both add policy uncertainty and weigh on risk sentiment. The war also reinforces our strategic themes for the 2020s: Great Power Rivalry, Hypo-Globalization, and Populism/Nationalism. Stagflation Cometh Stagflation Cometh Stagflation Cometh Trade Recommendation Inception Date Return Cyclically Long Global Defensives Versus Cyclicals 2022-01-20 10.8% Bottom Line: Tactically stay long global defensives and large caps. Cyclically stay long gold, US equities, aerospace/defense, and cyber security. Feature In our annual outlook, “The Gathering Storm,” we argued that the post-pandemic world economy would destabilize due to intensifying rivalry among the leading nations. We argued that China’s reversion to autocracy, US domestic divisions, and Russia’s commodity leverage would produce a toxic brew for global investors in 2022. By January 27 it was clear to us that Russia would invade Ukraine, so the storm was arriving sooner than we thought, and we doubled down on our defensive and risk-averse market positioning. We derived these three key views from new cyclical trends and the way they interact with our underlying strategic themes – Great Power Rivalry, Hypo-Globalization, and Populism/Nationalism (Table 1). These themes are mutually reinforcing, rooted in solid evidence over many years, and will not change easily. Table 1Three Geopolitical Strategic Themes Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Related Report  Geopolitical Strategy2022 Key Views: The Gathering Storm The Ukraine war reinforces them: Russia took military action to increase its security relative to the US and NATO; the West imposed sanctions that reduce globalization with Russia and potentially other states; Russian aggression stemmed from nationalism and caused a spike in global prices that will spur more nationalism and populism going forward. In this report we examine how these trends will develop in the second quarter and beyond. We see stagflation taking shape and recommend investors prepare for it by continuing to favor defensive sectors, commodities, and value plays. Checking Up On Our Russia View For 2022 Our third key view for 2022 – that oil producers like Russia and Iran possessed immense geopolitical leverage and would most likely use it – is clearly the dominant geopolitical trend of the year, as manifested in the Russian invasion of Ukraine.1 Russia first invaded Ukraine in 2014 and curtailed operations after commodity prices crashed. It launched a new and larger invasion in 2022 when a new commodity cycle began (Chart 1). Facing tactical setbacks, Russia has begun withdrawing forces from around the Ukrainian capital Kyiv. But it will redouble its efforts to conquer the eastern Donbas region and the southern coastline. The coast is the most strategic territory at stake (Map 1). Chart 1Russia's Commodity-Enabled Aggression Russia's Commodity-Enabled Aggression Russia's Commodity-Enabled Aggression Map 1Russian Invasion Of Ukraine, 2022 Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours The most decisive limitation on Russia’s military effort would come from a collapse of commodity exports or prices, which has not happened yet. Europe continues to buy Russian oil and natural gas, although it is debating a ban on the $4.4 billion worth of coal that it imports. With high energy prices making up for a drop in export volumes, Russian armed forces can still attempt a summer and fall campaign (Chart 2). The aim would be to conquer remaining portions of Donetsk and Luhansk, the “land bridge” to Crimea, and potentially the stretch of land between the Dnieper river and eastern Moldova, where Russian troops are already stationed. Chart 2Russia’s War Financing Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Ukraine’s military neutrality is the core Russian objective. Ukraine is offering neutrality in exchange for security guarantees in the current ceasefire talks. Hence a durable ceasefire is possible if the details of neutrality are agreed – Ukraine forswears joining NATO and hosting foreign military infrastructure while accepting limitations on military exercises and defense systems. The security guarantees that Ukraine demands are mostly symbolic, as the western powers that would be credible guarantors are already unwilling to use military force against Russia (e.g. the US, UK, NATO members). However, Russia’s withdrawal from Kyiv will embolden the Ukrainians, so we do not expect a durable ceasefire in the second quarter. Global investors will be mistaken if they ignore Ukraine in the second quarter, at least until core problems are resolved. What matters most is whether the war expands beyond Ukraine: The likelihood of a broader war is low but not negligible. So far the Russian regime is behaving somewhat rationally: Moscow attacked a non-NATO member to prevent it from joining NATO; it limited the size of the military commitment; and it is now accepting reality and withdrawing from Kyiv while negotiating on Ukrainian neutrality. But a major problem emerges if Russia’s military fails in the Donbas while Ukraine reneges on offers of neutrality. Any ceasefire could fall apart and the war could re-escalate. Russia could redouble its attacks on the country or conduct a limited attack outside of Ukraine to trigger a crisis in the western alliance. Moreover, if sanctions keep rising until Russia’s economy collapses, Moscow could become less rational. Finland and Sweden have seen a shift of public opinion in favor of joining NATO. Any intention to do so would trigger a belligerent reaction from Russia. These governments are well aware of the precarious balance that must be maintained to prevent war, so war is unlikely. But if their stance changes then Russia will threaten to attack. Russia would threaten to bomb these states since it cannot now credibly threaten invasion by land (Charts 3A & 3B). Chart 3ANordic States Joining NATO Would Trigger Larger War Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours ​​​​​ Chart 3BNordic States Joining NATO Would Trigger Larger War Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours ​​​​​​ The Black Sea is vulnerable to “Black Swan” events or military spillovers. Russia is re-concentrating its military efforts in the Donbas and land bridge to Crimea. Russia could expand its offensive to Odessa and the Moldovan border. Or Russia could attempt to create a new norm of naval dominance in the Black Sea. Or ships from third countries could hit mines or become casualties of war. For these and other reasons, investors should not take on additional risk in their portfolios on the basis that a durable ceasefire will be concluded quickly. Russia’s position is far too vulnerable to encourage risk-taking. Moscow could escalate tensions to try to save face. It is also critical to ensure that Russia and Europe maintain their energy trade: Neither side has an interest in total energy cutoff. Russia needs the revenue to finance its war and needs to discourage Europe from fulfilling its pledges to transition rapidly to other sources and substitutes. Europe needs the energy to avoid recession, maintain some tie with Russia, and enable its energy diversification strategy. So far natural gas flows are continuing (Chart 4). Chart 4Natural Gas Flows Continuing (So Far) Natural Gas Flows Continuing (So Far) Natural Gas Flows Continuing (So Far) ​​​​​​ Chart 5Global Oil Supply/Demand Balance Global Oil Supply/Demand Balance Global Oil Supply/Demand Balance ​​​​​​ However, risks to energy trade are rising. Russia is threatening to cut off energy exports if not paid in rubles, while the EU is beginning to entertain sanctions on energy. Russia can reduce oil or gas flows incrementally to keep prices high and prevent Europe from rebuilding stockpiles for fall and winter. Partial energy cutoff is possible. Europe’s diversification makes Russia’s predicament dire. Substantial sanction relief is highly unlikely, as western powers will want to prevent Russia from rebuilding its economy and military. Russia could try to impose significant pain on Europe to try to force a more favorable diplomatic solution. A third factor that matters is whether the US will expand its sanction enforcement to demand strict compliance from other nations, at pain of secondary sanctions: Secondary sanctions are likely in the case of China and other nations that stand at odds with the US and help Russia circumvent sanctions. In China’s case, the US is already interested in imposing sanctions on the financial or technology sector as part of its long-term containment strategy. While the Biden administration’s preference is to control the pace of escalation with China, and thus not to slap sanctions immediately, nevertheless substantial sanctions cannot be ruled out in the second quarter. Secondary sanctions will be limited in the case of US allies and partners, such as EU members, Turkey, and India. Countries that do business with Russia but are critical to US strategy will be given waivers or special treatment. Russia is not the only commodity producer that enjoys outsized geopolitical leverage amid a global commodity squeeze. Iran is the next most critical producer. Iran is also critical for the stability of the Middle East. In particular, the consequential US-Iran talks over whether to rejoin the 2015 nuclear deal are likely to come to a decision in the second quarter. Chart 6Failure Of US-Iran Talks Jeopardizes Middle East Oil Supply Failure Of US-Iran Talks Jeopardizes Middle East Oil Supply Failure Of US-Iran Talks Jeopardizes Middle East Oil Supply If the US and Iran agree to a strategic détente, then regional tensions will briefly subside, reducing global oil disruption risks and supply pressures. Iran could bring 1.3 million barrels per day of oil back online, adding to President Biden’s 1 million per day release of strategic petroleum reserves. The combination would amount to 2.3% of global demand and more than cover the projected quarterly average supply deficit, which ranges from 400k to 900k barrels per day for the rest of 2022 (Chart 5). If the US and Iran fail to agree, then the Middle East will suffer another round of instability, adding a Middle Eastern energy shock on top of the Russian shock. Not only would Iran’s 1.3 million barrels per day be jeopardized but so would Iraq’s 4.4 million, Saudi Arabia’s 10.3 million, the UAE’s 3.0 million, or the Strait of Hormuz’s combined 24 million per day (Chart 6). This gives Iran leverage to pursue nuclear weaponization prior to any change in US government that would strengthen Israel’s ability to stop Iran. We would not bet on an agreement – but we cannot rule it out. The Biden administration can reduce sanctions via executive action to prevent a greater oil shock, while the Iranians can accept sanction relief in exchange for easily reversible moves toward compliance with the 2015 nuclear deal. But this would be a short-term, stop-gap measure, not a long-term strategic détente. Conflict between Iran and its neighbors will revive sooner than expected after the deal is agreed, as Iran’s nuclear ambitions will persist. OPEC states are already producing more oil rapidly, suggesting no quick fix if the US-Iran deal falls apart. While core OPEC states have 3.5 million barrels per day in spare capacity to bring to bear, a serious escalation of tensions with Iran would jeopardize this solution. Finally, if commodity producers have geopolitical leverage, then commodity consumers are lacking in leverage. This is clear from Europe’s inability to prevent Russia’s attack or ban Russian energy. It is clear from the US’s apparent unwillingness to give up on a short-term deal with Iran. It is clear from China’s inability to provide sufficient monetary and fiscal stimulus as it struggles with Covid-19. Turkey, Egypt, and Pakistan are geopolitically significant importers of Russian and Ukrainian grain that are likely to face food insecurity and social unrest. We will address this issue below under our Populism/Nationalism theme. Bottom Line: Investors should not be complacent. Russia’s military standing in Ukraine is weak, but its ability to finance the war has not yet collapsed, which means that it will escalate the conflict to save face. What About Our Other Key Views For 2022? Our other two key views for 2022 are even more relevant in the wake of the Ukraine re-invasion. China’s reversion to autocracy is a factor in China’s domestic and foreign policy: Domestically China needs economic and social stability in the advance of the twentieth national party congress, when President Xi Jinping hopes to clinch 10 more years in power. In pursuit of this goal China is easing monetary and fiscal policy. However, with depressed animal spirits, a weakening property sector, and high debt levels, monetary policy is proving insufficient. Fiscal policy will have to step up. But even here, inflation is likely to impose a limitation on how much stimulus the authorities can utilize (Chart 7). Chart 7China Stimulus Impaired By Inflation China Stimulus Impaired By Inflation China Stimulus Impaired By Inflation ​​​​​​ Chart 8Chinese Supply Kinks To Persist Due To Covid-19 Chinese Supply Kinks To Persist Due To Covid-19 Chinese Supply Kinks To Persist Due To Covid-19 China is also trying but failing to maintain a “Covid Zero” policy. The more contagious Omicron variant of the virus is breaking out and slipping beyond the authorities’ ability to suppress cases of the virus to zero. Shanghai is on lockdown and other cities will follow suit. China will attempt to redouble its containment efforts before it will accept the reality that the virus cannot be contained. Chinese production and shipping will become delayed and obstructed as a result, putting another round of upward pressure on global prices (Chart 8). Stringent pandemic restrictions could trigger social unrest. China is ripe for social unrest, which is why it launched the “Common Prosperity” program last year to convince citizens that quality of life will improve. But this program is a long-term program that will not bring immediate relief. On the contrary, the economy is still suffering and the virus will spread more widely, as well as draconian social restrictions. The result is that the lead up to the national party congress will not be as smooth as the Xi administration had hoped. Global investors will remain pessimistic toward Chinese stocks. In foreign affairs, China’s reversion to autocracy is reinforced by Russia’s clash with the West and the need to coordinate more closely. Xi hosted Putin in Beijing on February 4, prior to the invasion, and the two declared that their strategic partnership ushers in a “new era” of “multipolarity” and that their cooperation has “no limits,” which really means that military cooperation is not forbidden. China agreed to purchase an additional 10 billion cubic meters of Russian natural gas over 30-years. While this amount would only replace 3% of Russian natural gas exports to Europe, it would mark a 26% increase in Russian exports to China. More importantly it acts as a symbol of Chinese willingness to substitute for Europe over time. There is a long way to go for China to replace Europe as a customer (Chart 9). But China knows it needs to convert its US dollar foreign exchange reserves, vulnerable to US sanctions, into hard investments in supply security within the Eurasian continent. Chart 9Long Way To Go For China NatGas Imports To Replace EU Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours China is helping Russia circumvent sanctions. China’s chief interest is to minimize the shock to its domestic economy. This means keeping Russian energy and commodities flowing. China could also offer military equipment for Russia. The US has expressly warned China against taking such an action. China could mitigate the blowback by stipulating that the assistance cannot be used in Ukraine. This would be unenforceable but would provide diplomatic cover. While China is uncomfortable with the disturbance of the Ukraine war – it does not want foreign affairs to cause even larger supply shocks. At the same time, China does not want Russia to lose the war or Putin’s regime to fall from power. If Russia loses, Taiwan and its western allies would be emboldened, while Russia could pursue a détente with the West, leaving China isolated. Since China faces US containment policy regardless of what happens in Russia, it is better for China to have Putin making an example out of Ukraine and keeping the Americans and Europeans preoccupied. Chart 10China Strives To Preserve EU Trade Ties China Strives To Preserve EU Trade Ties China Strives To Preserve EU Trade Ties China must also preserve ties with Europe. Diplomacy will likely succeed in the short run since Europe has no interest or desire to expand sanctions to China. The Biden administration will defer to Europe on the pace of sanctions – it is not willing or able to force Europe to break with China suddenly. Eventually Europe and China may sever relations but not yet – China has a powerful incentive to preserve them (Chart 10). China will also court India and other powers in an attempt to hedge its bets on Russia while weakening any American containment. Beyond the party congress, China will be focused on securing the economic recovery and implementing the common prosperity agenda. The first step is to maintain easy monetary and fiscal policy. The second step is to “let 100 flowers bloom,” i.e. relaxing social and regulatory controls to try to revive entrepreneurship and animal spirits, which are heavily depressed. Xi will have the ability to do this after re-consolidating power. The third step will be to try to stabilize economic relations with Europe and others (conceivably even the US temporarily, though no serious détente is likely). The remaining key view for 2022 is that the Biden administration’s domestic focus will be defensive and will invite foreign policy challenges. The Ukraine war vindicates this view but the question now is whether Biden has or will change tack: The Biden administration is focused on the midterm elections and the huge risk to the Democratic Party’s standing. Biden has not received a boost in opinion polls from the war. He is polling even worse when it comes to handling of the economy (Chart 11). While he should be able to repackage his budget reconciliation bill as an energy security bill, his thin majorities in both houses make passage difficult. Chart 11Biden And Democrats Face Shellacking In Midterm Election Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Biden’s weak standing – with or without a midterm shellacking – raises the prospect that Republicans could take back the White House in 2024, which discourages foreign nations from making any significant concessions to the United States in their negotiations. They must assume that partisanship will continue to contaminate foreign policy and lead to abrupt policy reversals. In foreign policy, the US remains reactive in the face of Russian aggression. If Russia signs a ceasefire, the US will not sabotage it to prolong Russian difficulties. Moreover Biden continues to exempt Europe and other allies and partners from enforcing the US’s most severe sanctions for fear of a larger energy shock. Europe’s avoidance of an energy ban is critical and any change in US policy to try to force the EU to cut off Russian energy is unlikely. China will not agree to structural reform or deep concessions in its trade negotiations, knowing that former President Trump could come back. The Biden administration’s own trade policy toward China is limited in scope, as the US Trade Representative Katherine Tai admitted when she said that the US could no longer aim to change China’s behavior via trade talks. Biden’s only proactive foreign policy initiative, Iran, will not bring him public kudos if it is achieved. But American inconstancy is one of the reasons that Iran may walk away from the 2015 nuclear deal. Why should Iran’s hawkish leaders be expected to constrain their nuclear program and expose their economy to future US sanctions if they can circumvent US sanctions anyway, and Republicans have a fair chance of coming back into power as early as January 2025? Biden’s unprecedented release of strategic petroleum reserves will not be able to prevent gasoline prices from staying high given the underlying supply pressures at home and abroad. This is especially true if the Iran talks fail as we expect. Even if inflation abates before the election, it is unlikely to abate enough to save his party from a shellacking. That in turn will weaken the global impression of his administration’s staying power. Hence Biden will focus on maintaining US alliances, which means allowing Europe, India, and others to proceed at a more pragmatic and dovish pace in their relations with Russia and China. Bottom Line: China’s reversion to autocracy and America’s policy insularity suggest that global investors face considerable policy uncertainty this year even aside from the war in Europe. Checking Up On Our Strategic Themes For The 2020s Russia’s invasion strongly confirmed our three strategic themes of Great Power Rivalry, Hypo-Globalization, and Populism/Nationalism. These themes are mutually reinforcing: insecurity among the leading nation-states encourages regionalization rather than globalization, while populism and nationalism encourage nations to pursue economic and security interests at the expense of their neighbors. First, the Ukraine war confirms and exacerbates Great Power Rivalry: Chart 12China And Russia Both Need To Balance Against US Preponderance Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Russia’s action vindicates the “realist” school of international relations (in which we count ourselves) by forcing the world to wake up to the fact that nations still care primarily about national security defined in material ways, such as armies, resources, and territories. The paradox of realism is that if at least one of the great nations pursues its national self-interest and engages in competition for security, then all other nations will be forced to do the same. If a nation neglects its national security interests in pursuit of global economic engagement and cooperation, then it will suffer, since other nations will take advantage of it to enhance their security. Hence, as a result of Ukraine, nations will give a higher weight to national security relative to economic efficiency. The result will be an acceleration of decisions to use fiscal funds and guide the private economy in pursuit of national interests – i.e. the Return of Big Government. Since actions to increase deterrence will provoke counteractions for the same reason, overall insecurity will rise. For example, the US and China will take extra precautions in case of future sanctions and war. But these precautions will reduce trust and cooperation and increase the probability of war over the long run. For the same reason, China cannot reject Russia’s strategic overture – it cannot afford to alienate and isolate Russia. China and Russia have a shared interest in countering the United States because it is the only nation that could conceivably impose a global empire over all nations (Chart 12). The US could deprive Beijing and Moscow of the regional spheres of influence that they each need to improve their national security. This is true not only in Ukraine and Taiwan but in other peripheral areas such as Belarus, the Caucasus, Central Asia, and Southeast Asia. China has much to gain from Russia. Russia is offering China privileged overland access to Russian, Central Asian, and Middle Eastern resources and markets. This resource base is vital to China’s strategic needs, given its import dependency and vulnerability to US maritime power (Chart 13). Chart 13China’s Maritime Vulnerability Forces Eurasian Strategy, Russian Alliance Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Investors should understand Great Power Rivalry in a multipolar rather than bipolar sense. As Russia breaks from the West, investors are quick to move rapidly to the bipolar Cold War analogy because that is what they are familiar with. But the world today has multiple poles of political power, as it did for centuries prior to the twentieth. While the US is the preponderant power, it is not hegemonic. It faces not one but two revisionist challengers – Russia and China. Meanwhile Europe and India are independent poles of power that are not exclusively aligned with the US or China. For example, China and the EU need to maintain economic ties with each other for the sake of stability, and neither the US nor Russia can prevent them from doing so. The same goes for India and Russia. China will embrace Russia and Europe at the same time, while hardening its economy against US punitive measures. India will preserve ties with Russia and China, while avoiding conflict with the US and its allies (the maritime powers), whom it needs for its long-term strategic security in the Indian Ocean basin. Ultimately bipolarity may be the end-game – e.g. if China takes aggressive action to revise the global order like Russia has done – but the persistence of Sino-European ties and Russo-Indian ties suggest we are not there yet. Second, the Ukraine war reinforces Hypo-Globalization: Since the pandemic we have argued that trade would revive on the global economic snapback but that globalization – the deepening of trade integration – would ultimately fall short of its pre-2020 and pre-2008 trajectory. Instead we would inhabit a new world of “hypo-globalization,” in which trade flows fell short of potential. So far the data support this view (Chart 14). Chart 14Globalization Falling Short Of Potential Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours The Ukraine war has strengthened this thesis not only by concretely reducing Russia’s trajectory of trade with the West – reversing decades of integration since the fall of the Soviet Union – but also by increasing the need for nations to guard against a future Chinese confrontation with the Western world. Trust between China and the West will further erode. China will need to guard against any future sanctions, and thus diversify away from the US dollar and assets, while the US will need to do a better job of deterring China against aggression in Asia, and will thus have to diversify away from Chinese manufacturing and critical resources like rare earths. While China and Europe need each other now, the US and China are firmly set on a long-term path of security competition in East Asia. Eventually either the US or China will take a more aggressive stance and Europe will be forced to react. Since Europe will still need US support against a decaying and aggressive Russia, it will likely be dragged into assisting the US against China. Third, the Ukraine war reflects and amplifies Populism/Nationalism: Populism and nationalism are not the same thing but they both stem from the slowing trend of global income growth, the rise of inequality, the corruption of the elite political establishments, and now the rise in inflation. Nations have to devote more resources to pacifying an angry populace, or distracting that populace through foreign adventures, or both. The Ukraine war reflects the rise in nationalism. First, the collapse of the Soviet Union ushered in a period in which Moscow lost control of its periphery, while the diverse peoples could pursue national self-determination and statehood. The independence and success of the Baltic states depended on economic and military cooperation with the West, which eroded Russian national security and provoked a nationalist backlash in the form of President Putin’s regime. Ukraine became the epicenter of this conflict. Ukraine’s successful military resistance is likely to provoke a dangerous backlash from Moscow until either policy changes or the regime changes. American nationalism has flared repeatedly since the fall of the Soviet Union, namely in the Iraq war. The American state has suffered economically and politically for that imperial overreach. But American nationalism is still a potent force and could trigger a more aggressive shift in US foreign policy in 2024 or beyond. European states have kept nationalism in check and tried to subsume their various nationalist sentiments into a liberal and internationalist project, the European Union. The wave of nationalist forces in the wake of the European debt crisis has subsided, with the exception of the United Kingdom, where it flowered in Brexit. The French election in the second quarter will likely continue this trend with the re-election of President Emmanuel Macron, but even if he should suffer a surprise upset to nationalist Marine Le Pen, Europe’s centripetal forces will prevent her from taking France out of the EU or euro or NATO (Chart 15). Over the coming decade, nationalist forces will revive and will present a new challenge to Europe’s ruling elites – but global great power competition strongly supports the EU’s continued evolution into a single geopolitical entity, since the independent states are extremely vulnerable to Russia, China, and even the US unless they unite and strengthen their superstructure. Chart 15Macron Favored, Le Pen Would Be Ineffective Macron Favored, Le Pen Would Be Ineffective Macron Favored, Le Pen Would Be Ineffective In fact the true base of global nationalism is migrating to Asia. Chinese and Indian nationalism are very potent forces under President Xi Jinping and Prime Minister Narendra Modi. Xi is on the verge of clinching another ten years in power while Modi is still favored for re-election in 2024, so there is no reason to anticipate a change anytime soon. The effects are various but what is most important for investors is to recognize that as China’s potential GDP has fallen over the past decade, the Communist Party has begun to utilize nationalism as a new source of legitimacy, and this is expressed through a more assertive foreign policy. President Xi is the emblem of this shift and it will not change, even if China pursues a lower profile over certain periods to avoid provoking the US and its allies into a more effective coalition to contain China. Chart 16Food Insecurity Will Promote Global Unrest, Populism Food Insecurity Will Promote Global Unrest, Populism Food Insecurity Will Promote Global Unrest, Populism The surge in global prices will destabilize regimes that lack food security and contribute to new bouts of populism and nationalism. Turkey is the most vulnerable due to a confluence of political, economic, and military risks that will unsettle the state. But Egypt is vulnerable to an Arab Spring 2.0 that would have negative security implications for Israel and add powder to the Middle Eastern powder keg. Pakistan is already witnessing political turmoil. Investors may overlook any Indonesian unrest due to its attractiveness in a world where Russia and China are scaring away western investment (Chart 16). All three of these strategic themes are mutually reinforcing – and they tend to be inflationary over the long run. Great powers that redouble the pursuit of national interest – through defense spending and energy security investments – while simultaneously being forced to expand their social safety nets to appease popular discontent, will drive up budget deficits, consume a lot of natural resources, and purchase a lot of capital equipment. They will also more frequently engage in economic or military conflicts that constrain supply (Chart 17). Chart 17War And Preparation For War Are Inflationary War And Preparation For War Are Inflationary War And Preparation For War Are Inflationary Bottom Line: The Ukraine war is a powerful confirmation of our three strategic themes. It is also a confirmation that these themes have inflationary macroeconomic implications. Investment Takeaways Chart 18Global Investors Still Flee To US For Safety Global Investors Still Flee To US For Safety Global Investors Still Flee To US For Safety Now that great power rivalry is intensifying immediately and rapidly, and yet China’s and Europe’s economies are encountering greater difficulties, we expect stagflation to arrive sooner rather than later. High headline and core inflation, the Ukraine war, tacit Chinese support for Russia, persistent Chinese supply kinks, US and EU sanctions, US midterm elections, and a potential US-Iran diplomatic breakdown will all weigh on risk sentiment in the second quarter. In Ukraine, Russia’s position is too weak to give comfort for investors, who should continue to favor defensive over cyclical equities and US stocks over global stocks. Russia’s break with the West, and the West’s use of sanctions to prevent Russia from accessing its foreign exchange reserves, has raised new questions about the global currency reserve system and the dollar’s status within that system. Over the coming years China will redouble the efforts it began in the wake of the Great Recession to reduce its dependency on US dollar assets within its reserve basket, while also recycling new current account surpluses into non-dollar assets. However, the evidence does not suggest that King Dollar will suffer a structural breakdown. First, the world lacks alternative safe-haven assets to US Treasuries – and net foreign purchases of US bonds rose in the face of the Ukraine war (Chart 18). Second, the return of war to Europe will weaken the perceived long-term security of European currency and government bonds relative to US counterparts. Even if the Ukraine war is contained in the short run, as we expect, Russia is in structural decline and will remain a disruptive player for some time. We are not at all bearish on the euro or European bonds but we do not see the Ukraine war as increasing their value proposition, to put it lightly. The same logic extends to Japanese bonds, since China, like Russia, is an autocratic and revisionist state that threatens to shake up the security order in its neighborhood. Japan is relatively secure as a nation and we are bullish on the yen, but China’s de facto alliance with Russia weakens Japan’s security outlook over the very long run, especially relative to the United States. Thus, on a cyclical basis the dollar can depreciate, but on a structural basis the US dollar will remain the dominant reserve currency. The US is not only the wealthiest and most secure country in the world but also the largest oil producer. Meanwhile Chinese potential growth, domestic political stability, and foreign relations are all worsening. The US-Iran talks are the most critical geopolitical dynamic in the second quarter aside from Russia’s clash with the West. The fate of the 2015 nuclear deal will be decided soon and will determine whether an even bigger energy shock begins to emanate from the Middle East. We would not bet on a new US-Iran deal but we cannot rule it out. Any deal would be a short-term, stop-gap deal but would prevent an immediate destabilization of the Middle East this year. As such it would reduce the risk of stagflation. Since we expect the deal to fail, we expect a new energy shock to emerge. We see stagflation as more likely than the BCA House View. It will be difficult to lift productivity in an environment of geopolitical and political uncertainty combined with slowing global growth, rising interest rates, and a worsening commodity shock (Chart 19). We will gladly revise this stance if Biden clinches an Iran deal, China relaxes its Covid Zero policy and stabilizes domestic demand, Russia and Europe maintain energy trade, and commodity prices fall to more sustainable levels for global demand. Chart 19Stagflation Cometh Stagflation Cometh Stagflation Cometh Strategically we remain long gold, overweight US equities, overweight UK equities, long British pound and Japanese yen, long aerospace/defense stocks and cyber security stocks. We remain short Chinese renminbi and Taiwanese dollar and short emerging European assets. Our short Chinese renminbi trade and our short Taiwanese versus Korean equity trade are our worst-performing recommendations. However, the above analysis should highlight – and the Ukraine war should underscore – that these two economies face a fundamentally negative geopolitical dynamic. Both Chinese and Taiwanese stocks have been underperforming global peers since 2021 and our short TWD-USD trade is in the money. While we do not expect war to break out in Taiwan this year, we do expect various crisis events to occur, particularly in the lead up to the crucial Taiwanese and American 2022 midterms and 2024 presidential election. We also expect China to depreciate the renminbi when inflation peaks and commodity prices subside. Cyclically we remain long North American and Latin American oil producers and short Middle Eastern producers, based on our pessimistic read of the Iran situation. The Americas are fundamentally better protected from geopolitical risks than other regions, although they continue to suffer from domestic political risks on a country-by-country basis. Cyclically we continue to take a defensive positioning, overweighting defensive sectors and large cap equities.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1      That the Russian threat fell under our third key view for 2022 implies that we did not get our priorities straight. However, consider the timing: shortly after publishing our annual outlook on December 15, the Russians issued an ultimatum to the western powers demanding that NATO stop expanding toward Russia. Diplomats from Russia and the West met on January 12-13 but Russia’s demands were not met. We upgraded the odds that Russia would invade Ukraine from 50% to 75% on January 27. Shuttle diplomacy ensued but failed. Russia invaded on February 24. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades () Section II: Special (EDIT this Header) Section III: Geopolitical Calendar

Executive Summary Natgas Price Surge Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Russia's invasion of Ukraine and the surge in EU natural gas prices it provoked will accelerate investment in clean-hydrogen technology, which uses renewable energy to separate water into hydrogen and oxygen. This already has pushed the cost of clean – or "green" – hydrogen below the cost of competing forms of the fuel on the continent. Widespread adoption of carbon pricing will further enhance the attractiveness of green hydrogen, making it more competitive in transportation and refining applications. The cost of producing clean hydrogen in China also has fallen, owing to the competition for liquified natural gas (LNG) with the EU. Relatively low US natural gas prices are keeping the cost of green hydrogen above alternatives. The US DOE is prioritizing hydrogen development, and is funding research to reduce its cost from ~ $5/kg to $1/kg over the next 10 years. Falling clean-hydrogen costs raise the risk of stranded investment in natural-gas exploration and production. Bottom Line: The EU's drive to diversify away from Russian natural gas as quickly as possible will keep competition for scarce LNG between the EU and Asian markets high, as both bid for scarce supplies. This will redound to the benefit of clean hydrogen and its supporting technology, but might limit natgas E+P. Feature The war in Ukraine will keep the price of natural gas, particularly in its liquid state (LNG), elevated, as the EU and Asia compete for scarce supplies to refill inventories and prepare for the coming winter, along with keeping their heavy industries operating (Chart 1). In the Europe-Middle East-Africa (EMEA) markets and China, higher natgas prices, including LNG, already have lifted the cost of pulling hydrogen from natgas – so-called blue and grey hydrogen – above that of green (or "clean") hydrogen, which is produced by separating the hydrogen and oxygen in water via electrolysis. With natgas prices remaining elevated this year and next, investment in clean-hydrogen technology and its supporting infrastructure can be expected to increase. Government support for hydrogen as a clean fuel – i.e., research funding and tax support – will allow this technology to reach economies of scale and lower costs over the coming decade. Chart 1Russia's Invasion Of Ukraine Will Boost Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Related Report  Commodity & Energy StrategySurging Metals Prices And The Case For Carbon-Capture Government policy can increase the advantage of green-hydrogen and other clean-energy technologies by adopting carbon-pricing schemes on a large scale, as well. Such schemes would assess actual – and avoidable – costs of pollution to incentivize investment in non-polluting technologies. We have argued in the past that this is best done via taxes that can provide revenues to support and fund the development of renewable energy. Ideally, such schemes would include mechanisms to offset the regressive nature of such taxes. Absent a tax, Carbon Clubs that impose tariffs or duties on states not abiding by carbon-reduction policies seeking to export to states that do employ such policies, as developed by William Nordhaus, would be useful.1 Ukraine War Improves Hydrogen Economics Governments supporting low- or zero-carbon emission technologies in their push to contain the rise in the Earth's temperature are focused on hydrogen, which, when consumed in a fuel cell, emits no pollution. Apart from being a fuel source, hydrogen also can be used to store energy. It can power electric grids when there is intermittent electricity supply, making it ideal as a back-up energy source for renewable-energy technologies – solar and wind, in particular – which, as the UK and Europe discovered last summer, can be extremely variable and unreliable. Based on its method of production, hydrogen is assigned a color – grey, blue, or green (Chart 2). In a nutshell: Chart 2Types of Hydrogen By Color EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Grey hydrogen is produced when steam reacts with a hydrocarbon fuel (typically natural gas) to produce hydrogen via a process known as steam-methane reforming (SMR). The downside of this technology is it can result in CO2 and carbon escaping into the environment. Blue hydrogen is created by the same SMR process as grey hydrogen; however, carbon capture and storage (CCS) technology is added to the process to reduce carbon emissions from the steam and fuel reaction. Green hydrogen – aka "clean hydrogen" – is produced with electricity from renewables like wind or solar – in a process that separates water into oxygen and hydrogen via electrolysis. Electricity is the primary cost driver in the production of green hydrogen, followed by the elctrolyzers used to separate oxygen and hydrogen (Chart 3). For this reason, countries where renewable electricity is abundant will be ideal candidates for so-called clean hydrogen. Among renewables, wind and solar are the most developed, and cheapest sources of electricity (Chart 4). As a result, the International Renewable Energy Agency (IRENA) believes countries in the Middle East, Africa, and Oceania have the highest potential to become green hydrogen exporters.2 A constant electric load is crucial for efficient and cost-effective hydrogen production. Electrolyzers will either underperform or overheat if subjected to a variable electric load, reducing their lifespan, and hence increasing overall capital costs. This is yet another reason why countries with vast quantities of wind and solar energy will be at an advantage producing clean hydrogen. Chart 3Renewables Are Primary Cost For Green Hydrogen EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Chart 4Cheap Wind And Solar Electricity Can Reduce Green Hydrogen Costs EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Until now, deficient electrolyzer investment and production have resulted in high capital costs. Low innovation in the technology is due to a dearth of consumer demand due to the high prices, leading to a vicious cycle (Diagram 1). According to IRENA, increasing the manufacturing intensity of stacks – the primary component of the electrolyzer – could reduce the share of its cost from 45% to 30% of the total.3 Russia's invasion of Ukraine and the surge in EU natural gas prices it provoked will accelerate investment in green-hydrogen technology. The war already has pushed the cost of clean hydrogen below the cost of competing grey and blue forms of the fuel on the continent. We expect this will persist over the next two years, as the EU and Asia compete for scarce natural gas and LNG supplies going into the coming winter to rebuild depleted gas inventories, and to keep base metals smelters and refineries up and running. Diagram 1The Vicious Cycle Plaguing Hydrogen EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects The cost of grey hydrogen from natgas was ~ $6.70/kg last month vs a mid-point estimate of ~ $5.75/kg for green hydrogen in the Europe-Middle East-Africa (EMEA) markets.4 In China, green hydrogen was running at ~ $3.20/kg vs a grey cost of ~ $5.30/kg. The US is the outlier here, given its abundance of natural gas production. Grey hydrogen cost $1.20/kg, while green hydrogen was running at ~ $3.30/kg. It is difficult to determine whether green hydrogen will remain cheaper than blue in the EMEA and China markets. Under normal conditions – absent highly backwardated fuel markets – blue hydrogen is considered a bridge to the green variant, since it only builds on the incumbent grey hydrogen production process and is cheaper (Chart 5). Approximately 90% of total hydrogen produced annually is grey. If the EU is forced to ration natgas – Germany, e.g., is preparing its population for such a contingency in the event Russian supplies are shut off – reduced fuel availability will act as a hard constraint for blue-hydrogen production. This would prolong green-hydrogen's cost advantage. Chart 5Green Hydrogen Typically Most Expensive Hue EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects That being said, green hydrogen has its own geopolitical problems. Procuring the critical minerals and metals required to build electrolyzers can prove to be challenging, given the metals’ locations are highly concentrated in states with stressed electrical infrastructures like South Africa, which produces 85% and 70% of global iridium and platinum supply respectively (Chart 6). Both metals are in commonly used electrolyzers. Metals supply disruptions in China similar to those that occurred this past winter can affect numerous metal supply chains necessary for hydrogen production. Chart 6Concentration Risks In Hydrogen Materials EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Displacing High-Polluting Technology According to the IRENA, hydrogen could cover up to 12% of global energy use by 2050.5 Green hydrogen has numerous potential applications: Backstopping intermittent renewable energy; Performing as a “zero-emissions” fuel for maritime shipping and aviation; An energy source for high-heat industrial processes that cannot otherwise be electrified; A feedstock in some industrial processes, like steel production.6 The adoption of hydrogen for new applications has been slow, with uptake limited to the last decade, when fuel cell electric vehicle (FCEV) deployment started gaining traction. In addition, this energy source can be used to produce commodities such as steel, cement and glass used in construction, and ammonia needed to fertilize crops.7 In terms of size, global hydrogen demand was 90 Mt in 2020, with most of it coming from refining and industrial uses. Governments have committed to greater hydrogen use, but not nearly enough to meet net-zero energy emissions by 2050 (Chart 7).8 IRENA estimates that over 30% of hydrogen could be traded across borders by 2050, a higher share than natural gas today.9 According to the Energy Networks Association, up to a fifth of natural gas consumption currently used could be replaced by hydrogen.10 Countries most able to generate cheap renewable electricity will be best placed to produce competitive green hydrogen.11 Chart 7Hydrogen Contributes To Lower Emissions EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Investment Implications High natgas prices – in its pipeline and liquid forms – will redound to the benefit of clean hydrogen and its supporting technology. The relative cost advantage green hydrogen has over its grey and blue competition will persist this year and most likely in 2023, as the EU and China continue to bid for scarce natgas supplies in the wake of Russia's invasion of Ukraine. This could persist, if markets begin pricing the availability and future reliability of clean hydrogen on par with fossil-fuel availability. However, this will require significant increases in green-hydrogen technology investment, particularly in electrolysers. Government support – e.g., the US DOE's efforts to reduce the cost of green hydrogen to $1/kg over the next 10 years from $5/kg – will be important in this regard. The development of green-hydrogen capacity and its infrastructure could limit the further development of natural gas, which will be increasingly important during the global energy transition. The conventional natgas resource base benefits from a fully developed global infrastructure, which, if augmented with funding and tax support for carbon-capture and storage technology, will provide a necessary bridge to a low-carbon energy grid.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodity Round-Up Industrial bulks (iron ore and steel) and metals are becoming more expensive, increasing the cost of Europe’s effort to diversify away from Russian natural gas. European countries that relied on pipeline natgas from Russia will need to construct import facilities and regasification plants to switch to LNG from other exporters. Cross-border European pipelines also will be required to transport imported natural gas from the Iberian Peninsula and Eastern Europe to inland Europe. The US will be expanding LNG export facilities in the Gulf out to 2025, after which growth in export capacity will level off at ~ 10 Bcf/d. It has a large latent export capacity of ~ 187 million tons of LNG, however 48% of that capacity will come via projects currently under construction or awaiting permits. The build-out and expansion of LNG import and export facilities will be steel- and metals- intensive. Renewables-based energy the EU will look to as another alternative to Russian gas will compete with new LNG facilities’ metal demand, given green energy’s infrastructure requirements (Chart 8). The US and China will compete with the EU for these metals, as the world aims to achieve net-zero carbon emissions by 2050. The downside risk is the current COVID wave in China, and the stringent lockdown accompanying it, which started in end-March. Lockdowns will slow down economic activity and demand for metals. So far, however, copper - widely used in the nation’s large property sector - seems to have been untouched by activity in China. This is likely due to low inventory levels, the Ukraine crisis, and political uncertainty in the copper rich countries of Peru and Chile, which has slowed investment activity in the region. According to BCA’s China Investment Strategy, China’s zero-tolerance COVID policy will lead to frequent lockdowns and outweigh the positive effects of stimulus, given the high transmissibility of the Omicron variant now spreading there. Copper demand growth likely slows in China, but outside China demand for steel and base metals is holding up.. Chart 8 EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Footnotes 1     Please see Surging Metals Prices And The Case For Carbon-Capture, which we published 13 May 2021. It is available at ces.bcaresearch.com. Nordhaus is the 2018 Nobel Laureate in Economics in 2018. Please see Carbon Market Clubs and the New Paris Regime published by the World Bank in July 2016. The intellectual and computational framework for this technology was developed by Nordhaus. 2     Please see Geopolitics of The Energy Transformation: The Hydrogen Factor, published by IRENA. 3    Please see Green Hydrogen Cost Reduction: Scaling Up Electrolyzers to Meet the 1.5°C Climate Goal, published by IRENA. 4    Please see Ukraine war | Green hydrogen 'now cheaper than grey in Europe, Middle East and China': BNEF, published by rechargenews.com on March 7, 2022.  5    https://www.irena.org/newsroom/pressreleases/2022/Jan/Hydrogen-Economy-… 6    Please see Hydrogen: Future of Clean Energy or a False Solution? published by Sierra Club 5 January 2022. 7     Please see Green hydrogen has long been hyped as a replacement for fossil fuels. Now, one of the industry’s biggest players is preparing its IPO published by Fortune on January 10, 2022. 8    Please see Global Hydrogen Review 2021 published by IEA November 2021. 9    Please see Hydrogen Economy Hints at New Global Power Dynamics published by IRENA on January 15, 2022. 10   Please see Hydrogen could replace 20% of natural gas in the grid from next year published by Institution for Mechanical Engineers 14 January 2022. 11    See footnote #9. Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image  

Executive Summary Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Macroeconomic Outlook: Global growth will reaccelerate in the second half of this year provided a ceasefire in Ukraine is reached. Inflation will temporarily come down as the dislocations caused by the war and the pandemic subside, before moving up again in late 2023. Equities: Maintain a modest overweight in stocks over a 12-month horizon, favoring non-US equities, small caps, and value stocks. Look to turn more defensive in the second half of 2023 in advance of another wave of inflation. Fixed income: The neutral rate of interest in the US is around 3.5%-to-4%, which is substantially higher than the consensus view. Bond yields will move sideways this year but will rise over the long haul. Overweight Germany, France, Japan, and Australia while underweighting the US and the UK in a global bond portfolio. Credit: Corporate debt will outperform high-quality government bonds over the next 12 months. Favor HY over IG and Europe over the US. Spreads will widen again in late 2023. Currencies: As a countercyclical currency, the US dollar will weaken later this year, with EUR/USD rising to 1.18. We are upgrading our view on the yen from bearish to neutral due to improved valuations. The CNY will strengthen as the Chinese authorities take steps to boost domestic demand. Commodities: Oil prices will dip in the second half of 2022 as the geopolitical premium in crude declines and more OPEC supply comes to market. However, oil and other commodity prices will start moving higher by mid-2023. Bottom Line: The cyclical bull market in stocks that began in 2009 is running long in the tooth, but the combination of faster global growth later this year and a temporary lull in inflation should pave the way for one final hurrah for equities.   Dear Client, Instead of our regular report this week, we are sending you our Quarterly Strategy Outlook, where we explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. Next week, please join me for a webcast on Monday, April 11 at 9:00 AM EDT (2:00 PM BST, 3:00 PM CEST, 9:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist P.S. You can now follow me on LinkedIn and Twitter.   I. Overview We continue to recommend overweighting global equities over a 12-month horizon. However, we see downside risks to stocks both in the near term (next 3 months) and long term (2-to-5 years). In the near term, stocks will weaken anew if Russia’s stated intentions to scale back operations in Ukraine turn out to be a ruse. There is also a risk that China will need to temporarily shutter large parts of its economy to combat the spread of the highly contagious BA.2 Omicron variant. While stocks could suffer a period of indigestion in response to monetary tightening by the Fed and a number of other central banks, we doubt that rates will rise enough over the next 12 months to undermine the global economy. This reflects our view that the neutral rate of interest in the US and most other countries is higher than widely believed. If the neutral rate ends up being between 3.5% and 4% in the US, as we expect, the odds are low that the Fed will induce a recession by raising rates to 2.75%, as the latest dot plot implies (Chart 1). Chart 1The Market Sees The Fed Raising Rates To Around 3% And Then Backing Off 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The downside of a higher neutral rate is that eventually, investors will need to value stocks using a higher real discount rate. How fast markets mark up their estimate of neutral depends on the trajectory of inflation. We were warning about inflation before it was cool to warn about inflation (see, for example, our January 2021 report, Stagflation in a Few Months?; or our February 2021 report, 1970s-Style Inflation: Yes, It Could Happen Again). Our view has been that inflation will follow a “two steps up, one step down” pattern. We are currently near the top of those two steps: US inflation will temporarily decline in the second half of this year, as goods inflation drops but service inflation is slow to rise. The decline in inflation will provide some breathing room for the Fed, allowing it to raise rates by no more than what markets are already discounting over the next 12 months. Unfortunately, the respite in inflation will not last long. By the end of 2023, inflation will start to pick up again, forcing the Fed to resume hiking rates in 2024. This second round of Fed tightening is not priced by the markets, and so when it happens, it could be quite disruptive for stocks and other risk assets. Investors should overweight equities on a 12-month horizon but look to turn more defensive in the second half of 2023.    II. The Global Economy War and Pestilence Are Near-Term Risks BCA’s geopolitical team, led by Matt Gertken, was ringing the alarm bell about Ukraine well before Russia’s invasion. Recent indications from Russia that it will scale back operations in Ukraine could pave the way for a ceasefire; or they could turn out to be a ruse, giving Russia time to restock supply lines and fortify its army in advance of a new summertime campaign against Kyiv. It is too early to tell, but either way, our geopolitical team expects more fighting in the near term. The West is not keen to give Putin an easy off-ramp, and even if it were, it is doubtful he would take it. The only way that Putin can salvage his legacy among his fan base in Russia is to decisively win the war in order to ensure Ukraine’s military neutrality.  For his part, Zelensky cannot simply agree to Russia’s pre-war demands that Ukraine demilitarize and swear off joining NATO unless Russian forces first withdraw. To give in to such demands without any concrete security guarantees would raise the question of why Ukraine fought the war to begin with.   The Impact of the Ukraine War on the Global Economy The direct effect of the war on the global economy is likely to be small. Together, Russia and Ukraine account for 3.5% of global GDP in PPP terms and 1.9% in dollar terms. Exports to Russia and Ukraine amount to only 0.2% of G7 GDP (Chart 2). Most corporations have little direct exposure to Russia, although there are a few notable exceptions (Chart 3). Chart 2Little Direct Trade Exposure To Russia And Ukraine 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral In contrast to the direct effects, the indirect effects have the potential to be sizable. Russia is the world’s second largest oil producer, accounting for 12% of annual global output (Chart 4). It is the world’s top exporter of natural gas. About half of European natural gas imports come from Russia. Russia is also a significant producer of nickel, copper, aluminum, steel, and palladium. Chart 3Only A Handful Of Firms Have Significant Sales Exposure To Russia 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 4Russia is The World's Second Largest Oil Producer Russia is The World's Second Largest Oil Producer Russia is The World's Second Largest Oil Producer Russia and Ukraine are major agricultural producers. Together, they account for a quarter of global wheat exports, with much of it going to the Middle East and North Africa (Chart 5). They are also significant producers of potatoes, corn, sugar beets, and seed oils. In addition, Russia produces two-thirds of all ammonium nitrate, the main source of nitrogen-based fertilizers. Largely as a result of higher commodity prices and other supply disruptions, the OECD estimates that the war could shave about 1% off of global growth this year, with Europe taking the brunt of the hit (Chart 6). At present, the futures curves for most commodities are highly backwardated (Chart 7). While one cannot look to the futures as unbiased predictors of where spot prices are heading, it is fair to say that commodity markets are discounting some easing in prices over the next two years. If that does not occur, global growth could weaken more than the OECD expects. Chart 5Developing Economies Buy The Bulk Of Russian And Ukrainian Wheat 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 6The War In Ukraine Could Shave One Percentage Point Off Of Global Growth 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 7Futures Curves For Most Commodities Are Backwardated 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral     Another Covid Wave Two years after “two weeks to flatten the curve,” the world continues to underappreciate the power of exponential growth. Suppose that it takes five days for someone with Covid to infect someone else. If everyone with Covid infects an average of six people, the cumulative number of Covid cases would rise from 1,000 to 10 million in around four weeks. Suppose you could cut the number of new infections in half to three per person. In that case, it would take about six weeks for 10 million people to be infected. In other words, mitigation measures that cut the infection rate by half would only extend how long it takes for 10 million people to be infected by two weeks. That’s not a lot.  The point is that any infection rate above one will generate an explosive rise in cases. In the pre-Omicron days, keeping the infection rate below one was difficult, but not impossible for countries with the means and motivation to do so. As the virus has become more contagious, however, keeping it at bay has grown more difficult. The latest strain of Omicron, BA.2, appears to be 40% more contagious than the original Omicron strain, which itself was about 4-times more contagious than Delta. BA.2 is quickly spreading around the world. The number of cases has spiked across much of Europe, parts of Asia, and has begun to rise in North America (Chart 8). In China, the authorities have locked down Shanghai, home to 25 million people. Chart 8Covid Cases Are On The Rise Again 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The success that China has had in suppressing the virus has left its population with little natural immunity; and given the questionable efficacy of its vaccines, with little artificial immunity as well. Moreover, as is the case in Hong Kong, a large share of mainland China’s elderly population remains completely unvaccinated. Chart 9New Covid Drugs Are Set To Hit The Market 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral This presents the Chinese authorities with a difficult dilemma: Impose severe lockdowns over much of the population, or let the virus run rampant. As the logic of exponential change described above suggests, there is not much of a middle ground. Our guess is that the Chinese government will choose the former option. China has already signed a deal to commercialize Pfizer’s Paxlovid. The drug is highly effective at preventing hospitalization if taken within five days from the onset of symptoms. Fortunately, Paxlovid production is starting to ramp up (Chart 9). China will probably wait until it has sufficient supply of the drug before relaxing its zero-Covid policy. While beneficial to growth later this year, this strategy could have a negative near-term impact on activity, as the authorities continue to play whack-a-mole with Covid.   Chart 10Inflation Is Running High, Especially In The US Inflation Is Running High, Especially In The US Inflation Is Running High, Especially In The US Central Banks in a Bind Standard economic theory says that central banks should adjust interest rates in response to permanent shocks, while ignoring transitory ones. This is especially true if the shock in question emanates from the supply side of the economy. After all, higher rates cool aggregate demand; they do not raise aggregate supply. The lone exception to this rule is when a supply shock threatens to dislodge long-term inflation expectations. If long-term inflation expectations become unanchored, what began as a transitory shock could morph into a semi-permanent one. The problem for central banks is that the dislocations caused by the Ukraine war are coming at a time when inflation is already running high. Headline CPI inflation reached 7.9% in the US in February, while core CPI inflation clocked in at 6.4%. Trimmed-mean inflation has increased in most economies (Chart 10). Fortunately, while short-term inflation expectations have moved up, long-term expectations have been more stable. Expected US inflation 5-to-10 years out in the University of Michigan survey stood at 3.0% in March, down a notch from 3.1% in January, and broadly in line with the average reading between 2010 and 2015 (Chart 11). Survey-based measures of long-term inflation expectations are even more subdued in the euro area and Japan (Chart 12). Market-based inflation expectations have risen, although this partly reflects higher oil prices. Even then, the widely-watched 5-year, 5-year forward TIPS inflation breakeven rate remains near the bottom of the Fed’s comfort range of 2.3%-to-2.5% (Chart 13).1  Chart 11Long-Term Inflation Expectations Remain Contained In The US... Long-Term Inflation Expectations Remain Contained In The US... Long-Term Inflation Expectations Remain Contained In The US... ​​​​​​ Chart 12... And In The Euro Area And Japan ... And In The Euro Area And Japan ... And In The Euro Area And Japan Chart 13The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone The Market's Long-Term Inflation Expectations Are Near The Bottom Of The Fed's Comfort Zone Goods versus Services Inflation Most of the increase in consumer prices has been concentrated in goods rather than services (Chart 14). This is rather unusual in that goods prices usually fall over time; but in the context of the pandemic, it is entirely understandable. Chart 14Goods Prices Have Been A Major Driver Of Overall Inflation 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The pandemic caused spending to shift from services to goods (Chart 15). This occurred at the same time as the supply of goods was being adversely affected by various pandemic-disruptions, most notably the semiconductor shortage that is still curtailing automobile production.   Chart 15AGoods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (I) Chart 15BGoods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Goods Inflation Should Fade Goods Inflation Should Fade As Consumption Shifts Back Towards Services (II) Looking out, the composition of consumer spending will shift back towards services. Supply chain bottlenecks should also abate, especially if the situation in Ukraine stabilizes. It is worth noting that the number of ships on anchor off the coast of Los Angeles and Long Beach has already fallen by half (Chart 16). The supplier delivery components of both the manufacturing and nonmanufacturing ISM indices have also come off their highs (Chart 17). Even used car prices appear to have finally peaked (Chart 18). Chart 16Shipping Delays Are Abating Shipping Delays Are Abating Shipping Delays Are Abating Chart 17Delivery Times Are Slowly Coming Down Delivery Times Are Slowly Coming Down Delivery Times Are Slowly Coming Down Chart 18Used Car Prices May Have Finally Peaked Used Car Prices May Have Finally Peaked Used Car Prices May Have Finally Peaked On the Lookout for a Wage-Price Spiral Could rising services inflation offset any decline in goods inflation this year? It is possible, but for that to happen, wage growth would have to accelerate further. For now, much of the acceleration in US wage growth has occurred at the bottom end of the income distribution (Chart 19). It is easy to see why. Chart 20 shows that low-paid workers have not returned to the labor market to the same degree as higher-paid workers. However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution Chart 20More Low-Wage Employees Should Return To Work More Low-Wage Employees Should Return To Work More Low-Wage Employees Should Return To Work Chart 21More Workers Will Return To Their Jobs Once The Pandemic Ends More Workers Will Return To Their Jobs Once The Pandemic Ends More Workers Will Return To Their Jobs Once The Pandemic Ends The end of the pandemic should allow more workers to remain at their jobs. In January, during the height of the Omicron wave, 8.75 million US workers (5% of the total workforce) were absent from work due to the virus (Chart 21).   How High Will Interest Rates Eventually Rise? If goods inflation comes down swiftly later this year, and services inflation is slow to rise, then overall inflation will decline. This should allow the Fed to pause tightening in early 2023. Whether the Fed will remain on hold beyond then depends on where the neutral rate of interest resides. Chart 22The Yield Curve Inverted in Mid-2019 But Growth Accelerated The Yield Curve Inverted in Mid-2019 But Growth Accelerated The Yield Curve Inverted in Mid-2019 But Growth Accelerated The neutral rate, or equilibrium rate as it is sometimes called, is the interest rate consistent with full employment and stable inflation. If the Fed pauses hiking before interest rates have reached neutral, the economy will eventually overheat, forcing the Fed to resume hiking. In contrast, if the Fed inadvertently raises rates above neutral, unemployment will start rising, requiring the Fed to cut rates. Markets are clearly worried about the latter scenario. The 2/10 yield curve inverted earlier this week. With the term premium much lower than in the past, an inversion in the yield curve is not the powerful harbinger of recession that it once was. After all, the 2/10 curve inverted in August 2019 and the economy actually strengthened over the subsequent six months before the pandemic came along (Chart 22). Nevertheless, an inverted yield curve is consistent with markets expectations that the Fed will raise rates above neutral. That is always a dangerous undertaking. Raising rates above neutral would likely push up the unemployment rate. There has never been a case in the post-war era where the 3-month moving average of the unemployment rate has risen by more than 30 basis points without a recession occurring (Chart 23). Chart 23When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising When Unemployment Starts Rising, It Usually Keeps Rising   As discussed in the Feature Section below, the neutral rate of interest is probably between 3.5% and 4% in the US. This is good news in the short term because it lowers the odds that the Fed will raise rates above neutral during the next 12 months. It is bad news in the long run because it means that the Fed will find itself even more behind the curve than it is now, making a recession almost inevitable. The Feature Section builds on our report from two weeks ago. Readers familiar with that report should feel free to skip ahead to the next section. III. Feature: A Higher Neutral Rate Conceptually, the neutral rate is the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.2  Anything that reduces savings or increases investment would raise the neutral rate (Chart 24). Chart 24The Savings-Investment Balance Determines The Neutral Rate Of Interest 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral A number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 25). Household wealth has soared since the start of the pandemic (Chart 26). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by 4% of GDP. Chart 25Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Chart 26Net Worth Has Soared Since The Pandemic Net Worth Has Soared Since The Pandemic Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 27). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. For the first time since the housing boom, mortgage equity withdrawals are rising. Banks are easing lending standards on consumer loans across the board. Chart 27US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated US Household Deleveraging Pressures Have Abated Chart 28Baby Boomers Have Amassed A Lot Of Wealth 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 28). As baby boomers transition from being savers to dissavers, national savings will decline. Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 29).Chart 29Fiscal Policy: Tighter But Not Tight 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.3 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 30). After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 31). Capex intention surveys remain upbeat (Chart 32). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 33). Chart 30Much Of The Deceleration In Potential Growth Has Already Happened Much Of The Deceleration In Potential Growth Has Already Happened Much Of The Deceleration In Potential Growth Has Already Happened Chart 31Positive Signs For Capex (I) Positive Signs For Capex (I) Positive Signs For Capex (I) Chart 32Positive Signs For Capex (II) Positive Signs For Capex (II) Positive Signs For Capex (II) Chart 33An Aging Capital Stock An Aging Capital Stock An Aging Capital Stock Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 34). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 34US Housing Is In Short Supply US Housing Is In Short Supply US Housing Is In Short Supply   The New ESG: Energy Security and Guns The war in Ukraine will put further upward pressure on the neutral rate, especially outside of the United States. After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 35). As Mathieu Savary points out in his latest must-read report on Europe, capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Germany has already announced plans to construct three new LNG terminals. The push to build out Europe’s energy infrastructure is coming at a time when businesses are looking to ramp up capital spending. As in the US, Europe’s capital stock has aged rapidly over the past decade (Chart 36). Chart 35European Capex Should Recover European Capex Should Recover European Capex Should Recover Chart 36European Machines Need More Than Just An Oil Change European Machines Need More Than Just An Oil Change European Machines Need More Than Just An Oil Change   Chart 37The War In Ukraine Calls For More Spending Across Europe The War In Ukraine Calls For More Spending Across Europe The War In Ukraine Calls For More Spending Across Europe Meanwhile, European governments are trying to ease the burden from rising energy costs. For example, France has introduced a rebate on fuel. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. European military spending will rise. Military spending currently amounts to 1.5% of GDP, well below NATO’s threshold of 2% (Chart 37). Germany has announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate Ukrainian refugees. The UN estimates that four million refugees have left Ukraine, with the vast majority settling in the EU.   A Smaller Chinese Current Account Surplus? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 38). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic infrastructure spending or raising household consumption. Notably, China’s credit impulse appears to have bottomed and is set to increase in the second half of the year. This is good news not just for Chinese growth but growth abroad (Chart 39). Chart 38Will China Be A Source Of Excess Savings? Will China Be A Source Of Excess Savings? Will China Be A Source Of Excess Savings? Chart 39China's Credit Impulse Appears To Have Bottomed China's Credit Impulse Appears To Have Bottomed China's Credit Impulse Appears To Have Bottomed The IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. IV. Financial Markets A. Portfolio Strategy Chart 40The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles The Markets Wobbled And Then Recovered After The Beginning Of The Last Four Fed Rate Cycles As noted in the overview, if the neutral rate turns out to be higher than currently perceived, the Fed is unlikely to induce a recession by raising rates over the next 12 months. That is good news for equities. A look back at the past four Fed tightening cycles shows that stocks often wobble when the Fed starts hiking rates, but then usually rise as long as rates do not move into restrictive territory (Chart 40). Unfortunately, a higher neutral rate also means that investors will eventually need to value stocks using a higher discount rate. It also means that any decline in inflation this year will not last. The US economy will probably start to overheat again in the second half of 2023. This will set the stage for a second, and more painful, tightening cycle in 2024. Admittedly, there is a lot of uncertainty over our “two steps up, one step down” forecast for inflation. It is certainly possible that the “one step down” phase does not last long and that the resurgence in inflation we are expecting in the second half of next year occurs earlier. It is also possible that investors will react negatively to rising rates, even if the economy is ultimately able to withstand them. As such, only a modest overweight to equities is justified over the next 12 months, with risks tilted to the downside in the near term. More conservative asset allocators should consider moving to a neutral stance on equities already, as my colleague Garry Evans advised clients to do in his latest Global Asset Allocation Quarterly Portfolio Outlook.   B. Fixed Income Stay Underweight Duration Over a 2-to-5 Year Horizon Our recommendation to maintain below-benchmark duration in fixed-income portfolios panned out since the publication of our Annual Outlook in December, with the US 10-year Treasury yield rising from 1.43% to 2.38%. We continue to expect bond yields in the US to rise over the long haul. Conceptually, the yield on a government bond equals the expected path of policy rates over the duration of the bond plus a term premium. The term premium is the difference between the return investors can expect from buying a long-term bond that pays a fixed interest rate, and the return from rolling over a short-term bill. The term premium has been negative in recent years. Investors have been willing to sacrifice return to own long-term bonds because bond prices usually rise when the odds of a recession go up. The fact that monthly stock returns and changes in bond yields have been positively correlated since 2001 underscores the benefits that investors have received from owning long-term bonds as a hedge against unfavorable economic news (Chart 41). However, now that inflation has emerged as an increasingly important macroeconomic risk, the correlation between stock returns and changes in bond yields could turn negative again. Unlike weak economic growth, which is bad for only stocks, high inflation is bad for both bonds and stocks. Chart 41Correlation Between Stock Returns And Bond Yields Could Turn Negative Correlation Between Stock Returns And Bond Yields Could Turn Negative Correlation Between Stock Returns And Bond Yields Could Turn Negative If bond yields start to rise whenever stock prices fall, the incentive to own long-term bonds will decline. This will cause the term premium to increase. Assuming the term premium rises to about 0.5%, and a neutral rate of 3.5%-to-4%, the long-term fair value for the 10-year US Treasury yield is 4%-to-4.5%. This is well above the 5-year/5-year forward yield of 2.20%.   Move from Underweight to Neutral Duration Over a 12-Month Horizon Below benchmark duration positions usually do well when the Fed hikes rates by more than expected over the subsequent 12 months (Chart 42). Chart 42The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Given our view that US inflation will temporarily decline later this year, the Fed will probably not need to raise rates over the next 12 months by more than the 249 basis points that markets are already discounting. Thus, while a below-benchmark duration position is advisable over a 2-to-5-year time frame, it could struggle over a horizon of less than 12 months. Our end-2022 target range for the US 10-year Treasury yield is 2.25%-to-2.5%. Chart 43Bond Sentiment And Positioning Are Bearish Bond Sentiment And Positioning Are Bearish Bond Sentiment And Positioning Are Bearish Supporting our decision to move to a neutral benchmark duration stance over a 12-month horizon is that investor positioning and sentiment are both bond bearish (Chart 43). From a contrarian point of view, this is supportive of bonds.   Global Bond Allocation BCA’s global fixed-income strategists recommend overweighting German, French, Australian, and Japanese government bonds, while underweighting those of the US and the UK. They are neutral on Italy and Spain given that the ECB is set to slow the pace of bond buying. The neutral rate of interest has risen in the euro area, partly on the back of more expansionary fiscal policy across the region. In absolute terms, however, the neutral rate in the euro area is still quite low, and possibly negative. Unlike in the US, where inflation has risen to uncomfortably high levels, much of Europe would benefit from higher inflation expectations, as this would depress real rates across the region, giving growth a boost. This implies that the ECB is unlikely to raise rates much over the next two years. As with the euro area, Japan would benefit from lower real rates. The Bank of Japan’s yield curve control policy has been put to the test in recent weeks. To its credit, the BoJ has stuck to its guns, buying bonds in unlimited quantities to prevent yields from rising. We expect the BoJ to stay the course. Unlike in the euro area and Japan, inflation expectations are quite elevated in the UK and wage growth is rising quickly there. This justifies an underweight stance on UK gilts. Although job vacancies in Australia have climbed to record levels, wage growth is still not strong enough from the RBA’s point of view to justify rapid rate hikes. As a result, BCA’s global fixed-income strategists remain overweight Australian bonds. Finally, our fixed-income strategists are underweight Canadian bonds but are contemplating upgrading them given that markets have already priced in 238 basis points in tightening over the next 12 months. Unlike in the US, high levels of consumer debt will also limit the Bank of Canada’s ability to raise rates.   Modest Upside in High-Yield Corporate Bonds Credit spreads have narrowed in recent days but remain above where they were prior to Russia’s invasion of Ukraine. Since the start of the year, US investment-grade bonds have underperformed duration-matched Treasurys by 154 basis points, while high-yield bonds have underperformed by 96 basis points (Chart 44). The outperformance of high-yield relative to investment-grade debt can be explained by the fact that the former has more exposure to the energy sector, which has benefited from rising oil prices. Looking out, falling inflation and a rebound in global growth later this year should provide a modestly supportive backdrop for corporate credit. High-yield spreads are still pricing in a default rate of 3.8% over the next 12 months (Chart 45). This is well above the trailing 12-month default rate of 1.3%. Our fixed-income strategists continue to prefer US high-yield over US investment-grade. Chart 44Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Spreads Have Narrowed Over The Past Two Weeks But Remain Above Pre-War Levels Chart 45Spread-Implied Default Rate Is Too High 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral   European credit is attractively priced and should benefit from any stabilization in the situation in Ukraine. Our fixed-income strategists prefer both European high-yield and investment-grade bonds over their US counterparts. As with equities, the bull market in corporate credit will end in late 2023 as the Fed is forced to resume raising rates in 2024 in the face of an overheated economy.   C. Currencies Chart 46Widening Interest Rate Differentials Have Supported The Dollar Widening Interest Rate Differentials Have Supported The Dollar Widening Interest Rate Differentials Have Supported The Dollar The US Dollar Will Weaken Starting in the Second Half of 2022 Since bottoming last May, the US dollar has been trending higher. While the dollar could strengthen further in the near term if the war in Ukraine escalates, the fundamental backdrop supporting the greenback is starting to fray. If US inflation comes down later this year, the Fed is unlikely to raise rates by more than what markets are already discounting over the next 12 months. Thus, widening rate differentials will no longer support the dollar (Chart 46). The dollar is a countercyclical currency: It usually weakens when global growth is strengthening and strengthens when global growth is weakening (Chart 47). The dollar tends to be particularly vulnerable when growth expectations are rising more outside the US than in the US (Chart 48). Chart 47The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 48Better Growth Prospects Abroad Will Weigh On The US Dollar Better Growth Prospects Abroad Will Weigh On The US Dollar Better Growth Prospects Abroad Will Weigh On The US Dollar Global growth should rebound in the second half of the year once the pandemic finally ends and the situation in Ukraine stabilizes. Growth is especially likely to recover in Europe. This will support the euro, a dovish ECB notwithstanding. Chester Ntonifor, BCA’s Foreign Exchange Strategist, expects EUR/USD to end the year at 1.18.   The Dollar is Overvalued The dollar’s ascent has left it overvalued by more than 20% on a Purchasing Power Parity (PPP) basis (Chart 49). The PPP exchange rate equalizes the price of a representative basket of goods and services between the US and other economies. PPP deviations from fair value have done a reasonably good job of predicting dollar movements over the long run (Chart 50). Chart 49USD Remains Overvalued 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 50Valuations Matter For FX Long-Term Returns Valuations Matter For FX Long-Term Returns Valuations Matter For FX Long-Term Returns Reflecting the dollar’s overvaluation, the US trade deficit has widened sharply (Chart 51). Excluding energy exports, the US trade deficit as a share of GDP is now the largest on record. Equity inflows have helped finance America’s burgeoning current account deficit (Chart 52). However, these inflows have ebbed significantly as foreign investors have lost their infatuation with US tech stocks. Chart 51The US Trade Deficit Has Widened The US Trade Deficit Has Widened The US Trade Deficit Has Widened Chart 52Net Inflows Into US Equities Have Dried Up Net Inflows Into US Equities Have Dried Up Net Inflows Into US Equities Have Dried Up Dollar positioning remains stretched on the long side (Chart 53). That is not necessarily an obstacle in the short run, given that the dollar tends to be a momentum currency, but it does suggest that the greenback could weaken over a 12-month horizon as more dollar bulls jump ship.     The Yen: Cheaper but Few Catalysts for a Bounce The trade-weighted yen has depreciated by 6.4% since the start of the year. The yen is 31% undervalued relative to the dollar on a PPP basis (Chart 54). In a nod to these improved valuations, we are upgrading our 12-month and long-term view on the yen from bearish to neutral. Chart 53Still A Lot of Dollar Bulls Still A Lot of Dollar Bulls Still A Lot of Dollar Bulls Chart 54The Yen Has Gotten Cheaper The Yen Has Gotten Cheaper The Yen Has Gotten Cheaper       While the yen is unlikely to weaken much from current levels, it is unlikely to strengthen. As noted above, the Bank of Japan has no incentive to abandon its yield curve control strategy. Yes, the recent rapid decline in the yen is a shock to the economy, but it is a “good” shock in the sense that it could finally jolt inflation expectations towards the BoJ’s target of 2%. If inflation expectations rise, real rates would fall, which would be bearish for the currency.   Favor the RMB and other EM Currencies The Chinese RMB has been resilient so far this year, rising slightly against the dollar, even as the greenback has rallied against most other currencies. Real rates are much higher in China than in the US, and this has supported the RMB (Chart 55). Chart 55Higher Real Rates In China Have Supported The RMB Higher Real Rates In China Have Supported The RMB Higher Real Rates In China Have Supported The RMB Chart 56The RMB Is Undervalued Based On PPP The RMB Is Undervalued Based On PPP The RMB Is Undervalued Based On PPP   Despite the RMB’s strength, it is still undervalued by 10.5% relative to its PPP exchange rate (Chart 56). While productivity growth has slowed in China, it remains higher than in most other countries. The real exchange rates of countries that benefit from fast productivity growth typically appreciates over time. China holds about half of its foreign exchange reserves in US dollars, a number that has not changed much since 2012 (Chart 57). We expect China to diversify away from dollars over the coming years. Moreover, as discussed earlier in the report, the incentive for China to run large current account surpluses may fade, which will result in slower reserve accumulation. Both factors could curb the demand for dollars in international markets. Chart 57Half Of Chinese FX Reserves Are Held In USD Assets 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral A resilient RMB will provide a tailwind for other EM currencies. Many EM central banks began to raise rates well before their developed market counterparts. In Brazil, for example, the policy rate has risen to 11.75% from 2% last April. With inflation in EMs likely to come down later this year as pandemic and war-related dislocations subside, real policy rates will rise, giving EM currencies a boost.   D. Commodities Longer-Term Bullish Thesis on Commodities Remains Intact BCA’s commodity team, led by Bob Ryan, expects crude prices to fall in the second half of the year, before moving higher again in 2023. Their forecast is for Brent to dip to $88/bbl by end-2022, which is below the current futures price of $97/bbl. Chart 58Dearth Of Oil Capex Will Put A Floor Under Oil Prices 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral The risk to their end-2022 forecast is tilted to the upside. The relationship between the Saudis and the US has become increasingly strained. This could hamper efforts to bring more oil to market. Hopes that Iranian crude will reach global markets could also be dashed if, as BCA’s geopolitical strategists expect, the US-Iran nuclear deal falls through.  A cut-off of Russian oil could also cause prices to rise. While Urals crude is being sold at a heavy discount of $30/bbl to Brent (compared to a discount of around $2/bbl prior to the invasion), it is still leaving the country. In fact, Russian oil production actually rose in March over February. An escalation of the war would make it more difficult for Russia to divert enough oil to China, India, and other countries in order to evade Western sanctions. Looking beyond this year, Bob and his team see upside to oil prices. They expect Brent to finish 2023 at $96/bbl, above the futures price of $89/bbl. Years of underinvestment in crude oil production have led to tight supply conditions (Chart 58). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade.   Stay Positive on Metals As with oil, there has been little investment in mining capacity in recent years. While a weaker property market in China will weigh on metals prices, this will be partly offset by increased infrastructure spending. The shift towards green energy will also boost metals prices. The typical electric vehicle requires about four times as much copper as a typical gasoline-powered vehicle. Huge amounts of copper will also be necessary to expand electrical grids.   Favor Gold Over Cryptos After breaking above $2,000/oz, the price of gold has retreated to $1,926/oz. In the near term, gold prices will be swayed by geopolitical developments. Longer term, real rates will dictate the direction of gold prices. Chart 59 shows that there is a very strong correlation between the price of gold and TIPS yields. If we are correct that the neutral rate of interest is 3.5%-to-4% in the US, real bond yields will eventually need to rise from current levels. Gold prices are quite expensive by historic standards, which represents a long-term risk (Chart 60). Chart 59Strong Correlation Between Real Rates And Gold Strong Correlation Between Real Rates And Gold Strong Correlation Between Real Rates And Gold Chart 60Gold Is Quite Pricey From A Historical Perspective Gold Is Quite Pricey From A Historical Perspective Gold Is Quite Pricey From A Historical Perspective That said, we expect the bulk of the increase in real bond yields to occur only after mid-2023. As mentioned earlier, the Fed will probably not have to deliver more tightening that what markets are already discounting over the next 12 months. Thus, gold prices are unlikely to fall much in the near term. In any case, we continue to regard gold as a safer play than cryptocurrencies. As we discussed in Who Pays for Cryptos?, the long-term outlook for cryptocurrencies remains daunting. Many of the most hyped blockchain applications, from DeFi to NFTs, will turn out to be duds. Concerns that cryptocurrencies are harming the environment, contributing to crime, and enriching a small group of early investors at the expense of everyone else will lead to increased regulatory scrutiny. Our long-term target for Bitcoin is $5,000.   E. Equities Equities Are Still Attractively Priced Relative to Bonds Corporate earnings are highly correlated with the state of the business cycle (Chart 61). A recovery in global growth later this year will bolster revenue, while easing supply-chain pressures should help contain costs in the face of rising wages. It is worth noting that despite all the shocks to the global economy, EPS estimates in the US and abroad have actually risen this year (Chart 62). Chart 61The Business Cycle Drives Earnings The Business Cycle Drives Earnings The Business Cycle Drives Earnings Chart 62Global EPS Estimates Have Held Up Reasonably Well 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Chart 63Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds Equities Are Still Attractive Versus Bonds As Doug Peta, BCA’s Chief US Strategist has pointed out, the bar for positive earnings surprises for Q1 is quite low: According to Refinitiv/IBES, S&P 500 earnings are expected to fall by 4.5% in Q1 over Q4 levels. Global equities currently trade at 18-times forward earnings. Relative to real bond yields, stocks continue to look reasonably cheap (Chart 63). Even in the US, where valuations are more stretched, the earnings yield on stocks exceeds the real bond yield by 570 basis points. At the peak of the market in 2000, the gap between earnings yields and real bond yields was close to zero.   Favor Non-US Markets, Small Caps, and Value Valuations are especially attractive outside the US. Non-US equities trade at 13.7-times forward earnings. Emerging markets trade at a forward P/E of only 12.1. Correspondingly, the gap between earnings yields and real bond yields is about 200 basis points higher outside the US. In general, non-US markets fare best in a setting of accelerating growth and a weakening dollar – precisely the sort of environment we expect to prevail in the second half of the year (Chart 64). US small caps also perform best when growth is strengthening and the dollar is weakening (Chart 65). In contrast to the period between 2003 and 2020, small caps now trade at a discount to their large cap brethren. The S&P 600 currently trades at 14.4-times forward earnings compared to 19.7-times for the S&P 500, despite the fact that small cap earnings are projected to grow more quickly both over the next 12-months and over the long haul (Chart 66). Chart 64A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks A Weaker Dollar And Stronger Global Economy Are Tailwinds For Non-US Stocks Chart 65US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening US Small Caps Usually Fare Well When The Economy Is Strengthening And The Dollar Is Weakening Globally, growth stocks have outperformed value stocks by 60% since 2017. However, only one-tenth of that outperformance has come from faster earnings growth (Chart 67). This has left value trading nearly two standard deviations cheap relative to growth. Chart 66Small Caps Look Attractive Relative To Large Caps Small Caps Look Attractive Relative To Large Caps Small Caps Look Attractive Relative To Large Caps Chart 67Value Remains Cheap Value Remains Cheap Value Remains Cheap Chart 68Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Higher Yields Tend To Flatter Bank Stocks And Usually Weigh On Tech Tech stocks are overrepresented in growth indices, while banks are overrepresented in value indices. US banks have held up relatively well since the start of the year but have not gained as much as one would have expected based on the significant increase in bond yields (Chart 68). With the deleveraging cycle in the US coming to an end, US banks sport both attractive valuations and the potential for better-than-expected earnings growth. European banks should also recover as the situation in Ukraine stabilizes. They trade at only 7.9-times forward earnings and 0.6-times book. On the flipside, structurally higher bond yields will weigh on tech shares. Moreover, as we discussed in our recent report entitled The Disruptor Delusion, a cooling in pandemic-related tech spending, increasing market saturation, and concerns about Big Tech’s excessive power will all hurt tech returns.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1     The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. 2     These savings can either by generated domestically or imported from abroad via a current account deficit. 3    Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. Global Investment Strategy View Matrix 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral Special Trade Recommendations   Current MacroQuant Model Scores 2022 Second Quarter Strategy Outlook – The New Neutral 2022 Second Quarter Strategy Outlook – The New Neutral

Executive Summary Europe Is Russia's Key Gas Customer Germany Closer To Rationing Natgas Germany Closer To Rationing Natgas Full-on rationing of natural gas by Germany took a step closer to reality, as the standoff with Russia over its insistence on being paid in roubles for gas plays out. News that Germany initiated its first step toward rationing spiked European and UK natgas prices by more than 12% on Wednesday. Higher prices for coal, oil and renewable energy will follow, as these energy sources compete at the margin with natgas in Europe. Inflation and inflation expectations will move higher if Germany ultimately rations scarce natgas supplies. We are watching to see who blinks first – Germany or Russia. The risk of aluminum-smelter shut-downs in Europe once again is elevated. Other metals-refining operations also are at risk of shutdown if rationing is invoked. Trade difficulties arising from Russia's invasion of Ukraine and related sanctions will lead to further bottlenecks on base-metal exports from Russia, as Rusal warned this week. This will further confound the energy transition. Western governments will be forced to accelerate investments and subsidies in carbon-capture technology as fossil-fuel usage and prospects revive. Bottom Line: Fast-changing EU natural gas supply-demand dynamics are impacting competing energy and base metals markets.  This is throwing up confusion around the global renewable-energy transition and extending its timetable.  Fossil fuels fortunes are being revived, as a result. We remain long commodity index exposure and the equities of oil-and-gas producers and base-metals miners.   Feature Events in the EU natural gas markets are changing rapidly in the wake of fast-changing developments in the Russia-Ukraine war.  In the wake of these changes, economic prospects for Europe and Russia are rapidly evolving – both potentially negatively over the short run. Full-on rationing of natural gas by Germany took a step closer to reality, as its standoff with Russia over payment for gas in roubles plays out.  News Germany is preparing its citizens for rationing spiked European and UK natgas prices by more than 12% Wednesday. It's not clear whether Russia or Germany are bluffing on this score.  Russia's oil and gas exports last year accounted for close to 40% of the government's budget. According to Russia's central bank, crude and product revenue last year amounted to just under $180 billion, while pipeline and LNG shipments of natgas generated close to $62 billion last year.  Europe is Russia's biggest natgas market, accounting for ~ 40% of its exports.  However, as the relative shares of revenues indicate, natgas exports are less important to Russia than crude and liquids exports.  Losing this revenue stream for a year would amount to losing ~ $25 billion of revenue, all else equal.  In the event, however, the net loss might be lower, since this would put a bid under the natgas market ex-Europe, which would offset part or most of the lost natgas sales to Europe.  If Russia is able to re-market those lost volumes, it could offset the loss of European sales. Knock-On Effects The immediate knock-on effect of this news turns out to be higher prices for oil, UK and European natgas.  This is not unexpected, as gasoil competes at the margin with natgas in space heating markets, while competition across regions also can be expected to increase.  Once again, the risk of aluminum-smelter shut-downs in Europe is elevated if rationing is imposed by Germany.  Other metals-refining operations also are at risk of shutdown if rationing is invoked.  Lastly, fertilizer production in Europe would be materially impacted, given some 70% of fertilizer costs are accounted for by natgas. In addition to these endogenous EU effects, trade difficulties arising from Russia's invasion of Ukraine and related sanctions will lead to further bottlenecks on base-metal exports from Russia, as Rusal warned this week.1 This will further confound the energy transition as the world's third-largest aluminum smelter faces sanctions – official and self-imposed – and the loss of inputs from Western suppliers, along with reduced access to capital and funding from the West. If, over time, Russia's base metals industries are degraded by the lack of access to capital and technology as oil and gas will be, the global renewable-energy transition will be slowed considerably.   We already expect Russia's oil and gas production to fall over time due to the economic isolation created by Russia's invasion of Ukraine, rendering it a diminished member of OPEC 2.0.  Russia accounts for ~ 10% of global crude oil supplies, and is the second largest producer of crude oil in the coalition.  A long-term degradation of its production profile will exacerbate the persistent imbalance between demand relative to supply globally, which continues to force oil inventories lower (Chart 1). On the metals side, Russia accounts for 6%, 5% and 4% of global primary aluminum, refined nickel and copper production.  Persistent supply deficits have left inventories in these markets – particularly nickel and copper – tight and getting tighter (Chart 2).2 Chart 1Oil Inventories Remain Tight... Oil Inventories Remain Tight... Oil Inventories Remain Tight... Chart 2… As Do Metals Inventories Germany Closer To Rationing Natgas Germany Closer To Rationing Natgas Europe's Radical Pivot In a little over a month's time, the EU has been forced to abandon once-immutable post-Cold War beliefs shared by the electorate and politicians of all stripes.  Ever-deepening commercial ties with Russia did not ensure EU energy security, nor did they obviate what arguably is any state's primary responsibility: Protecting and defending its citizens.  Because of its failed engagement policy with Russia over the post-Cold War interval, the EU is forced to scramble to restore its energy production and expand its sources of energy imports.  In addition, it is repeatedly asserting its intent to "double down" of the speed of its renewable-energy transition.  And, last but certainly not least, it is forced to rapidly rearm itself in industrial commodity markets that are in the midst of prolonged physical deficits and inventory drawdowns.3 The Russian invasion of Ukraine spurred the EU to action on both the energy and defense fronts.  It is rushing head-long into eliminating its dependence on Russia for fuel, particularly natural gas, and will pursue re-arming its member states forthwith (Chart 3).  Chart 3Weaning EU Off Russian Gas Will Prove Difficult Germany Closer To Rationing Natgas Germany Closer To Rationing Natgas On the energy front, the EU adopted a two-prong approach to cleave itself from Russian natgas: 1) Diversify its sources of natural gas, which largely will be in the form of liquified natural gas (LNG), and 2) doubling down on renewable energy generation. EU officials are aiming to replace two-thirds of their Russian gas imports by the end of this year, which is an ambitious target.  Over the next two years or so, EU officials hope to fully wean themselves from Russian natgas via a combination of infrastructure buildouts and a renewed push to increase domestic production, which was being throttled back by earlier attempts to secure increased Russian supplies, and a strong focus on renewables. EU's US LNG Deal The EU signed a deal with the US to receive an additional 15 Bcm of natural gas in 2022, and 50 Bcm annually by 2030, which is equal to ~ 30% of the EU’s 2020 Russian gas imports.  How exactly this will be done is unknown. In 2021, the EU imported 155 bcm of natgas from Russia, or more than 3x the amount being discussed with the US; 14 bcm of that was LNG.4 Just exactly what meeting of the minds was achieved between the EU and US government is totally unclear at this point.  The US is not an LNG supplier, nor can it order private companies to renege on existing contacts.  The US government likely will use its good offices to attempt to persuade Asian buyers to allow their contracted volumes to be diverted to European buyers, but that would, in all likelihood, mean they would switch to another fuel (e.g., coal) as an alternative if they take that deal.  This would, we believe, require some sort of financial incentive to induce such behavior. US liquefaction capacity is also running at near full capacity (Chart 4). While there are projects in the pipeline, in the medium-term (2 – 5 years) the lack of export capacity will act as a constraint to the amount of LNG that can be shipped to the EU. Chart 4Europe Critical To Russia's Gas Industry Germany Closer To Rationing Natgas Germany Closer To Rationing Natgas For Russia, its shipments of gas to OECD-Europe represent more than 70% of its exports (Chart 5). Arguably, Europe is just as important to Russia as Russia is to Europe.  With the EU set on a course to sever ties completely, Russia will be forced to invest in pipeline capacity to take more of its gas to China via the Power of Siberia 2 pipeline. In the short-term, US LNG exports to the EU will face headwinds since much of Central and Eastern Europe rely on piped gas from Russia. As a result, many countries within Europe are not equipped with sufficient regasification facilities and are running at near peak utilization rates (Chart 6).  Germany does not have any such capacity.  Chart 5Not Much Room For US LNG Exports To Grow… Germany Closer To Rationing Natgas Germany Closer To Rationing Natgas Chart 6…Or For Additional European LNG Imports Germany Closer To Rationing Natgas Germany Closer To Rationing Natgas LNG import facilities that have additional intake capacity in the Iberian Peninsula and Eastern Europe do not have sufficient pipeline capacity to move gas inland.  This will require additional infrastructure investment as well.  To deal with this lack of infrastructure, Germany, Italy and the Netherlands are moving quickly to procure Floating Storage and Regasification (FSRUs) to convert LNG back to its gaseous state.  While not the five-year proposition a dedicated LNG train requires to bring on line, setting up FSRUs still could be a years-long process.5 How quickly these assets can be mobilized, and the volumes they can deliver remain to be seen. Investment Implications Fast-changing EU natural gas supply-demand dynamics are impacting competing energy and base metals markets.  This is throwing up confusion around the global renewable-energy transition and extending its timetable.  Fossil fuels fortunes are being revived, as a result. At this point it is impossible to handicap the odds of a cut-off of Russian natgas to Europe, or its duration if it does occur.  Either way, competitive suppliers to Russia – particularly US shale-gas producers selling into the LNG market and the vessels that transport it – will benefit regardless of the course taken by Germany and Russia on rationing. We remain long commodity index via the S&P GSCI and COMT ETF, and the equities of oil-and-gas producers and base-metals miners via the PICK, XME and XOP ETFs.   Commodity Round-Up Energy: Bullish Oil prices were whipsawed by new reports suggesting Russia would substantially reduce its military operations in Kyiv ahead of ceasefire talks with Ukraine, only to have that speculation dashed by US officials indicating nothing had changed in the status quo to warrant such a view.  Markets restored the risk premium that fell out of prices on the unwarranted speculation, with Brent prices once again above $110/bbl this week.  At present, the fundamental oil picture remains tight.  In the run-up to a decision from OPEC 2.0's March meeting today, we continued to expect  KSA, the UAE and Kuwait to increase production by up to 1.6mm b/d this year, and another 600k b/d next year.  To date, OPEC 2.0 has fallen short by ~ 1.2mm b/d since it started returning production taken off line during the pandemic.  In return for higher output, we continue to expect the US to deepen its commitment to defending the Gulf Co-operation Council (GCC) states making up core-OPEC 2.0.  If we do not see an increase in core-OPEC 2.0 production, we will have to re-assess our fundamental outlook on KSA's, the UAE's and Kuwait's ability to increase production.  We also will have to determine whether – even if the supply is available to return to the market – these states have embraced a revenue-maximization strategy, given the fiscal breakeven price for these states now averages ~ $64/bbl.  It also is possible that heavily discounted Russian crude oil – trading more than $30/bbl below Brent (vs. the standard $2.50/bbl Urals normally commands) – convinces core-OPEC 2.0 states that oil prices are not so high for large EM buyers like India and China as to create demand destruction.  We believe the latter view likely is prevailing at present.  We continue to expect Brent to average $93/bbl this year and next (Chart 7). Base Metals: Bullish BHP Group Ltd. will invest more than $10 billion to expand metals production over the next 50 years in Chile.  The metals giant aims to stay ESG compliant, provided there is a supportive investment environment provided by the Chilean government. Resource-rich Latin American countries such as Chile and Peru have elected left-leaning governments intent on redistributing mining profits and ensuring companies comply with the ESG framework. As Chile considers raising mining royalties and redrafts its constitution, mining investment in the country has stalled. Political uncertainty in these countries has coincided with low global copper inventories (Chart 8) and high demand. Chart 7 Higher Prices Expected Higher Prices Expected Chart 8 Copper Inventories Moving Up Copper Inventories Moving Up     Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Footnotes 1     Please see Aluminum Giant Rusal Flags Stark Risks Triggered by War in Ukraine published by Bloomberg on March 30, 2022. 2     Please see our Special Report entitled Commodities' Watershed Moment, published on March 10, 2022.  It is available at ces.bcaresearch.com. 3    Please see footnote 2. 4    Please see How Deep Is Europe's Dependence on Russian Oil? published by the Columbia Climate School on March 14, 2022. 5    Please see Europe battles to secure specialised ships to boost LNG imports published by ft.com 28 March 2022.  Germany appears to be most advanced in its procurement of FSRU capacity, and is close to concluding a deal that would allow it to regasify 27 bcm annually.   Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image