Energy

Special Report

Executive Summary Failure Of Iran Deal Tightens Oil Supply The US and Iran suspended their attempt to negotiate a nuclear deal on March 11. Countries often get cold feet before major agreements but there are good reasons to believe this suspension will be permanent. A confirmed failure to restore the US-Iran strategic détente will lead to Middle Eastern instability. Iran will be on a trajectory to achieve nuclear weapons in a few years while Israel and the US will have to underscore their red lines against weaponization. The Strait of Hormuz will come under threat again. The immediate impact on oil prices should be positive: sanctions will continue to hinder Iran’s exports, while Iranian conflict with its neighbors will sharply increase the odds of oil disruptions caused by militant actions. Not to mention the Russia-induced energy supply shock. However, a decisive move by the Gulf Arab states to boost crude production would counteract the effect of Iranian sanctions and drive oil down. The Gulf Arabs will be more inclined to coordinate with the Biden administration as long as the Iran deal is ruled out. Thus oil volatility is the main implication beyond any short term oil spike.     Trade Recommendation Inception Date Return Long Gold (Strategic) 2019-12-06 36.8% Bottom Line: Go long US equities relative to global; long US and Canadian stocks versus Saudi and UAE stocks. Stay long XOP ETF, S&P GSCI index, and COMT ETF for exposure to oil prices and backwardation in oil forward curves. Feature The current Iran talks would have restored Joint Comprehensive Plan of Action (JCPA), which created a strategic détente between the US and Iran. Iran froze its nuclear program while the US lifted sanctions. President Barack Obama negotiated the deal in 2015, without congressional approval, while President Donald Trump nullified it in 2018, arguing that it did not restrict Iran’s ballistic missile development or support for regional militant groups. Chart 1Bull Market In Iran Tensions Will Be Super-Charged Since then there has been a bull market in Iran tensions (Chart 1), a secret war in which sporadic militant attacks, assassinations, and acts of sabotage occurred but neither side pursued open confrontation. These attacks can be significant, as with the Iran-backed attack on the Abqaiq refinery in Saudi Arabia, which took 6mm b/d of oil-processing capacity offline briefly in September 2019. The implication of this trend is energy supply disruption. Now the trend will be super-charged in the context of a global energy shortage. If no US-Iran détente is achieved, the Middle East will be set on a new trajectory of conflict, or at least a nuclear arms race and aggressive containment strategy. Since Trump turned away from the US-Iran détente and reimposed sanctions on Iran we have given a 40% chance of large-scale military conflict, according to our June 2019 decision tree (Diagram 1). The basis for such a conflict is Iran’s likelihood of obtaining nuclear arms and the need of Israel, its Arab neighbors, and the US to prevent that from happening. Diagram 1US-Iran Conflict: Critical Juncture In Our Decision Tree Between now and then, tit-for-tat military exchanges will increase, posing risks to oil supply in the short and medium run. Without a major diplomatic breakthrough that halts Iran’s nuclear weaponization, a bombing campaign against Iran will be the likeliest long-term consequence, due to the fateful logic of Israel’s strategic predicament (Diagram 2). Diagram 2Over Medium Term, Unilateral Israeli Military Action Is Possible Why Rejoining The US-Iran Deal Was Unlikely Under the Biden administration’s new plan, Iran would have frozen its nuclear program once again while Biden would have relaxed US “maximum pressure” sanctions on Iran, opening the way for foreign investment and the development of Iran’s energy sector and economy. The basis for a deal was the belief among some US policymakers that engagement with Iran would open up its economy, reducing regional war risks (especially in Iraq), expanding global energy supply, and fomenting pro-democratic sentiment in Iran. Also the Washington military-industrial complex wanted to reduce the US’s commitment to the Middle East and arrange a grand strategic “pivot to Asia” so as to counter the rise of China. Up till August 2021, we viewed a deal as likely, but that view changed when Iran’s hawkish or hardline faction came back into the presidency. Biden had a very small window of opportunity to negotiate with outgoing Iranian President Hassan Rouhani, who negotiated the original 2015 deal and whose administration fell apart after President Trump withdrew from the deal. When the hawkish Iranian faction took back power, this opportunity slipped. Iran’s hawks were vindicated for having opposed détente with the US in the first place. Since then we have argued that strategic tensions would escalate, for the following reasons: The Iranians could not trust the Americans, since they knew that any new deal could be torn up as early as January 20, 2025 if the Republican Party took back the White House. Indeed, former Vice President Mike Pence recently confirmed this view explicitly. The Iranians were not compelled to agree to the deal because high oil prices ensured that they could export oil regardless of US sanctions (Chart 2). The US no longer has the diplomatic credibility to galvanize a coalition that includes the Russians and Chinese to isolate Iran, like it did back in 2014-15. Chart 2Iranians Not Compelled To A Deal, Can Circumvent Sanctions As for Iran’s weak economy spurring social unrest and forcing Supreme Leader Ayatollah Ali Khamenei to agree to a deal, the US has had maximum pressure sanctions in place since 2019 and it has not produced that effect. Yes, Iran is ripe for social unrest, but the regime is consolidating power under the hardliners rather than taking any risky course of opening up and reform that could foment pro-democratic and pro-western demands for change. With oil revenues flowing in, the regime will be more capable of suppressing domestic opposition. The Americans could not trust the Iranians because they knew that they would ultimately pursue nuclear weapons regardless of any short-term revival of the 2015 deal. The Iranians have a stark choice between North Korea, which achieved nuclear weaponization and now has a powerful guarantee of future regime survival, and countries like Ukraine and Libya, which gave up nuclear weapons or programs only to be invaded by foreign armies. Moreover the Iranian nuclear deal lacked popular support, even among Obama Democrats back in 2015, not to mention today in the wake of the deal’s cancellation. The deal’s provisions would have begun expiring in 2025 under any conditions. The Israelis and Gulf Arabs opposed the deal. The Russians also switched to opposing the deal and made new demands at the last minute as a result of the US sanctions imposed on Russia in the wake of its invasion of Ukraine. The Russians do not have an interest in Iran obtaining a nuclear weapon and they supported the 2015 deal and the 2021-22 renegotiation while demanding their pound of flesh in the form of Ukraine. But they also know that Israel and the US will use military force to prevent Iran from getting the bomb, so they are not compelled to join any agreement. Crippling US sanctions over Ukraine likely caused them to interfere with the deal. Our pessimistic view is now confirmed, with the suspension of talks. True, informal talks will continue, diplomacy could somehow revive, and it is still possible for a deal to come together. But given our fundamental points above, we would give any durable diplomatic solution a low probability, say 5%. That means that the US and Iran will not engage, which means Iran will re-activate its regional militant proxies and begin pursuing nuclear weaponization. Iran has a powerful incentive to increase regime security before the dangerous leadership succession that looms over the nearly 83 year-old Khamenei and the threatening possibility of a Republican’s reelection in 2024. At present, it is unknown which side of the Iran nuclear deal talks suspended them. While the Iranians were not compelled by an international coalition to join the deal as they were in 2015, we cannot ignore the possibility the suspension in talks arises from a deal being reached between the US and core OPEC 2.0 producers (Saudi Arabia, the UAE, and Kuwait). Very simply, such a deal would entail that the Arab states increase output, to ease the global shortage, in return for the US walking away from the flawed Iran deal and pledging to work with Israel and the Gulf Arabs to contain Iran. Israel and the Gulf Arabs are increasingly aligned in their goal of countering Iran under the Abraham Accords, negotiated in 2020 by the Trump administration. If the US and Gulf states agreed, then the Gulf states are likely to increase production to ease the global shortage and prolong the business cycle, meaning that oil prices could fall rather than rise as their next move. Either way they will remain volatile as a result of global developments. What Next? Escalation In The Middle East The Iranians have made substantial nuclear progress since 2018, despite Israeli attempts at sabotaging critical facilities. Today Iran stands on the brink of achieving “breakout” levels of highly enriched uranium – levels at which it is possible to construct a nuclear device (Table 1). Table 1Iran Will Reach ‘Breakout’ Nuclear Capability The suspension of talks means the Iranians will soon reach breakout capacity, which will splash across global headlines. This news will rattle global financial markets as it will point to a nuclear arms race in the most volatile of regions. There is a gap of one-to-two years between breakout uranium enrichment and deliverable nuclear weapon, according to most experts.1 However, it is much easier to monitor nuclear programs than missile programs, which means western intelligence will lose visibility when it comes to knowing precisely when Iran will obtain a functional nuclear warhead that it can mount on a ballistic missile. The Iranians are skillful at ballistic missiles. The clock will start ticking once nuclear breakout is achieved and the Israelis and Americans will be forced to respond by underscoring their red line against weaponization. Starting right away, Israel and the US will need to demonstrate publicly that they have a “military option” to prevent Iran from achieving nuclear weaponization. They will refrain from immediate military action but will seek to re-establish a credible threat through shows of force. They will also redouble their efforts to use special operations and cyber attacks to set back the Iranian programs. The Iranians will seek to deter them from attacking and will want to highlight the negative consequences. The US-Iran talks were not only about the nuclear program but also about a broader strategic détente. The Iranians will no longer rein in their regional militant proxies, whether the militias in Iraq or the Houthis in Yemen or Hezbollah in Lebanon. In effect we are now looking at a major escalation of militant attacks in the Middle East at a time when oil is already soaring. In many cases the express intent of the Iran-backed groups will be to threaten oil supply to demonstrate the leverage that they have to intimidate the US and its allies and discourage them from applying too much pressure too quickly. Bottom Line: On top of the current oil shock, we are about to have a higher risk premium injected into oil from Middle Eastern proxy conflict involving Iran. If OPEC does not act quickly to boost production then financial markets face additional commodity price pressures, on top of the existing Russia-induced supply shock. Commodity And Energy Implications Our Commodity & Energy Strategist, Bob Ryan, outlines the following implications for the oil market: In BCA Research's oil supply-demand balances, while we recognized the Geopolitical Strategy view that the US-Iran deal would not materialize, nevertheless we assumed that Iran would return up to 1.3mm b/d of production by 2H22, which would have been available for export markets. This would have given a significant boost to oil supply as the market continues to tighten. Chart 3Failure Of Iran Deal Tights Oil Supply The failure of these barrels to return to the market will result in an oil-price increase of about $15/bbl in 2023, based on our modeling (Chart 3). We can expect backwardations to increase in Brent and WTI, as demand for precautionary inventories increases. The modelled prices include the oil risk premium of ~USD 9/bbl in H2 2022 and USD 5/bbl in 2023. Relative to 2021, we expect core- OPEC - KSA, UAE and Kuwait – and total US crude supply to increase by 1.7 mmb/d and 0.65 mmb/d respectively in 2022. Compared to 2022, core-OPEC supply will level off in 2023, and will increase by 0.6 mmb/d for total US. If the US has a deal with core OPEC, then, based on the reference production levels agreed by OPEC 2.0 in July 2021, core OPEC’s production capacity could cover a large bit of the volumes markets are short (Table 2). This is due to lower monthly additions of output that was supposed to be returned to markets – now above 1mm b/d – and the lost Iranian output (Table 2). Table 2OPEC 2.0 Reference Production Levels Per the OPEC 2.0 reference production schedule released following the July 2021 meeting in Vienna, Saudi Arabia’s output is free to go to 11.5mm b/d by May, the UAE's to 3.5mm b/d, and Kuwait's to just under 3mm b/d. Iraq also could raise output, but its output is variable and it will lie at the center of the new escalation in military tensions, so we do not count it as core OPEC 2.0 production. Assuming these numbers are consistent with actual capacity for core OPEC 2.0, that means Saudi Arabia could lift production by ~ 1.1mm b/d, UAE by ~ 0.5m b/d, and Kuwait by close to 0.3mm b/d. That’s almost 2mm b/d. These reference-production levels might be on the high side of what core OPEC 2.0 is able or willing to do. But they would be close to covering most of the deficit resulting from less-than-anticipated return of 400k b/d from OPEC 2.0 producers beginning last August ( ~ 1.2mm b/d). Most of Iran’s lost output also would be covered. More than likely, these barrels will find their way to market "under the radar" (i.e., smuggled out of Iran) over the next year or so. This was one reason our geopolitical strategists did not view Iran as sufficiently pressured to sign a deal. US shale-oil output will be increasing above the 0.9 mm b/d that we forecast last month for 2022, and the 0.5mm b/d we expect next year, given the sharp price rally prompted by the Russian invasion of Ukraine. Our Commodity & Energy Strategy service will be updating our estimate next week when we publish new supply-demand balances and price forecasts. Releases from the Strategic Petroleum Reserves of the US and OECD are available to tide the market over for brief periods due to Middle East shocks or sanctions on Russian oil. Releases from the Strategic Petroleum Reserves of the US and OECD are available to tide the market over for brief periods due to Middle East shocks or sanctions on Russian oil. Over time, a significant share of these displaced Russian barrels will find their way to China, and the volumes being displaced will be re-routed to other Asian and western buyers. Investment Takeaways One of our key geopolitical views for 2022 is that oil producers have enormous strategic leverage, specifically Russia and Iran. The Ukraine war and now the suspension of US-Iran détente bears out this view. It is highly destabilizing for global politics and economy. One of our five black swans for 2022 is that Israel could attack Iran – this is a black swan because it is highly unlikely on such a short time frame. However, if the US-Iran deal cannot be salvaged, then the clock is ticking to a time when Israel and/or the US will have to decide whether to prevent Iran from going nuclear or instead choose containment strategy as with North Korea. Yet the Iran dilemma is less stable than the Korean dilemma because the Israelis are committed to preventing weaponization. The Israelis will not act unilaterally until the last possible moment, when all other options to prevent weaponization are exhausted, as the operation would be extremely difficult and they need American military assistance. If diplomacy fails on Iran, the two options for the future are a major war or a nuclear arms race in the Middle East. The latter would involve an aggressive containment strategy. The global economy faces a major new risk to energy supply as a result of this material increase in Middle East tensions. A stagflationary outcome is much more likely. Europe’s energy security will be far more vulnerable now as it tries to diversify away from Russia but faces a more volatile Middle East (Chart 4). Undoubtedly Russia and Iran recognize their tremendous leverage. China, India, and other resource imports face a larger energy shock if the Gulf Arabs do not boost production promptly. They certainly face greater volatility. China’s policy support for the economy will remain lackluster in an environment in which inflation continues to threaten economic stability. China’s internal stability was already at risk and now it will have to scramble to secure energy supplies amid a global price shock and looming Middle Eastern instability. China has no choice but to accept Russia’s decision to cut ties with the West and lash itself to China as a strategic ally for the foreseeable future (Chart 5). Chart 4The EU’s Two-Pronged Energy Insecurity​​​​​ Chart 5China's Energy Insecurity​​​​​ Chart 6AGo Long US And Canada / Short Saudi And UAE ​​​​​ Chart 6BGo Long US And Canada / Short Saudi And UAE ​​​​​ Geopolitical Strategy recommends investors go long US equities relative to global equities on a strategic basis. We also recommend long US / short UAE equities and long Canadian / short Saudi equities (Charts 6A and 6B). Chart 7Worst Case Oil Risk In Historical Context Unlike Ukraine, the onset of a new Middle East crisis may not come with “shock and awe.” Weeks or months may pass before Iran reaches nuclear breakout. But make no mistake, if diplomacy fails, Iran will ignite a nuclear race and activate its militant proxies, while its enemies will increase sabotage, rattle sabers, and review military options. The Iranians will not be afraid to threaten the Strait of Hormuz, their other nuclear option (Chart 7). A total blockage of Hormuz is not by any means imminent. But war becomes more likely if Iran achieves nuclear breakout and diplomacy continues to fail.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Footnotes 1      See Ariel Eli Levite, “Can a Credible Nuclear Breakout Time With Iran Be Restored?” Carnegie Endowment for International Peace, June 24, 2021, carnegieendowment.org. See also Simon Henderson, “Iranian Nuclear Breakout: What It Is and How to Calculate It,” Washington Institute for Near East Policy, Policy Watch 3457, March 24, 2021, washingtoninstitute.org.   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Special Report

Executive Summary Tight Inventories Spike Metals Russia's war against Ukraine is a watershed moment, which will realign production, distribution and consumption of commodities globally. The development of new sources of the critical metals desperately needed to build out renewable energy grids and the drive to secure access to oil, gas and coal will intensify along political lines. China, reinforced by Russia, will lead the East, while the US and its allies will lead the West, in a redux of the Cold War. Local politics will intrude on this process, as left-of-center governments in important commodity-producing states secure their electoral victories and claim greater shares of commodity revenues. The rebuilding of defense systems, particularly in Europe, will compete with the renewable-energy transition. This will stress already-tight metals markets, where low inventories will predispose markets to higher volatility a la this week's oil, natgas and nickel price spikes. This will retard economic growth. In the short term, CO2 emissions will surge. Longer term, the transition to net-zero carbon emissions by 2050 will be pushed back years, as states compete for access to commodities. East-West trade restrictions and hoarding of commodities secured via trade within these respective blocs, as is occurring presently, will increase. Bottom Line: Russia's war against Ukraine is a watershed moment.  The development of new sources of the critical metals desperately needed to build out renewable energy grids, and the drive to secure access to oil, gas and coal will intensify. China, reinforced by Russia, will lead the East, while the US and its allies will lead the West, in a redux of the Cold War. Feature Russia's war with Ukraine provoked a watershed moment for Europe: Leaders suddenly realized they had to reverse decades of energy dependence on Russia, rebuild their militaries, and sustain a massive buildout of the continent's renewable-energy generation and grid. This occurred as inventories of the basic commodities required to achieve all of these objectives were stretched so tight that the mere threat of the cutoff of pipeline natural gas was enough to send benchmark EU natgas prices to a record $113/MMBtu, up nearly 80% from the previous day's close before it settled back to still-elevated levels (Chart 1). Oil inventories also were stretched extremely thin even before Russia launched its invasion of Ukraine 24 February (Chart 2). The situation is not improving, since, in the wake of the Ukraine war, numerous refiners and trading companies now are observing self-imposed sanctions against taking any Russian oil or refined products. It is worthwhile remembering this began before the US and UK announced they would ban all imports of Russian material this week.1 This will stretch supply chains by unknow durations – the movement of crude from Russia to a refiner could take months instead of weeks, until new trade patterns are established. Chart 1Little Flex In EU Gas Inventories Chart 2Little Flex In EU Gas Inventories   Global economic and policy uncertainty is massively elevated, with percent changes in oil and gas prices swinging on a double-digit basis daily. This makes it extremely difficult to bid or offer oil cargoes in the physical market or make markets (i.e., bid or offer) in the futures markets, which has the effect of compounding uncertainty and volatility. Fundamentals – supply, demand and inventories – take a back seat to fear and uncertainty in such markets. This makes it virtually impossible to assign a probability to any price outcomes based on supply and demand – the true definition of uncertainty in the Frank Knight sense – and to make long-term capex decisions over the long term.2 We raised our 2022 and 2023 Brent forecasts on the back of the massive uncertainty in the markets to $90/bbl and $85/bbl, respectively, right after Russia's invasion of Ukraine. We assume 1Q22 Brent will average $100/bbl. We expect core OPEC 2.0 producers – Saudi Arabia, UAE and Kuwait – will increase production beginning in 2Q22; US shale-oil output will rise, and ~ 1.2mm b/d of Iranian production will return to market in 2H22. Among the risks to our forecasts are a failure by core OPEC 2.0 to lift output (we expect an announcement at the end of this month when the producer coalition meets); lower-than-expected US shale output, and a failure to resolve the Iran nuclear deal with the US. Our modeling indicated these outcomes could lift Brent to between $120/bbl and $140/bbl by 2023 (Chart 3). We will be updating our forecasts next week.3 Chart 3Brent Forwards Lift EU's Watershed Metals Moment EU leadership is setting out to reverse decades of energy dependence on Russia, rebuild their militaries, and sustain a massive buildout of the continent's renewable-energy grid, all a result of the Ukraine war. This will require massive investment in metals mining and refining, along with steel-making capacity. Already, Germany is pledging to increase LNG import capacity and measures to reduce its dependence on Russian natural gas by 75% this year.4 The EU is looking to restore its natgas inventories to 90% of capacity before next winter, and has pledged to double down on renewables, in order to remove member-state dependence on Russian energy exports.5 These ambitious goals are up against the hard reality of scarce base metals supply globally. This will be exacerbated going forward by actions taken by and against Russia. The Russia-Ukraine crisis will destabilize metal markets, given supply uncertainty from Russia and its contribution to global supply. The commodities heavyweight constitutes 6%, 5% and 4% of global primary aluminum, refined nickel and copper production. Against the backdrop of very low global inventories in these metals (Chart 4), the prices of all three hit record highs over the last few days due to uncertain supply (Chart 5). LME nickel prices more than quadrupled on Tuesday as traders rushed to cover short positions and margin calls. Chart 4Low Inventories... Chart 5...Lead To Price Volatility Uncertainty has engulfed metal markets, with a Western ban on Russian metal imports still a possibility. Putin’s announcement regarding raw material export restrictions will further fuel supply uncertainty.6 As in the case of oil, private entities’ self-sanctioning, sanctions on the Russian financial system, and war-related supply chain disruptions are causing current Russian metal export disruptions.7 So far, Western sanctions on commodities have not directly interfered with metal flows from Russia. But markets are taking it day to day. Supply disruptions and sanctions force the formation of new trade patterns, as private entities aim to maximize arbitrage opportunities. For example, high European aluminum price spreads incentivized shipments from China, the world’s largest producer and consumer of refined aluminum. Normally, Europe relies on Russia for aluminum supplies. Rising European physical premiums for delivered metal, caused by Russian export disruptions, will see trading companies take advantage of arbitrage opportunities in other commodities as well. Europe's Risk Profile Rising Since the Ukraine war began, rising European physical premiums in commodities ranging from metals to natgas indicate the continent – more so than others – is particularly vulnerable to Russian export disruptions. Europe’s reliance on Russian energy and its supply disruptions will raise operating costs for smelters and refiners on the continent, threatening smelter shutdowns similar to those we saw this past winter. Markets were expecting power price relief over the warmer months and higher smelting activity. Elevated fuel and power prices, however, will constrain metals refining in Europe, and could shut or close even more smelters, keeping refined metals supply scarce and prices high. Rebuilding Europe's Defenses EU leaders are scheduled to take up a new energy and defense funding proposal today, which media reports are describing as "massive" (no detail provided ahead of the meeting, of course). This program reportedly will be akin to the EU's $2 trillion COVID-relief fund.8 The EU's fast response to defense shortfalls comes against the backdrop discussed above regarding super-tight metals markets, which now face a further complication of unpredictable local politics in metals-producing states. Some of these states have voted left-of-center governments into office, which now appear to be intent on nationalizing mining operations.9 Chile, e.g., accounts for ~ 30% of global copper ore output, and is in the process of re-writing its constitution, which will change tax and royalty law, and could pave the way for nationalization of copper and lithium mines. This political risk compounds any long-term planning operations by consumers like the EU and producers. Investment Implications Energy markets – broadly defined to include oil, gas and coal along with the base metals required for renewables and their supporting grids and electric vehicles – are being rocked by Russia's war with Ukraine. Base metals, in particular, will have to find price levels that destroy demand among competing uses, if the EU's dual-track plan to build out its renewables generation and restore a military capability is approved. A "massive" funding effort in Europe, coupled with equally massive efforts in the US and China – both intent on building out their renewable generation and grids, as well as expanding their defensive capabilities – will be extremely difficult to pull off. Critical base metals inventories remain low, and prices are high because demand exceeds supply for the foreseeable future (Chart 6). Chart 6Tight Inventories Spike Metals The EU will join a world in which the other two great economic centers – the US and China – will engage in a geopolitical competition over access to and control of scarce base metals, oil, gas and coal resources. Russia will remain aggressive toward the West, at least until the Putin regime falls, and will play an ancillary role to China. Fossil fuels and base metals have been starved for capex for more than a decade. Governmental pronouncements will not reverse this. These markets will remain tight, and will get tighter in order to allocate increasingly scarce supply with rapidly growing demand. As such, we remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to oil and gas producers via the XOP ETF, and the XME and PICK ETFs to retain exposure to base metals and bulks producers and traders.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Footnotes 1     Please see Russian tankers at sea despite ‘big unknown’ over who will buy oil, published by ft.com on March 7, 2022. 2     Please see Explained: Knightian uncertainty, published by mit.edu for discussion. 3    Please see Oil Risk Premium Abates, But Still Remains, which we published on February 25, 2022. 4    Please see Germany Revives LNG Import Plans to Cut Reliance on Russian Natural Gas in Marked Policy Shift, published by naturalgasintel.com on March 1, 2022. 5    Please see Climate change: EU unveils plan to end reliance on Russian gas, published by bbc.co.uk on March 8, 2022, and The EU plan to drastically ramp renewables to replace Russian gas, published by pv-magazine.com on March 9, 2022. 6    Please see Russia to Omit Raw Material Exports but Omits Details, published by Bloomberg on March 9, 2022. 7     Please see here for Which companies have stopped doing business with Russia? 8    Please see Ukraine: ECB governing council to meet as crisis intensifies, published on March 8, 2022 by greencentralbanking.com. 9    Please see Chile a step closer to nationalizing copper and lithium, published by mining.com on March 7, 2022, and Add Local Politics To Copper Supply Risks, which we published on November 25, 2021.   Investment Views and Themes Recommendations Strategic Recommendations

Feature We are closing our overweight of the Energy sector, bringing the allocation back to neutral in the face of a great geopolitical uncertainty. We have outperformed the S&P 500 by 60% since we initiated the trade on the 22 of November 2021. The recent war in Ukraine has upended the energy market, lifting the geopolitical risk premium. With oil surging 45% since the beginning of the year, and 20% since the beginning of the war, the trade has turned into a geopolitical gamble, held hostage by the immediate actions of OPEC.  The BCA Commodity & Energy strategy expects to see an increase in the oil supply by the US shale producers, Saudi Arabia, and Gulf states, which will bring Brent crude back to $85 by the second half of 2022. This is a consensus position in the market, which is reflected in the extremely backwardated energy futures curve.  It is important to note, that while OPEC members can open the oil spigots immediately, it takes the US shale producers roughly six months to ramp up production. To do so, they need to increase their Capex. In our recent Special Report on the Energy sector, we posited that the industry is in the early innings of the new Capex cycle. To reflect this structural theme in our portfolio, we will remain overweight Energy Equipment & Services (E&S) sub-industry.  Chart 1​​​​​ Chart 2​​​​​ Bottom Line: We close overweight in the Energy industry, bringing the weight back to the benchmark. We have locked in a 60% gain since the position’s inception. We remain overweight the Energy Equipment & Services industry, as a leveraged play on the energy Capex revival. We will revisit the sector once the fog of war dissipates. ​​​​​

Executive Summary Euro Natgas Soars; LME Nickel Squeezed Russian Energy Minister Alexander Novak's threat to halt shipmentsof natgas on Nord Stream 1 to Europe lifted European gas prices 25% overnight, and will reverberate for years. We make the odds of a cut-off of Russian natgas exports to the EU low but not extremely low. Russia’s war is about the status of Ukraine. Russia needs the EU markets, and the EU needs Russia's gas. However, if Russia follows through on Novak's threat, it would be a major disruption for gas markets in the short term. Over the medium to long term, US shale gas producers, LNG terminal operators and exporters will benefit from new demand. On the import side, China likely benefits most from Russia's need to re-route gas. But this will require substantial infrastructure investment to monetize Russia's gas supplies and as such will take years to realize. Separately, the LME has shut down its nickel markets following an explosive 250% rally over two days that took prices above $100,000/MT. Nickel settled at ~ $80,000/MT before the LME closed the market today for margin calls on shorts squeezed by the surge in prices to make margin calls. Bottom Line: We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to oil and gas producers via the XOP ETF. We also remain long the XME and PICK ETFs to retain exposure to base metals and bulks.

Executive Summary Will The War Stall The Expected Downturn In Inflation This Year? The Russia/Ukraine conflict is impacting financial markets across numerous channels – uncertainty, risk aversion, growth expectations & inflation expectations – but all have a common link through soaring commodity prices, most notably for oil. For global bond investors, allocations to inflation-linked bonds are a necessary hedge to the war and the associated commodity shock, particularly with breakevens in most countries re-establishing the link to oil prices. We recommend investors maintain neutral allocations to inflation-linked bonds versus nominal government bonds across the developed world until there is greater clarity on future global oil production. Markets are discounting a peak in interest rates at the low end of the Bank of Canada’s neutral range, which is reasonable given high household debt levels in Canada. This creates an opportunity for bond investors to go long Canadian government bonds versus US Treasuries. Bottom Line: The supply premium on global oil prices will persist until there are signs of more global oil production or less chaos in the Ukraine – neither of which is imminent. Maintain neutral allocations to inflation-linked bonds versus nominal government debt across the developed markets. Feature Chart 1A Broad-Based Surge In Commodity Prices The Russia/Ukraine war has sent an inflationary shock though the world through a very traditional source – rising commodity prices. Energy prices are getting most of the attention, with oil prices back to levels last seen in 2008 and US gasoline prices now above $4 per gallon. The commodity rally is not just in energy, though. Industrial metals prices have also gone up substantially, with the spot prices for copper and aluminum hitting an all-time-high and 16-year-high, respectively (Chart 1). Agricultural commodities have seen even larger increases, with the price of wheat up 22% and the price of corn up 11% since the Russian invasion began on February 24th. Europe is acutely exposed to the war-driven spike in energy prices given its reliance on Russia for natural gas supplies. Natural gas prices in Europe have spiked a staggering 117% since the invasion started, exacerbating a sharp demand/supply imbalance dating back to the reopening of Europe’s economy from COVID lockdowns one year ago (Chart 2). To date, booming energy prices have fueled a huge rise in headline inflation rates in the euro area – producer prices were up 31% on a year-over-year basis in January – but with little trickle down to core inflation which was only up 2.3% in January. High energy prices are not only a problem for global growth and inflation, but also for the future policy moves by central banks. Inflation rates boosted over the past year by commodity supply squeezes and supply chain disruptions were set to decline this year, but the Ukraine shock has thrown that into question. If the benchmark Brent oil price were to hit $150/bbl, this would end the decelerating trend for energy price inflation momentum, on a year-over-year basis, that has been in place since mid-2021 (Chart 3). That means a higher floor for the energy component of inflation indices, and thus overall headline inflation rates, throughout the major economies in the coming months. Chart 2Europe's Reliance On Russian Natural Gas Is A Big Problem​​​​​ Chart 3Will The War Stall The Expected Downturn In Inflation This Year?​​​​​ Chart 4The Oil Price Spike Makes Life More Difficult for CBs How will bond markets respond to higher-than-expected inflation? Rate hike expectations have been highly correlated to the trend of headline inflation in the US, Europe, UK, Canada and Australia over the past year (Chart 4). Currently, overnight index swap (OIS) curves are still discounting between 5-6 rate hikes from the Fed, the Bank of England, the Bank of Canada and the Reserve Bank of Australia before the end of 2022. A single rate hike is still priced into the European OIS curve, even with the Ukraine shock. Global bond yields have been volatile, but surprisingly resilient despite the worries about war and commodity inflation. The 10-year Treasury yield has been trading in a range between 1.7% and 2% since the Russian offensive began, while the 10-year German Bund yield has hovered around 0%. Bond markets are pricing in a stagflation-type outcome of slowing growth and rising inflation, as multiple rate hikes are still discounted despite the geopolitical risks from the war. That reduces the value of using increased duration exposure to position for risk-off moves in a bond portfolio. At the same time, real bond yields are falling and breakeven rates are rising for global inflation-linked bonds – a part of the fixed income universe that looks to offer good protection against the uncertainties of war. Inflation-Linked Bonds – A Good Hedge Against War Risks Since the Russian invasion began, breakeven inflation rates on 10-year inflation-linked bonds have moved higher in the US (+13bps), Canada (+19bps), Australia (+15bps) and even Japan (+15bps). The moves have been even more significant on the European continent – 10-year breakevens have shot up in the UK (+23bps), Germany (+45bps), France (+31bps) and Italy (+36bps). Chart 5Inflation Breakevens Are Rising, Especially In Europe The absolute levels of breakevens in Europe are high in the context of recent history (Chart 5). However, breakevens also look a bit stretched in other countries like the US. Our preferred metric to evaluate the upside potential for inflation-linked bonds is our Comprehensive Breakeven Indicators (CBI). The CBI for each country is comprised of three components: the deviation of 10-year breakevens from our model-implied fair value, the spread between 10-year breakevens and longer-term survey-based inflation expectations (the “inflation risk premium”) and the gap between actual inflation and the central bank inflation target. Those three components are all standardized and added together with equal weights to come up with the CBI. A higher CBI reading suggests less potential for inflation breakevens to widen, and vice versa. Currently, the CBIs for the eight countries in our Model Bond Portfolio universe are close to or above zero, suggesting more limited scope for breakevens to widen further (Chart 6). Only in Canada is the CBI below zero, and only slightly so as high realized Canadian inflation is offset by breakevens trading below both fair value and survey-based measures of inflation (Chart 7). Chart 6Global Inflation Breakeven Valuations Are Not That Cheap In the US, the CBI is above zero mostly because of high realized US inflation. In Europe, the CBIs of the UK, Germany and Italy all are well above zero, while in France the CBI is close to zero. The UK has the highest CBI in our eight-country universe, with all three components contributing roughly equally (Chart 8). The Japanese CBI is also just above the zero line. Chart 7Some Mixed Signals On Inflation Breakeven Valuations​​​​​​ Chart 8European Breakevens Have Adjusted Sharply To The Energy Shock​​​​​​ We have been recommending a relative cautious allocation to global breakeven bonds in recent months. We saw the upside potential on breakevens as capped given the dearth of “cheap” signals on breakevens from our CBIs, especially with central banks moving towards monetary tightening in response to elevated inflation – moves intended to restore inflation-fighting credibility with bond markets. Yet the Ukraine commodity shock has boosted inflation breakevens even in countries with modest underlying (non-commodity) inflation like Japan and the euro area. We now see greater value in owning inflation-linked bonds in global bond portfolios as a hedge against the inflation risks stemming from the Ukraine and the worsening geopolitical tensions between the West and Russia. This is true even without the typical positive signal for breakevens from having CBIs below zero. We recommend that fixed income investors maintain a neutral allocation to inflation-linked bonds in dedicated government bond portfolios across the entire developed market “linker” universe. In our model bond portfolio, we had been allocating to linkers based off the signal from the CBIs, but in the current stagflationary war environment, we see country allocations as secondary to having neutral exposure to linkers in all countries. The new weightings to inflation-linked bonds are shown in the model bond portfolio tables on pages 12-14.1 Bottom Line: For global fixed income investors, allocations to inflation-linked bonds are a necessary hedge to the war and the associated commodity shock, particularly with breakevens in most countries re-establishing the link to oil prices. Canada Update: BoC Liftoff At Last The Bank of Canada (BoC) raised its policy interest rate by 25bps to 0.5% last week, commencing the start of the first rate hike cycle since 2018. The move was no surprise after BoC Governor Tiff Macklem signaled at the January monetary policy meeting that the start of a rate hiking cycle was imminent. The Canadian Overnight Index Swap (OIS) curve is discounting another 171bps of hikes in 2022, with a peak rate of 1.98% reached by March 2023 - near the low-end of the BoC’s range of neutral rate estimates between 1.75% and 2.75% (Chart 9). Chart 9Markets Discounting A Shallow BoC Rate Hiking Cycle, Even With High Inflation The BoC noted that the Canadian economy was recovering faster than expected from the effects of the Omicron variant and the associated restrictions on activity, coming off a robust 6.7% annualized real GDP growth rate in Q4/2021. The BoC now estimates that economic slack created by the pandemic shock has been fully absorbed, with the unemployment rate at 6.5%. Canadian headline inflation reached a 32-year high of 5.1% in January (Chart 10) – a level that Governor Macklem bluntly called “too high” in a speech the day following the rate hike. The BoC’s CPI-trim measure that excludes the most volatile components is also at an elevated reading of 4%, suggesting that the higher inflation is broad based. The BoC sees persistent high inflation as a risk to the stability of medium-term inflation expectations, thus justifying tighter monetary policy. According the latest BoC Survey of Consumer Expectations, Canadians expect inflation to be 4.1% over the next two years and 3.5% over the next five years, both of which are above the BoC’s 1-3% inflation target band. So with a robust economy, tight labor market, inflation well above the BoC target and elevated consumer inflation expectations showing no signs of settling, why is the OIS curve discounting such a relatively low peak in the BoC policy rate? The answer lies with Canada’s housing bubble and the associated high household debt levels. In a recent Special Report, our colleagues at The Bank Credit Analyst estimated that the neutral rate in Canada was no higher than 1.75%- the previous peak in rates during the 2017-2018 tightening cycle. A big reason for that was the high level of Canadian household debt, which now sits at 180% of disposable income. This compares to the equivalent measure in the US of 124%, showing that unlike their southern neighbors, Canadian households had little appetite for deleveraging after the 2008 financial crisis (Chart 11). Chart 10Good Reasons For A More Aggressive BoC​​​​​​ Chart 11A Big Reason For A Less Aggressive BoC​​​​​​ Chart 12Position For Narrower Canada-US Bond Spreads The Bank Credit Analyst report estimated that if the BoC hiked rates to 2.5% over the next two years – just below the high end of the BoC neutral range – the Canadian household debt service ratio would climb to a new high of 15.5% (bottom panel). This would greatly restrict Canadian consumer spending and likely trigger a sharp pullback in both housing demand and real estate prices. The conclusion: the neutral interest rate in Canada is likely closer to the peak seen during the previous 2018/19 hiking cycle around 1.75%. We have been recommending an underweight stance on Canadian government bonds in global fixed income portfolios dating back to the spring of 2021. However, with markets now discounting a peak in rates within plausible estimates of neutral, the window for additional underperformance of Canadian government bonds may be closing - but not equally versus all developed economies. We have found that a useful leading indicator of 10-year cross-country government bond yield spreads is the differential between our 24-month discounters. The discounters measure the cumulative amount of short-term interest rate increases over the next two years priced into OIS curves. Currently the “discounter gaps” are signaling room for Canadian spread widening versus the UK and Japan and, to a lesser extent, core Europe (Chart 12). However, the discounter gap is pointing to significant potential for narrowing of the Canada-US 10-year spread over the next year (top panel). This would occur even if the BoC follows the Fed with rate hikes in 2022, as the Fed is likely to deliver more increases in 2023/24 than the BoC. This week, we are introducing two new recommended positions to benefit from narrower Canada-US government bond spreads: We are reducing the size of our underweight position in our model bond portfolio in half, offset by a reduction in the allocation to US Treasuries (see the table on page 13). We are introducing a new trade in our Tactical Overlay, going long Canadian 10-year government bond futures versus selling 10-year US Treasury futures on a duration-matched basis (the specific details of the trade can be found in the table on page 15) We are maintaining our cyclical underweight recommendation on Canada, in a global bond portfolio context, given the potential for Canadian yield spreads to widen versus core Europe, Japan and the UK. That underweight recommendation will be more concentrated versus countries relative to the US. Bottom Line: Markets are discounting a peak in interest rates at the low end of the Bank of Canada’s neutral range, which is reasonable given high household debt levels in Canada. This creates an opportunity for bond investors to go long Canadian government bonds versus US Treasuries.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The allocations to inflation-linked bonds shown in the model bond portfolio reflect both the recommended country weights and the recommended weighting of linkers versus nominal bonds within each country.  For example, we are neutral US TIPS versus nominal bonds within the US Treasury component of the portfolio, but since we are also underweight the US as a country allocation, the TIPS allocation is below the custom benchmark index weight. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Tactical Overlay Trades

Executive Summary US Can Do Without Russia's Oil, EU, NATO … Not So Much The US will ban Russian oil imports shortly.  This is not as big a deal markets had feared over the weekend, when news of a possible ban of Russian oil and refined products into the US and Europe was telegraphed by US officials, powering prices to $140/bbl.1 The US imported a combined 400k b/d of Russian crude oil and refined products in December 2021, the EIA reports, which accounted for less than 5% of the 8.6mm b/d of imports. Europe is another story.  Roughly 60% of Russia's 11.3mm b/d of crude oil and refined-products output goes to OECD Europe, according to the IEA. Russia considers Western sanctions to be on an equal footing with a declaration of war.2  President Putin has threatened a nuclear response if the West interferes with invasion of Ukraine, which could elicit a similar response from the West.3  US shale producers will be highly incentivized to increase output given high prices.  Our view continues to include a production increase from core OPEC 2.0 – Saudi Arabia, UAE and Kuwait.  We also anticipate a return of 1mm b/d from Iran, following a nuclear deal with the US. Bottom Line: We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to oil and gas producers via the XOP ETF. Footnotes 1     Please see Crude price jumps on talk of US oil ban as Russia steps up shelling of civilian areas, published by the Financial Times on March 6, 2022. 2     Please see Putin says Western sanctions are akin to declaration of war, published on March 5, 2022. 3    Please see How likely is the use of nuclear weapons by Russia?, published by Chatham House on March 1, 2022.  The report notes, " If Russia were to attack Ukraine with nuclear weapons, NATO countries would most likely respond on the grounds that the impact of nuclear weapons crosses borders and affects the countries surrounding Ukraine. NATO could respond either by using conventional forces on Russian strategic assets, or respond in kind using nuclear weapons as it has several options available."

Executive Summary Nuclear Worries Take Center Stage Vladimir Putin has now committed himself to orchestrating a regime change in Kyiv. Anything less would be seen as a defeat for him. Assuming he succeeds, and it is far from obvious that he will, the resulting insurgency will drain Russian resources. Along with continued sanctions, this will lead to a further deterioration in Russian living standards and growing domestic discontent. If Putin concludes that he has no future, the risk is that he will decide that no one else should have a future either. Although there is a huge margin of error around any estimate, subjectively, we would assign an uncomfortably high 10% chance of a civilization-ending global nuclear war over the next 12 months. These odds place some credence on Brandon Carter’s highly controversial Doomsday Argument. Even if World War III is ultimately averted, markets could experience a freak-out moment over the next few weeks, similar to what happened at the outset of the pandemic. Google searches for nuclear war are already spiking. Despite the risk of nuclear war, it makes sense to stay constructive on stocks over the next 12 months. If an ICBM is heading your way, the size and composition of your portfolio becomes irrelevant. Thus, from a purely financial perspective, you should largely ignore existential risk, even if you do care about it greatly from a personal perspective. Bottom Line: The risk of Armageddon has risen dramatically. Stay bullish on stocks over a 12-month horizon. All In on Sanctions In the criminal justice system, there is a reason why the punishment for armed robbery is lower than for murder. If the punishment were the same, an armed robber would have a perverse incentive to kill his victim in order to better conceal his crime. The same logic applies, or at least used to apply, to geopolitics: You do not impose maximum sanctions from the get-go because that removes your ability to influence your enemy with the threat of further sanctions. Following Russia’s invasion of Ukraine, the West chose to go all in on sanctions, levying every type imaginable with the exception of those entailing a big cost to the West (such as cutting off Russian energy exports). Most notably, many Russian banks have been blocked from the SWIFT messaging system while the Russian central bank’s foreign exchange reserves have been frozen. Even FIFA has barred Russia from international competition, just weeks before it was set to participate in the qualifying rounds of the 2022 World Cup. At this point, there is not much more that can be done on the sanctions front. This leaves military intervention as the only avenue available to further pressure Russia. A growing chorus of Western pundits, some of whom could not have picked out Ukraine on a map two weeks ago, have begun clamoring for regime change… this time, in Moscow. As one might imagine, this is not something that sits well with Putin. Last week, he declared that “No matter who tries to stand in our way or … create threats for our country and our people, they must know that Russia will respond immediately, and the consequences will be such as you have never seen in your entire history.” To ensure there was no uncertainty about what he was talking about, he proceeded to place Russia’s nuclear forces on “special regime of combat duty.” Yes, It’s Possible The Putin regime has used nuclear weapons of a sort in the past. The FSB likely orchestrated the poisoning of Alexander Litvinenko with polonium-210 in 2006, leaving traces of the radioactive substance scattered in dozens of places across London. As former US presidential advisor and Putin biographer Fiona Hill said in a recent interview with Politico, “Every time you think, “No, he wouldn’t, would he?” Well, yes, he would.” Admittedly, there is a big difference between dropping polonium into a cup of tea at the Millennium hotel in Mayfair and dropping a 10-megaton nuclear bomb on London or any other major Western city. Still, if Putin feels that he has no future, he may try to take everyone down with him. The collapse in the ruble, and what is sure to be a major plunge of living standards across Russia, could foment internal opposition to Putin. A quiet retirement is not an option for him. Based on the latest exchange rates, Russia’s GDP is smaller than Mexico’s and barely higher than that of Illinois (Chart 1). While denying gas to Europe is a very real threat, it has a limited shelf life. Europe will aggressively build out infrastructure to process LNG imports. Chart 1Russia's Economic Power Has Faded In a few years, the one viable weapon that Russia will have at its disposal is its nuclear arsenal. As Dutch historian Jolle Demmers has said, “It is precisely the decline and contraction of Russian power, coupled with the possession of nuclear weapons and a tormented repressive president, that poses great risks.” Some of the world’s most prominent strategic thinkers flagged these risks before the invasion, but with little effect. The Mother of All Risks In simulated war games, it is generally difficult to get participants to cross the nuclear threshold, but once they do, a full-blown nuclear exchange usually ensues.1 The idea of “limited” nuclear war is a mirage.  How high are the odds of such a full-blown war? I must confess that my own feelings on the matter are heavily colored by my writings on existential risk. As I argued in Section XII of my special report, “Life, Death, and Finance in the Cosmic Multiverse,” we are probably greatly understating existential risk, especially when we look prospectively into the future. Although there is a huge margin of error around any estimate, subjectively, we would assign an uncomfortably high 10% chance of a civilization-ending global nuclear war over the next 12 months. These odds place some credence on Brandon Carter’s highly controversial Doomsday argument (See Box 1). A Paradox for Investors For investors, existential risk represents a paradoxical concept. If an ICBM is heading your way, the question of whether you are overweight or underweight stocks would be pretty far down on your list of priorities. And even if you were inclined to think about your portfolio, how would you alter it? In a full-blown global nuclear war, most stocks would go to zero while governments would probably be forced to default or inflate away their debt. Gold might retain some value – provided that you kept it in your physical possession – but even then, you would still have trouble exchanging it for anything of value if nothing of value were available to purchase. This means that from a purely financial perspective, you should largely ignore existential risk, even if you do care greatly about it from a personal perspective. What, then, can we say about the current market environment? I touched on many of the key issues in Monday’s Special Alert, in which we tactically downgraded global equities from overweight to neutral. I encourage readers to consult that report for our latest market views. In the remainder of today’s report, allow me to elaborate on a couple of key themes. A Freak-Out Moment Is Coming Chart 2Nuclear Worries Take Center Stage The market today reminds me of early 2020. We wrote a report on February 21 of that year entitled “Markets Too Complacent About The Coronavirus,” in which we noted that a full-blown pandemic “could lead to 20 million deaths worldwide,” and that “This would likely trigger a global downturn as deep as the Great Recession of 2008/09, with the only consolation being that the recovery would be much more rapid than the one following the financial crisis.” Many saw that report as alarmist, just as they saw our subsequent decision to upgrade stocks in March as cavalier.  Even if you knew in February 2020 that the S&P 500 would reach an all-time high later that year, you should have still shorted equities aggressively on a tactical basis. I feel the same way about the present. Google searches for nuclear war are spiking (Chart 2). A freak-out moment is coming, which will present a good buying opportunity for investors. Just to be on the safe side, I picked up a couple of bottles of Potassium Iodide earlier this week. When I checked the pharmacy again yesterday, all the bottles were sold out. They are now being hawked on Amazon for ten times the regular price. From Cold War to Hot Economy? The spike in commodity prices – especially energy prices – will have a negative near-term impact on global growth, while also limiting the ability of central banks to slow the pace of planned rate hikes (Chart 3). In general, inflation expectations and oil prices move together (Chart 4).   Chart 3Central Banks: Caught Between A Rock And A Hard Place   Chart 4Inflation Expectations And Oil Prices Go Hand-In-Hand Assuming the geopolitical situation stabilizes in a few months, oil prices should come down. The forward curve for oil is heavily backwardated now: The spot price for Brent is $111/bbl while the December 2022 price is $93/bbl (Chart 5). BCA’s commodity strategists expect the price of Brent oil to fall to $88/bbl by year-end. The decline in energy prices should provide some relief to global growth and risk assets in the back half of the year, which is one reason we are more constructive on equities over a 12-month horizon than a 3-month horizon. Looking out beyond the next year or two, the new cold war will lead to higher, not lower, interest rates. Increased spending on defense and alternative energy sources will prop up aggregate demand, especially in Europe where the need to diversify away from Russian gas is greatest. As Chart 6 shows, capex in the euro area cratered following the euro debt crisis. Capital spending via the Recovery Fund and other sources will rise significantly over the next few years. Chart 5The Brent Curve Is Heavily Backwardated Chart 6European Capex Is Poised To Increase In addition, the shift to a multipolar world will expedite the retreat from globalization. Rising globalization was an important force restraining inflation – and interest rates – over the past few decades. Lastly, the ever-present danger of war could prompt households to reduce savings. It does not make sense to save for a rainy day if that day never arrives. Lower savings implies a higher equilibrium rate of interest. As we discussed in our recent report entitled “A Two-Stage Fed Tightening Cycle,” after raising rates modesty this year, the Fed will resume hiking rates towards the end of 2023 or in 2024, as it becomes clear that the neutral rate in nominal terms is closer to 3%-to-4% rather than the 2% that the market assumes. The secular bull market in equities will likely end at that point. In summary, equity investors should be somewhat cautious over the next three months, more optimistic over a 12-month horizon, but more cautious again over a longer-term horizon of 2-to-5 years. Box 1The Doomsday Argument In A Nutshell Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1     For example, an article from the Center for Arms Control and Non-Proliferation discusses a Reagan administration war game called “Proud Prophet,” an exercise the Americans hatched to test the theory of limited nuclear strikes. The result of this exercise was that the “Soviet Union perceived even a low-yield nuclear strike as an attack, and responded with a massive missile salvo.” Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Executive Summary Chinese Onshore Stocks Are Less Impacted By External Factors We are upgrading Chinese onshore stocks from underweight to neutral relative to global stocks. At the same time, we are closing our tactical trade of long Chinese investable stocks/short global stocks. In the near term, Russia’s armed invasion of Ukraine will spark a further selloff in global risk assets. Volatility in Chinese onshore stock prices will remain high; A-share prices in absolute terms may also drop but should fall by less than their peers in European and emerging markets. On the other hand, Chinese offshore stocks are more vulnerable to geopolitical risks compared with their onshore counterparts. There are tentative signs that home prices may be stabilizing, although demand for housing remains in deep contraction. Chinese policymakers remain vigilant in preventing the property market from overheating and credit creation from overshooting. However, the ongoing Russia/Ukraine incursion has the potential to catalyze a larger stimulus package in China. If the escalating geopolitical crisis threatens the global economy, China’s authorities will likely strengthen policy supports at home to buttress the country’s domestic political, economic and financial conditions. Bottom Line: Chinese onshore stocks will weather the ongoing geopolitical storm better than their offshore and global peers. China’s economy is also less negatively impacted by the Russia/Ukraine hostilities. If the crisis deepens, China’s leadership will likely step up measures to support its economy and ensure stable domestic financial and political dynamics. Feature The conflict between Russia and Ukraine unnerved global financial markets in the past few weeks. Chinese offshore stocks were not insulated from the geopolitical event; the MSCI China Index declined by about 4% in February, in-line with the selloff in global stocks. Chart 1Chinese Onshore Financial Markets Held Up Relatively Well Last Month The current global geopolitical environment, however, has turned us a bit more positive on Chinese onshore stocks in relative terms. In the near term, the onshore market should hold up better than its offshore and European counterparts. China’s closed capital market prevents panic capital outflows and its large current account surplus as well as favorable real interest rate differentials help to maintain strength in the RMB (Chart 1). On a cyclical basis, China’s domestic economic fundamentals will continue to drive prices in the A-share market. China’s aggregate economy is less affected by the Russia/Ukraine conflict than Europe. Energy supplies from Russia to China will likely continue and may even accelerate, mitigating the risks of energy shock-induced inflation spikes. As such, we are upgrading Chinese onshore stocks from underweight to neutral in a global portfolio, both in tactical and cyclical time horizons. We remain cautious about the size of Chinese stimulus for the year and, therefore, are neutral in our cyclical view on Chinese onshore stocks relative to global equities. Despite some nascent signs of reflation and an easing of housing policy in a few Chinese cities, aggregate property demand remains weak and overall policy easing in the sector has been marginal. Nonetheless, the situation surrounding Ukraine and the global sanctions against Russia are highly fluid and may provide some ground for Chinese policymakers to ramp up stimulus at home. If the conflict intensifies and derails the European/global economy, Beijing will be more inclined to adopt measures to ensure the stability of its domestic economy, financial markets and political dynamics. Meanwhile, we are closing our long MSCI China/short MSCI global tactical trade. Chinese offshore stocks are more vulnerable to geopolitical tensions and risk-off sentiment among global investors. The Russia Incursion Has Limited Direct Impact On China’s Economy Chinese stocks were not immune last week to the global financial market’s gyrations triggered by Russia’s invasion of Ukraine. While Russia’s attack on its neighbor will create short-term disruptions on the prices of global commodities and China’s A-shares, the cyclical performance of Chinese onshore stocks is tied to the country’s domestic economic fundamentals. The military conflict between Russia and Ukraine should have a limited knock-on effect on China’s business cycle dynamics for the following reasons: Russia and Ukraine together account for less than 3% of Chinese total exports as of 2021, limiting the negative impact from reduced demand in the region on China’s current account balance.  Chart 2Ukraine: China’s Major Source Of Agricultural Commodity Supplies Russia’s incursion of Ukraine may have consequences on China’s food prices. Ukraine is a major agricultural commodity exporter to China, hence a prolonged military conflict may disrupt agricultural supplies and push up imported food prices in China (Chart 2). In this scenario, we expect that Beijing will provide subsidies to ease pressures on domestic food prices due to supply shocks, rather than tighten monetary policy to reduce demand. China is unlikely to experience shocks linked to possible energy disruptions. Russia is a core exporter of energy to China and supplies of crude oil, natural gas and coal have increased in recent years (Chart 3). We do not expect that Russia’s energy supply to China will be disrupted. Indeed, following the 2014 Russia’s invasion of Crimea, Russia’s crude oil exports to China increased by 40% (Chart 3, top panel). We anticipate that oil prices will fall from the current level in the second half of the year, limiting the upshot from higher oil prices on Chinese inflation. So far, the US and EU have announced tough sanctions on Russia’s non-energy sectors, but they have avoided halting Russia’s energy exports. ​​​​​​​In the unlikely scenario that energy flows from Russia to Europe are disrupted in any meaningful and long-lasting way, either through European sanctions or a Russian embargo, Russia would probably turn to China to absorb its energy exports. Given that Russia cannot easily replace Europe with any other alternative market, particularly natural gas, China would gain an upper hand in price negotiations with the Russians (Chart 4). Thus, a steady supply of cheap natural gas and other forms of energy would be a net positive for China’s economy. Chart 4Russia Cannot Easily Replace Europe With Any Alternative Consumer Other Than China Chart 3Russia's Ties With China On Energy Supplies Will Likely Strengthen Meanwhile, oil’s current price spike may widen the gap in profits between China’s upstream and downstream industrial enterprises (Chart 5). However, the effect from higher oil prices on Chinese downstream manufacturers should be temporary. Our Commodity and Energy Strategists believe that the Russian invasion will prompt increased production from core OPEC producers. These production increases would reduce prices from last week’s $105 per barrel level to $85 per barrel by the second half of 2022 and keep it at that level throughout 2023 (Chart 6). Chart 6Crude Oil Price Risk Premium Will Abate But Not Disappear Chart 5Rising Oil Prices May Temporarily Widen Profit Gaps Between China's Up- And Downstream Industries Bottom Line: Russia’s invasion of Ukraine should have a limited direct impact on China’s domestic economy, inflation and monetary policy. Tentative Signs Of Home Price Stabilization Although the property market is showing some signs of improvement, the aggregate demand for homes remains very sluggish. Recently released housing data in China show some slight progress, as fewer cities reported a month-on-month drop in new home prices in January (Chart 7). The monthly average new home prices among China’s 70 cities were broadly flat last month following four consecutive months of falling prices. Tier 1 and Tier 2 cities had the largest increases in home prices, whereas prices in other regions continued to contract through January, albeit to a lesser degree (Chart 7, bottom panel). The minor improvement in home prices reflects recently implemented measures to help shore up the flagging market. Last month, the PBoC cut the policy rate by 10 bps and reduced the one- and five-year loan prime rates by 10 bps and 5 bps, respectively. Moreover, last week several regional banks lowered the down payments on mortgages for homebuyers. Chart 8...Demand For Housing Remains In Deep Contraction Chart 7Although There Are Some Early Signs Of Stabilization In Home Prices... Nonetheless, the aggregate demand for housing remains weak. China’s 100 largest developers experienced a roughly 40% year-on-year plunge in total sales in January, indicating that recent easing measures failed to revive the downbeat sentiment among homebuyers (Chart 8). Bottom Line: Policymakers will remain vigilant in not inducing another surge in house prices and will continue to target steady home prices. As such, it is too early to upgrade our cyclical view on China’s property market, stimulus and economic recovery. Investment Conclusions We are upgrading Chinese onshore stocks to neutral relative to global equities (both tactically and in the next 6 to 12 months), while closing our tactical trade of long MSCI China/short MSCI global index. Chart 9Chinese Onshore Stock Prices Are Largely Driven By Domestic Rather Than External Factors... Given the limited impact of the Russia/Ukraine conflict on China’s domestic economy and the low correlation to the global equity index, Chinese onshore stock prices may also fall in absolute terms in the coming weeks, but not by as much as their offshore and European counterparts (Chart 9). Furthermore, while we maintain a cautious cyclical outlook for China’s stimulus, the ongoing geopolitical crisis has the potential to provide a catalyst for Chinese policymakers to stimulate the domestic economy more forcefully. If the clash evolves into a real risk to the European economy and global financial markets, odds are high that Chinese policymakers will step up stimulus measures to ensure domestic stability. In this scenario, Chinese onshore stocks will likely outperform global equities. In the past, Chinese authorities refrained from a credit overshoot when the business cycle slowed in an orderly manner, but they stimulated substantially following an exogenous shock. For example, China rolled out massive stimulus packages after the 2008 Global Financial and the 2011/12 European credit crises. Beijing did not directly respond to Russia’s 2014 annexation of Crimea with additional monetary support to China’s domestic economy. However, the Chinese authorities started to aggressively stimulate when a collapse in domestic demand coincided with a global manufacturing recession in 2015. Chart 10...Whereas Chinese Offshore Stocks Are More Vulnerable To Global Risk-Off Sentiment The PBoC’s outsized liquidity injection in the interbank system last Friday is also a sign that Beijing is willing to accelerate policy easing if the geopolitical backdrop meaningfully worsens.  Regarding Chinese investable stocks, we maintain our cyclical underweight stance relative to global equities. In the near term, risk-off sentiment among global investors will undermine the performance of Chinese offshore stocks in both absolute and relative terms (Chart 10). Over a longer time horizon (6 to 12 months), growth stocks will likely underperform value stocks when global stocks recover. Thus, the tech-heavy MSCI China Index is less attractive to investors compared with other emerging and developed market equities that are more value-centric. Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations