Euro Area

Executive Summary Russia’s Crude Oil Output Will Fall EU Russian Oil Embargoes, Higher Prices EU Russian Oil Embargoes, Higher Prices Russia will have to lower oil production to ensure output it hasn’t placed with non-EU buyers does not tax its limited storage facilities, ahead of the bloc’s December 5 embargo. The EU’s insurance/reinsurance ban on ships carrying Russian material also commences in December. It will profoundly affect Russian output, if fully implemented. Russian and Chinese firms will expand ship-to-ship transfers on the high seas, along with external processing and storage services to mask crude and product exports. The EU embargos will force Russia to shut in ~ 1.6mm b/d of output by year-end, rising to 2mm b/d in 2023, by our reckoning. Gas-to-oil switching in Europe will boost distillate and residual fuel demand by ~ 800K b/d this winter. Chinese policymakers will be compelled to deploy greater fiscal and credit support to reverse weakening GDP. Tighter monetary policy in DM economies will dampen aggregate demand. Bottom Line: EU embargoes on Russian oil imports will significantly tighten markets, and lift Brent to $119/bbl by year-end. This has a 60% chance of being offset by ~ 1mm b/d of Iranian oil exports in 2023, in our estimation. We are maintaining our Brent forecast at $110/bbl on average for this year, and $117/bbl next year. WTI will trade $3-$5/bbl lower. At tonight’s close we are re-establishing our long COMT ETF position. Risks remain to the upside. Feature Chart 1Russia’s Crude Oil Output Will Fall EU Russian Oil Embargoes, Higher Prices EU Russian Oil Embargoes, Higher Prices Following an unexpected increase in production during June and July, Russia will have to begin reducing its oil output ahead of the implementation of the EU’s embargo on its seaborne crude oil imports, which kicks on December 5. EU, UK and US shipping insurance and reinsurance sanctions also are scheduled to be implemented in December. If fully implemented, ~ 2.3mm b/d of seaborne imports of Russian crude oil will be excluded from EU markets by year-end. Come February, another 800k b/d of refined products will be embargoed. On the back of these lost sales, and production that cannot be loaded on ships due to insurance/reinsurance bans, we expect Russian production to fall ~ 2mm b/d by the end of next year (Chart 1).1 As noted in previous research, a goodly chunk of Russian crude continues to go to China and India. Together, these two states accounted for just over 40% of Russia’s crude sales last month – ~ 1.9mm b/d of a total of ~ 4.5mm b/d. This is down from just under 45.5% in May, according to Reuters. Both China and India have benefited from discounted prices of ~ 30% vs. Brent, which is a powerful inducement to buy. Asia accounts for more than half of Russia’s seaborne crude oil sales, according to Bloomberg data. Related Report  Commodity & Energy StrategyTighter Oil Markets On The Way Whether China and India can maintain these purchases depends on whether ships taking oil to them can get their cargoes insured. Both states have domestic insurance providers, and, in the case of the latter, long-standing trade relationships going back decades. Other Asian economies do not have such financial infrastructure. Still, this is a high concentration of sales to two buyers. In addition, press reports indicate China spent $347mm to secure tankers to conduct high-risk ship-to-ship (STS) transfers of Russian crude in the Atlantic Ocean.2 Similar STS transfers have been used to move ~ 1.2mm b/d of Iranian and Venezuelan crude oil, most of which ends up in China, according to Lloyds. Base Case Sees Markets Balance In our base case analysis, markets remain relatively balanced going into winter. On the supply side, we expect core OPEC 2.0 – the Kingdom of Saudi Arabia (KSA) and the United Arab Emirates (UAE) – to continue to provide crude to the markets subject to their spare-capacity constraints (Chart 2, top panel). KSA likely will be producing close to 11mm b/d by year-end – vs its current output of 10.6mm b/d output presently – and the UAE will be close to 3.5mm b/d, vs 3.1mm b/d at present. KSA’s max capacity is 12mm b/d, while the UAE’s is 4mm b/d; both will want to maintain spare capacity to offset unexpected exogenous supply shocks next year. These two states account for most of the spare capacity in the world (Chart 3). The rest of OPEC 2.0 will continue to struggle to maintain its production, which makes the core producers’ spare capacity critically important (Chart 2, bottom panel). Chart 2Core OPEC 2.0 Will Increase Supply EU Russian Oil Embargoes, Higher Prices EU Russian Oil Embargoes, Higher Prices Chart 3Spare Capacity Concentrated In Core OPEC 2.0 EU Russian Oil Embargoes, Higher Prices EU Russian Oil Embargoes, Higher Prices Outside of OPEC 2.0, we are expecting the largest contribution to global supply will continue to come from US shale production (Chart 4). Shale-oil output in the top 5 US basins is expected to increase ~540K b/d this year, and next. This will take shale output to slighly above 7.5mm b/d and account for 76% of Lower 48 production in the States this year. Next year, we are expecting US Lower 48 production to rise 700K b/d, and for total US crude output to go to 12.8mm b/d, a new record. Chart 4US Remains Top Non-OPEC 2.0 Supplier US Remains Top Non-OPEC 2.0 Supplier US Remains Top Non-OPEC 2.0 Supplier This winter we are expecting an uptick in oil demand – particularly for distillates like gasoil and diesel in Europe, as EU firms switch from natural gas to oil on the margin. We expect this will add 800K b/d of demand over the winter months (November through March), which will lift our overall demand estimate 150k b/d this year, and 20K b/d next year – +2.19mm b/d vs +2.04mm b/d, and 1.82mm b/d vs. 1.80mm b/d next year. Chinese year-on-year oil demand growth remains negative. January-July 2022 demand was 15.24mm b/d vs 15.34mm b/d in 2021, continuing a string of y/y contractions. The two other major economic pillars of global oil demand – the US and Europe – show positive y/y growth of 800K b/d each over the same period. Global demand in 1H22 recovered to 98% of its pre-COVID-19 level – even with China’s negative y/y growth – while supply recovered to 96% of its pre-pandemic level, according to the International Energy Forum (IEF). Over most of the forecast period, we estimate global balances will continue to show the level of supply below that of demand, which will lead to continued physical deficits (Chart 5). Refined-product inventories increased by 34mm barrels in 1H22, while crude-oil stocks fell 23mm barrels. Global crude and product inventories are ~ 460mm barrels below their five-year average, which includes pandemic demand destruction, the IEF reported. We continue to expect inventories to remain below their 2010-14 average, which we prefer to track – it excludes the market-share wars of 2015-17 and that of 2020, and the pandemic’s effects on inventories (Chart 6). This will revive the backwardation in Brent and WTI prices, particularly if the loss of Russian barrels is larger than we expect this year and next. This could be dampened if the US resumes its SPR releases after they’ve run their course in October. Chart 5Global Market Balanced, But Slight Deficits Will Persist Global Market Balanced, But Slight Deficits Will Persist Global Market Balanced, But Slight Deficits Will Persist Chart 6OECD Inventories Below 5Y Average OECD Inventories Below 5Y Average OECD Inventories Below 5Y Average Investment Implications Our analysis indicates markets are mostly balanced going into winter (Table 1). That said, the balance of risks remains to the upside ahead of the EU’s embargoes on Russian crude and product imports, and the EU/UK/US insurance/reinsurance bans on providing cover for vessels carrying Russian material. This all is highly contingent on the extent to which the EU and its allies follow through on these punitive actions imposed on Russia in retaliation for its invasion of Ukraine. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 EU Russian Oil Embargoes, Higher Prices EU Russian Oil Embargoes, Higher Prices The removal from the market of some 2mm b/d of Russian oil production due to the various EU embargoes – even if it is offset by the return of 1mm b/d of Iranian exports on the back of a deal with the US – will push crude oil prices higher and inventories lower (Chart 7).3  Chart 7Brent Price Expectation Unchanged, But Demand Shifts To Winter Brent Price Expectation Unchanged, But Demand Shifts To Winter Brent Price Expectation Unchanged, But Demand Shifts To Winter Given these views, we remain long the oil and gas producer XOP ETF, which is up 19.5% since we re-established it on July 5, and, at tonight’s close, will be re-establishing our COMT ETF, to take advantage of higher energy and commodity prices and increasing backwardation in oil markets as inventories draw.   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 Commodities Round-Up Energy: Bullish US distillate inventories – diesel and heating oil mostly – were up less than 1% for the week ended 12 August 2022, according to the US EIA. US distillate inventories stood at 112mm barrels. This did nothing to reverse the deep drawdown in distillate inventories of 18.5% y/y, which, along with European stocks, refiners are attempting to rebuild going into the 2022-23 winter. We expect natgas-to-oil switching this winter to add 800k b/d of demand to the market over the Nov-Mar winter season. Most of this demand will be for distillates, in our view, given its dual use as a fuel for industrial applications and household space-heating. Distillate demand could be higher this winter, if a La Niña produces colder-than-normal temperatures. The US Climate Prediction Center gives the odds of such an outcome 60% going into the 2022-23 winter. This would lift ultra-low-sulfur diesel futures in the US and gasoil futures in Europe higher as inventories draw (Chart 8). Base Metals: Bullish Copper prices dropped on weaker-than-expected Chinese macroeconomic data for July, although the fall was bounded by the People’s Bank of China’s decision to cut interest rates. According to US CFTC data, copper trading volumes are lower than pre-pandemic levels, as hedge funds' net speculative positions turned negative beginning in May and have mostly remained in the red since then. Low trading volumes will result in copper prices being highly susceptible to macroeconomic events, especially those occurring in China. Precious Metals: Neutral Gold prices are facing difficulty overcoming market expectations of high interest rates for the rest of this year (Chart 9). The bearish influence of tightening monetary policy and a strong USD has the upper hand on the supportive effect of recession risks, inflation, and geopolitical uncertainty for gold prices. Recent strength in US stock markets - which historically is inversely correlated with gold prices - following better-than-expected earnings, also contributed to recent gold price weakness. Chart 8 EU Russian Oil Embargoes, Higher Prices EU Russian Oil Embargoes, Higher Prices Chart 9 Investors Expect Fed Tightening To Give Way To An Easing Cycle In 2023 Investors Expect Fed Tightening To Give Way To An Easing Cycle In 2023     Footnotes 1 Please see Oil: It Ain't Over Till It's Over, which we published 11 August 2022, for additional discussion. NB: We discuss the differences between our view and that of our Geopolitical Strategy service regarding a deal between the US and Iran, which returns 1mm b/d of crude oil exports to the market. We give 60% odds to such a deal, while our colleagues at the GPS service assign a 40% probability to it. In our base case modeling presented herein, we expect these barrels to return to the market by 2Q23, perhaps sooner. 2 Please see Anonymous Chinese shipowner spends $376m on tankers for Russian STS hub published by Lloyd’s List 9 August 2022. The report notes, “All the ships are aged 15 years or older, precluding them from chartering by most oil majors, as well being unable to secure conventional financing, suggesting the beneficial owner is cash rich. The high seas logistics network offers scant regulatory and technical oversight as crude cargoes loaded on aframax tankers from Baltic Russian ports are transferred to VLCCs mid-Atlantic for onward shipment to China. One cargo has been tracked to India.“ 3 Please see Oil: It Ain't Over Till It's Over, which we published 11 August 2022, for additional discussion. NB: We discuss the differences between our view and that of our Geopolitical Strategy service regarding a deal between the US and Iran, which returns 1mm b/d of crude oil exports to the market. We give 60% odds to such a deal, while our colleagues at the GPS service assign a 40% probability to it. In our base case modeling presented herein, we expect these barrels to return to the market by 2Q23, perhaps sooner.   Investment Views and Themes Strategic Recommendations Trades Closed in 2022

Listen to a short summary of this report.     Executive Summary Chart 1The Dollar Has Broken Below The First Line Of Support The Dollar Has Broken Before The First Line Of Support The Dollar Has Broken Before The First Line Of Support The softer CPI print in the US boosted growth plays and pushed the DXY index below its 50-day moving average (Feature Chart). This suggests CPI numbers will remain the most important print for currency markets in the coming weeks and months. If US inflation has peaked, then the market will price a less aggressive path for Fed interest rates, which will loosen support for the dollar. At the same time, other G10 central banks are still seeing accelerating inflation. This will keep them on a tightening path. This puts the DXY in a tug of war. On the downside, the Fed could turn less hawkish. On the other hand, currencies such as the EUR, GBP and even SEK face high inflation but deteriorating growth. This will depress real rates. Within this context, the most attractive currencies are those with relatively higher real rates, and a real prospect of a turnaround in growth. NOK and AUD stand out as potential candidates. Our short EUR/JPY trade has been performing well in this context. Stick with it.  RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short EUR/JPY 141.20 2022-07-21 3.29 Bottom Line: Our recommended strategy is a neutral dollar view over the next three months, until it becomes clear inflation has peaked and global growth has bottomed. Feature The DXY index peaked at 108.64 on July 14 and has dropped to 105.1 as we go to press. There have been two critical drivers of this move. First, the 10-year US Treasury yield has fallen from 3.5% to 2.8%. With this week’s all important CPI release, which showed a sharp deceleration in the headline measure, bond yields may well stabilize at current levels for a while. Second, the drop in energy prices has boosted the JPY, SEK and EUR, which are heavily dependent on imported energy. Related Report  Foreign Exchange StrategyA Montreal Conversation On FX Markets Another development has been happening in parallel – as US inflation upside surprises have crested, so has the US price impulse relative to its G10 counterparts (Chart 1). To the extent that this eases market pricing of a hawkish Fed (relative to other G10 central banks), it will continue to diminish upward pressure on the dollar. Much will depend on the incoming inflation prints both in the US, and abroad. With the DXY having broken below its 50-day moving average, the next support level is at 103.6. This is where the 100-day moving average lies, which the dollar tested twice this year before eventually bouncing higher (Chart 2). The next few sections cover the important data releases over the last month in our universe of G10 countries, and implications for currency strategy. What is clear is that most foreign central banks are committed to their tightening campaign, which argues for a neutral stance towards the DXY for now. Chart 1US Inflation Momentum Has Rolled Over US Inflation Momentum Has Rolled Over US Inflation Momentum Has Rolled Over Chart 2The Dollar Has Broken Below The First Line Of Support The Dollar Has Broken Below The First Line Of Support The Dollar Has Broken Below The First Line Of Support US Dollar: Consolidation Chart 3The Conditions For A Fed Hike Remain In Place The Conditions For A Fed Hike Remain In Place The Conditions For A Fed Hike Remain In Place The dollar DXY index is up 10% year to date. Over the last month, the DXY index is down 2.1% (panel 1). Incoming data continues to make the case for a strong dollar. Job gains are robust. In June, the US added 372K jobs. The July release was even stronger at 528K jobs. This pushed the unemployment rate to a low of 3.5% (panel 2). Wages continue to soar. Average hourly earnings came in at 5.2% year-on-year in July. The Atlanta Fed wage growth tracker continues to edge higher across all income cohorts (panel 3). The June CPI print was above expectations at 9.1% for headline, with core at 5.9%. The July print for headline that came out this week was 8.5%, below expectations of 8.7%. At 5.9%, the core measure is still well above the Fed’s target (panel 4). June retail sales remained firm, but consumer sentiment continues to weaken. While the University of Michigan current conditions index increase from 53.8 to 58.1 in June, this is well below the January 2020 level of 115. Correspondingly, the Conference Board consumer confidence index fell from 98.7 to 95.7 in July. On June 17, the Fed increased interest rates by 75bps, as expected. The US entered a second consecutive quarter of GDP growth contraction in Q2, falling by an annualized 0.9%. The ISM manufacturing index was flat in July suggesting Q3 GDP is not starting on a particularly strong foot. The Atlanta Fed Q3 GDP growth tracker is, however, printing 2.5%. Unit labor costs are soaring, rising 10.8% in Q2. This is sapping productivity growth, which fell 4.6% in Q2.  The key for the dollar’s outlook is the evolution of US inflation and the labor market. For now, inflation remains sticky, and wages are rising. Meanwhile, labor market conditions remain robust. This will keep the Fed on a tightening path in the near term. We initially went short the DXY index but were stopped out. We remain neutral in the short term, though valuation keeps us bearish over a long-term horizon. The Euro: A European Hard Landing Chart 4The Euro Is At Recession Lows The Euro Is At Recession Lows The Euro Is At Recession Lows The euro is down 9.2% year to date. Over the last month, the euro is up 2.7%, having faced support a nudge below parity. Incoming data continues to suggest weak economic conditions, with a stagflationary undertone: The ZEW Expectations Survey for July was at -51.1, the lowest reading since 2011 (panel 1). The current account remains in a deficit, at -€4.5bn in May. Consumer confidence continues to plunge. The July reading of -27 is the worst since the 2020 Covid-19 crisis (panel 2). Despite the above data releases, the ECB surprised markets by raising rates 50bps. CPI continues to surprise to the upside. The preliminary CPI print for July came in at 8.9%, well above the previous 8.6% print. PPI in the euro area was at 35.8% in June, a slight decline from the May reading (panel 3). The German Ifo business expectations index fell to 80.3 in July. Historically, that has been consistent with a manufacturing PMI reading of 45 (panel 4). The Sentix confidence index stabilized in August but remains very weak at -25.2. This series tends to be trending, having peaked in July last year. We will see if the next few months continue to show stabilization. The ECB mandate dictates that it will continue to fight soaring inflation. As such, it may have no choice but to generate a Eurozone-wide recession. This is the key risk for the euro since it could push EUR/USD below parity again. We continue to sell the EUR/JPY cross. In a risk-off environment, EUR/JPY will collapse. In a risk-on environment, like this week, the yen can still benefit since it is oversold. Meanwhile, investors remain overwhelmingly bearish (panel 5). The Japanese Yen: Quite A Hefty Rally Chart 5Some Green Shoots In Japan Some Green Shoots In Japan Some Green Shoots In Japan The Japanese yen is down 13.4% year-to-date, the worst performing G10 currency (panel 1). Over the last month, the yen is up 3.3%. Incoming data in Japan has been worsening as the rising number of Covid-19 cases is hitting mobility and economic data. According to the Eco Watcher’s survey, sentiment among small and medium-sized Japanese firms deteriorated in July. Current conditions fell from 52.9 to 43.8. The outlook component also declined from 47.6 to 42.8. Machine tool order momentum, one of our favorite measures of external demand, continues to slow. Peak growth was at 141.9% year-on-year in May last year. The preliminary reading from July was at 5.5% (panel 2). Labor cash earnings came in at 2.2% year-on-year, a positive sign. Household spending also rose 3.5%. Rising wages could keep inflation momentum rising in Japan (panel 3). On that note, the Tokyo CPI report for July was also encouraging, with an increase in the core-core measure from 1% to 1.2%. The Tokyo CPI tends to lead nationwide measures. The labor market remains robust. Labor demand exceeds supply by 27%. The Bank of Japan kept monetary policy on hold on July 20th, a policy move that makes sense given incoming data. The BoJ still views a large chunk of inflation in Japan as transitory. For inflation to pick up, wages need to rise. While they are rising, inflation expectations remain well anchored, suggesting little rationale for the BoJ to shift (panel 4). That said, the yen is extremely cheap after being the best short this year (panel 5).  British Pound: Coiled Spring Below 1.20? Chart 6Cable Is Vulnerable Cable Is Vulnerable Cable Is Vulnerable The pound is down 9.8% year to date. Over the last month, the pound is up by 2.5%. Sterling broke below a soft floor of 1.20, but quickly bounced back and is now sitting at 1.22, as sentiment picked up (panel 1). We find the UK to have an even bigger stagflation problem than the eurozone. CPI came in at 9.4% in June. The RPI came in at 11.8%. PPI was at 24%. All showed an acceleration from the month of May (panel 2). Nationwide house price inflation has barely rolled over unlike other markets, increasing from 10.7% in June to 11% in July. The Rightmove national asking price was 9.3% higher year-on-year in July, compared to 9.7% in June (panel 3). Meanwhile, mortgage approvals have been in steady decline over the last two years, which points toward stagflation. Retail sales excluding auto and fuel fell 5.9% year-on-year in June, the weakest reading since the Covid-19 crisis. Consumer confidence is lower than in 2020 (panel 4). Trade data continues to be weak, which has dipped the current account towards decade lows (panel 5). The external balance is the biggest driver of the pound, given the huge deficit. The above environment has put the BoE in a stagflationary quagmire. Last week, they raised rates by 50 bps suggesting inflation is a much more important battle than growth. Politically, the resignation of Prime Minister Boris Johnson, and broader difficulties for the Conservative Party, is fueling sterling volatility. We are maintaining our long EUR/GBP trade as a bet that at 1.03, the euro has priced in a recession (well below the 2020 lows), but sterling has not. On cable, 1.20 will prove to be a long-term floor but it will be volatile in the short term.  Australian Dollar: A Contrarian Play Chart 7Relatively Solid Domestic Conditions In Australia Relatively Solid Domestic Conditions In Australia Relatively Solid Domestic Conditions In Australia The AUD is down 2.3% year-to-date. Over the last month, the AUD is up 5.3%. AUD is fast approaching its 200-day moving average. If that is breached, it could signal that the highs of this year, above 76 cents, are within striking distance (panel 1). Inflation is accelerating in Australia. In Q2, the inflation reading was 6.1%, while the trimmed-mean and weighted-median measures were above the central bank’s 1-3% band (panel 2). As a result, the RBA stated the benchmark rate was “well below” the neutral rate. It increased rates by an additional 50bps in August, lifting the official cash rate to 1.85%. Further rate increases are likely. There are a few reasons for this. First, labor market conditions are the most favorable in decades. In June, unemployment reached 3.5%, its lowest level in 50 years, against a consensus of 3.8% (panel 3). The participation rate also increased to 66.8% in June from 66.7%, which has pushed the underutilization rate to multi-decade lows (panel 4). Despite this, consumer confidence continued its decline in August, dropping to 81.2 from 83.8. A pickup in Covid-19 cases and high consumer prices are the usual suspects. Beyond the labor market, monetary policy seems to be having the desired effect. Demand appears to be slowing as retail sales grew 0.2% month-on-month in June from 0.9%. Home loan issuance declined by 4.4% in June, driven by a 6.3% decline in investment lending. House price growth continued to decline in July, particularly in densely populated regions like Sydney and Melbourne. The manufacturing sector remains strong, with July PMI coming in at 55.7, suggesting the RBA might just be achieving a soft landing in Australia.  The external environment was largely favorable for the AUD in June, as the trade balance increased substantially by A$17.7bn with commodities rallying early in the month. However, commodity prices are rolling over. The price of iron for example, is down 24% from its peak in June. This will likely weigh on the trade balance going forward (panel 5). A weakening external environment are near-term headwinds for the AUD, but we will be buyers on weakness (panel 6).  New Zealand Dollar: Least Preferred G10 Currency Chart 8Near-Term Risks To NZD Near-Term Risks To NZD Near-Term Risks To NZD The NZD is down 6.1% this year. Over the last month, it is up 5% (panel 1). The Reserve Bank of New Zealand raised its official cash rate (OCR) in July by 50bps to 2.5%, in line with market expectations. Policymakers maintained their hawkish stance and guided towards increased tightening until monetary conditions can bring inflation within its target range of 1-3%. Inflation rose in Q2 to 7.3% from a 7.1% forecast, largely driven by rising construction and energy prices (panel 2). As of the latest data, monetary policy appears to be continuing to have the desired effect on interest rate sensitive parts of the economy. REINZ home sales declined 38.1% year-on-year in June. Home price growth continues to roll over (panel 3). The external sector continues to slow. Dairy prices, circa 20% of exports, saw a 12% drop in early August after remaining flat in July. The 12-month trailing trade balance remains in deficit. This is most likely due to a substantial slowdown in Chinese economic activity, given that China is an important trade partner with New Zealand. What is important is that the RBNZ’s “least regrets” approach seems to be working. Despite a cooling economy, sentiment seems to be stabilizing. ANZ consumer confidence improved to 81.9 in July from 80.5. Business confidence also improved to -56.7 from -62.6 (panel 4). Ultimately, the NZD is driven by terms of trade, as well as domestic conditions (panels 1 and 5). Thus, short-term headwinds from a deteriorating external sector do not make us buyers of the currency for now, though a rollover in the dollar will help the kiwi.  Canadian Dollar: Lower Oil, Hawkish BoC Chart 9The BoC Will Stay On A Hawkish Path The BoC Will Stay On A Hawkish Path The BoC Will Stay On A Hawkish Path The CAD is down 1.2% year to date. Over the last month, it is up 1.8%. The Canadian dollar did not fully catch up to oil prices on the upside. Now that crude is rolling over, CAD remains vulnerable, unless the dollar continues to stage a meaningful decline (panel 1). Canadian data has been rather mixed over the last month. For example: There have been two consecutive months of job losses. This is after a string of positive job reports. In July, Canada lost 31K jobs. In June, it lost 43K. The reasons have been mixed, from women dropping out of the labor force, to lower youth participation (the participation rate fell), but this is a trend worth monitoring (panel 2). CPI growth remains elevated and is accelerating both on headline and core measures(panel 3). Building permits and housing starts have started to roll over, as house price inflation continues to lose momentum. June housing starts were at 274K from 287.3K. June building permits also fell 1.5% month-on-month though annual inflation is still outpacing house price growth (panel 4). The Canadian trade balance is improving, hitting a multi-year high of C$5.05 bn in June. This has eased the need for foreign capital inflows. The BoC raised rates 100bps in July, the biggest interest rate increase in one meeting among the G10. Unless the labor market continues to soften, the BoC will continue to focus on inflation, which means more rate hikes are forthcoming. The OIS curve is pricing a peak BoC rate of 3.6% in 9 months (panel 5). Two-year real rates are still higher in the US compared to Canada. And the loonie has lost the tailwind from strong WCS oil prices. As such, unless the dollar softens further, the loonie will remain in a choppy trading pattern like most of this year.  Swiss Franc: A Safe Haven Chart 10The Franc Will Remain Strong Against The Euro For Now The Franc Will Remain Strong Against The Euro For Now The Franc Will Remain Strong Against The Euro For Now CHF is down 3.2% year-to-date and up 4.3% in the past month. The Swiss franc has been particular strong against the euro, with EUR/CHF breaching parity (panel 1). Switzerland remains an island of relative economic stability in the G10. Although slowing, the manufacturing PMI was a healthy 58 in July. The trade surplus was up to CHF 2.6bn in June, despite a strong franc. While most European countries are preparing for a tough winter with energy rationing, prospects for Switzerland, which derives only 13% of its electricity from natural gas, look more favorable.  Still, as a small open economy, Switzerland is feeling the impact of global growth uncertainty. The KOF leading indicator dropped to 90.1 in August with a sharp decline in the manufacturing component. This broader measure suggests the relative resilience of the manufacturing sector might not last long (panel 2). Consumer confidence also fell to the lowest level since the onset of the pandemic. Swiss headline inflation stabilized at 3.4% in July. The core measure rose slightly to the SNB’s 2% target (panel 3). The UBS real estate bubble index rose sharply in Q2, suggesting inflation is not only an imported problem. Labor market conditions also remain tight, with the unemployment rate at 2%, a two-decade low. The SNB will continue to embrace currency strength while inflation risks persist (panel 4), as can be seen by the decline in sight deposits and FX reserves (panel 5). The market is still pricing in another 50 bps hike in September although August inflation data that comes out before the meeting will likely be critical for that decision. CHF is one of the most attractive currencies in our ranking. Despite the recent outperformance, CHF is still down year-to-date against the dollar. A rise in safe-haven demand, and a possible energy crunch in winter will be supportive, especially against the euro.  Norwegian Krone: Oil Fields Are A Jewel Chart 11NOK Will Reap Dividends From Energy Exports NOK Will Reap Dividends From Energy Exports NOK Will Reap Dividends From Energy Exports NOK is down 7.4% year-to-date and up 7.1% over the last month. It is also up 4.2% versus the euro, despite softer oil prices (panel 1). Inflation in Norway continues to accelerate. In July, CPI grew 6.8% year-on-year, above the market consensus and the Norges Bank’s forecast. Underlying inflation jumped sharply to an all-time high of 4.5%, compared to the Bank’s 3.2% forecast made just over a month ago (panel 2). These figures are adding pressure on the central bank to increase the pace of interest rate hikes, with 50bps looking increasingly likely at the meetings in August and September. NOK jumped on the inflation news. The housing market is starting to show signs of slowing with prices down 0.2% on the month in July, the first decrease since December. This, together with household indebtedness (panel 3), makes the task of policy calibration challenging. Our bias is that a persistently tight labor market and strong wage growth (panel 4) will allow the bank to focus on inflation. Economic activity remains robust in Norway but is softening. The manufacturing PMI fell to 54.6 in July, while industrial production was down 1.7% month-over-month in June. Consumer demand remains frail with retail sales and household consumption flat in June from the previous month. On a more positive note, trade surplus remains near record levels and is likely to stay elevated as high European demand for Norwegian energy is likely to last at least through the winter (panel 5). As global risk sentiment picked up, the krone became the best performing G10 currency over the past month. If the risk appetite reverses, the currency is likely to feel some turbulence. Swedish Krona: Cheap, But No Catalysts Yet Chart 12SEK = EUR On Steroids SEK = EUR On Steroids SEK = EUR On Steroids SEK is down 10% year-to-date and up 5.6% over the past month. The vigorous rebound highlights just how oversold the Swedish krona is (panel 1). The Swedish economy grew 1.4% in Q2 from the previous three months, rebounding from a 0.8% contraction in the first quarter. This is impressive, given high energy prices and a slowdown in global economic activity. Going forward, growth is likely to slow. In July, the services and manufacturing PMIs declined, and consumer confidence fell sharply to the lowest reading in almost 30 years. Retail sales were down 1.2% month-on-month in June. The housing market is also feeling the pain of rising borrowing costs (panel 2). The Riksbank’s latest estimate sees a 16% decline in prices by the end of next year.  For now, inflation is still accelerating in Sweden. CPIF, the Riksbank’s preferred measure, increased from 7.2% to 8.5% in June. Headline inflation rose from 7.3% to 8.7% (panel 3). Headline inflation is likely to decline in July, given the drop in the price component of the PMIs, but inflation will remain well above target. This will keep real rates weak (panel 4). This suggests that the Riksbank is facing the same conundrum as the ECB: accelerate policy tightening and tip the economy towards recession or remain accommodative and risk inflation becoming more entrenched. Our bias is that the Riksbank is likely to frontload rate hikes as currently priced in the OIS curve, with a 50 bps hike in September, ahead of major labor union wage negotiations (panel 5). Much like the NOK, the Swedish krona rebounded strongly in the past month on global risk-on sentiment. Fundamentally, the krona remains more vulnerable to external shocks due to higher energy dependency and a strong dollar. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Artem Sakhbiev Research Associate artem.sakhbiev@bcaresearch.com Thierry Matin Research Associate thierry.matin@bcaresearch.com   Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary Oil Markets Remain Tight Oil Markets Remain Tight Oil Markets Remain Tight US and Iranian negotiators received an EU proposal for reviving the Iran nuclear deal on Monday, which could return ~ 1mm b/d of oil to markets.  The EU’s embargo of Russian seaborne crude imports, which commences December 5, will remove 90% of seaborne imports of Russian crude (~ 2.3mm b/d) by year-end.  In February 2023, another 800k b/d of refined products will be embargoed.  December also will usher in insurance and reinsurance sanctions on shipping Russian oil – arguably the strongest sanctions the EU, UK and US can impose. Without those Iranian barrels, the determination of the EU, UK and US to enforce a Russian oil embargo will be suspect. We give odds of 60% to a US-Iran deal getting done in the near term.  Our Geopolitical Strategy maintains the likelihood of a deal is 40% at best. Bottom Line: Oil markets are pricing in the likelihood of large energy supply dislocations over the next couple of months.  The evolution of prices hinges upon the degree to which the EU’s embargo on Russian oil imports is implemented.  A revived Iran nuclear deal with the West would offset some of the embargoed Russian oil.  Even so, oil balances still will remain tilted to deficit conditions in 2023.  We continue to expect Brent will move above our 2022 $110/bbl expectation by 4Q22, and average $117/bbl next year. Feature US and Iranian negotiators received a proposal from EU negotiators for reviving the Iran nuclear deal on Monday.1 If the US and Iran can agree, the door opens for 1mm b/d of Iranian oil to return to markets. These barrels are becoming increasingly important to the EU, especially following the suspension of southerly flows of oil on Russia’s Druzhba pipeline due to a payment dispute.2 Brent popped ~ $1.50/bbl Tuesday morning as the Druzhba news broke, and the backwardation in the forward market increased (Chart 1). Brent gave back these early gains by the end of trading, following news a Hungarian refiner transferred the fee required to use the Ukrainian section of the pipeline.3 Chart 1Oil Markets Remain Tight Oil Markets Remain Tight Oil Markets Remain Tight Complicated Motives On All Sides The EU obviously has an interest in freezing Iran’s nuclear program and accessing more Iranian fossil fuels while it is locked in an energy struggle with Russia – hence the its proposal to revive the Iran nuclear deal. However, the US and Iranian positions are more complicated. Iranian’s Supreme Leader Ali Khamenei has an interest in removing the US’s economic sanctions – and in obtaining deliverable nuclear weapons, notes Matt Gertken, BCA Research’s chief geopolitical strategist. Khamenei’s plan is to develop a nuclear weapon so that Iran can deter any aggression from a future US administration or the Abraham alliance. This is the path to regime survival, power succession, and national security. Hence Iran will not freeze its nuclear program over the long run. But Khamenei may wish to buy time while the Democrats still run the White House. Chart 2KSA, UAE Preserving Spare Capacity Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over We’ve noted repeatedly the Biden administration has been pressing the Kingdom of Saudi Arabia (KSA) and the United Arab Emirates (UAE) – the only states in OPEC 2.0 able to raise output and maintain production at higher levels – to increase output for the better part of this year. These efforts yielded only a 100k b/d production increase earlier this month. KSA and the UAE insist they are close to the maximum levels of oil they can supply to the market, given their current production and the need to maintain minimal spare capacity (Chart 2).4 KSA’s max capacity is 12mm b/d. The Kingdom will be producing at or slightly above 11mm b/d later this year to offset declines in non-core OPEC 2.0 production. KSA’s trying to get its max capacity to 13mm b/d, but that will take until 2027, according to the state oil company ARAMCO. UAE’s max capacity is 4mm b/d. It will be producing at or close to 3.5mm b/d this year, and after that they’ll want to hang on to that last bit as spare capacity. UAE’s trying to get its spare capacity to 5mm b/d, but that’s going to take until 2030, according to its state oil company ADNOC. There’s an increasing risk to the Russian output arising from the EU embargo scheduled to take effect December 5, and sanctions on providing insurance and reinsurance to ships carrying Russian material. If the EU/UK/US embargo is successful and results in Russia being forced to shut in 2mm b/d by the end of next year, per our expectation, KSA and UAE spare capacity will not cover the loss of production, and falling output within OPEC 2.0. Given these dynamics – and the expectation at least some of the sanctions will stick after Dec. 5 – KSA and UAE have to hang on to those last barrels to be able to meet the increasingly likely loss of Russian shut-in production. Additional spare capacity is not available in the US shales, or in any of the other producing provinces outside OPEC 2.0 sufficient to cover the loss of Russian barrels. Indeed, output from OPEC 2.0 outside the core producers has been trending lower for years (Chart 3).5 Complicating a deal with Iran is the possibility it could re-open the breach between the US and KSA. If KSA wanted to express its displeasure with a US-Iran deal it wouldn’t need to do much to re-balance the market: If the Kingdom does not offset production losses by the rest of OPEC 2.0, or step up to cover, e.g., Libyan production – now back on the market with just under 500k b/d – global supply falls and prices rise, all else equal.6 Chart 3KSA, UAE Are Core OPEC 2.0 Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over Our Geopolitical Strategy gives 40% odds of an Iran deal and 60% odds that negotiations fall apart (or drag on without resolution). We make the odds higher – 60% chance of success – given the compelling interest of the Biden administration to get more oil into the market going into midterms in November, and a general interest in the West to offset potential losses of Russian volumes to sanctions that kick in in December. The difference in these views hinges on what Iran will do, as the Biden administration is seeking a deal. Sanctions Kicking In In December The EU is set to roll into its embargo of Russian oil imports on December 5. If fully implemented, ~ 2.3mm b/d of seaborne imports of Russian crude oil will be excluded from EU markets by year-end. Beginning in February, another 800k b/d of refined products will be embargoed. EU, UK and US shipping insurance and reinsurance sanctions also are set to kick in in December. These arguably are the strongest sanctions available to the West in its effort to take Russian oil and refined products off the market (no insurance means no shipping). The EU recently relaxed sanctions on buying and transporting Russian crude oil, which will allow additional volumes of oil to be purchased and transported to end-use markets.7 While this will let a little more Russian oil into the market in the near term, we believe it opens the possibility of additional exceptions being made by the EU to make more oil available, if prices move sharply higher on the back of increasing supply scarcity. The EU and US are looking a bit wobbly on the insurance and reinsurance bans due to kick in in December.8 If they relax or forego these sanctions in some fashion, more Russian crude and products will flow to market in 4Q22 than currently is anticipated. This would undermine US efforts to secure a price cap on Russian oil sales. Slower sanction enforcement is a path available to Biden that does not involve bowing to Iran’s various demands. Some, but not all, of the Russian volumes lost to EU exports will continue to be scooped up by China and India, which have become the largest buyers of Russian oil following the sanctions imposed by the West after the invasion of Ukraine.9 India loaded 29.5mm barrels of Russian crude in July – a record – while China loaded 18.1mm barrels. These levels likely will fall, but these two states will remain big buyers of Russian crude and products going forward. Household Budgets Will Remain Strained High energy prices – particularly for gasoline and diesel fuel – and falling real incomes have eaten into US household budgets, and are a key factor for Biden’s low approval ratings (Chart 4). July US CPI was unchanged from June and was 8.5% higher y-o-y. While the gasoline price index dropped from June, it remained one of the main contributors to the high energy index. (Chart 5).10 Based on the sharp increase in gasoline prices over the first six months of this year, we estimate the cost of running a car is 50% higher in 1H22 vs. 1H21 in the US. Chart 4Wealth Destruction Key To Low Biden Approval Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over Chart 5Energy Driving High US Prices Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over US gasoline and distillate prices have rolled over since mid-June, driven by high refined-product prices, which weakened demand, and fear of global recession as central banks tighten monetary policy. Higher Russian crude output in 1H22 – up 3.6% to ~ 10.1mm b/d – partly contributed to weaker product prices. However, this trend likely will reverse: Russian crude output in 2Q22 was down 1.1% y/y to 9.7mm b/d, based on our estimates. We expect prices of gasoline and diesel fuel to remain at elevated levels, given low inventories (Chart 6), and a second consecutive year of lower US refining capacity (Chart 7). Higher crude oil prices brought about by Russian oil and product embargoes will feed into these refined product prices, pushing them higher. Chart 6Low Product Stocks… Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over Chart 7…And Refining Capacity Are Bullish For Petrol Products Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over There is scope for an increase in gasoline demand over the rest of the driving season, while elevated US and overseas distillate demand will support diesel and heating oil prices. The eurozone’s record high inflation in July was driven by energy prices (Chart 8), indicating high energy prices are a problem for households worldwide. According to the Household Electricity Price Index, residential electricity prices in EU capitals were more than 70% higher in 1H22 y/y. The IMF expects high fuel prices will increase EU households’ share of energy expenditure by 7% in 2022.11 In response to high energy prices, governments are enacting policies such as price caps and direct transfers to lower the damage to household wealth.12 An unintended consequence of this will be high prices for longer, as consumers will not register the signal the market is sending via higher prices to encourage lower demand. This will result in continued draws on inventories. Chart 8High Energy Prices Responsible For Eurozone Inflation High Energy Prices Responsible For Eurozone Inflation High Energy Prices Responsible For Eurozone Inflation Investment Implications With EU sanctions scheduled to become effective December 5, oil markets are focused on supply measures that could sharply reduce Russian oil exports. This makes the US-Iran negotiations to revive the Iran nuclear deal critically important. Agreement to restore the deal could return 1mm b/d of oil to markets at a time when supplies are at risk of contracting sharply going into 2023. Failure to restore these volumes will tighten supply significantly if the EU’s embargo of Russian oil imports is successful. We give the restoration of the Iran nuclear deal a 60% chance of success. In and of itself, the return of Iranian oil exports will not offset all of the potential loss of Russian crude oil exports to the EU. That said, the evolution of crude oil prices hinges upon the degree to which the EU’s embargo on Russian oil imports is implemented. There's a subtle point to be aware of in the evolution of US-Iran negotiations: The Biden administration could just turn a blind eye to Iranian crude sales, without agreeing to revive the nuclear deal being negotiated. Signing a deal, on the other hand, would be more positive for supply than merely not contesting Iranian's renewed exports of 1mm b/d of crude. It is worthwhile bearing in mind that the point of the deal is that Iran pauses its nuclear program, which reduces war risk in the medium term, or as long as deal is in force. Reducing the level of agita in the region, at least for a couple of years, is a net benefit. Our geopolitical strategist Matt Gertken notes, "If Iranians sign a deal, then they are endorsing Biden and the Democratic Party for 2024, meaning they want a Democratic White House in the US through 2028. There would be no reason to sign it unless you plan to implement at least through 2024." We remain bullish oil, and continue to expect Brent to trade above $110/bbl on average this year, and $117/bbl next year. We remain long the XOP ETF to retain our exposure to oil and gas E+Ps.   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     Commodities Round-Up Energy: Bullish The EIA expects US natural gas inventories to finish the injection season at ~ 3.5 Tcf – 6% below the five-year average – at the end of October (Chart 9). LNG exports are expected to average 11.2 Bcf/d, which, if realized, will be 14% over 2021 levels. The EIA increased its estimate of LNG exports on the back of an earlier-than-expected return of Freeport LNG exports. For 2023, the EIA expects US LNG exports will average 12.7 Bcf/d. Close to 70% of the 57 bcm of US LNG exports are being shipped to Europe, where it is helping offset the cutoff of Russian gas supplies following the war in Ukraine. In 1H22, the US became the world’s largest exporter of LNG. Dry gas production in the US is expected to average just under 97 Bcf/d in 2022, a 3% increase over 2021 levels. Base Metals: Bullish Total Chinese copper imports for July were up 9.3% at ~464kt for July, despite economic weakness and a property market slowed by companies' payment defaults and lower consumer confidence in real estate groups. Copper in SHFE warehouses were at 35kt which is 65% lower y/y as of the week ending August 5th, while stocks in China’s copper bonded inventories were 40% lower y/y at 262kt for the month of June. Low copper prices and Chinese stocks, and high imports indicate that the world’s largest copper consumer is capitalizing on weak prices to restock low inventories. Precious Metals: Bullish The World Gold Council reported gold ETF outflows for the third consecutive month in July at 80.1 tons (Chart 10) due to low gold prices, a strong USD and a hawkish Fed. The latest July US CPI data was unchanged from June, as high prices due to pandemic induced supply chain bottlenecks eased. Inflation remains well above target. Despite the mildly positive inflation data, we expect the Fed to hike interest rates again in September. The magnitude of this hike will depend on the August US CPI and employment prints, given the Fed’s data dependency. By year-end, if the Russian oil embargo and insurance bans on shipping vessels are implemented in their current form, high crude oil prices will feed into inflation, and the Fed will be forced to remain aggressive. Chart 9 Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over Chart 10 Oil: It Ain't Over Till It's Over Oil: It Ain't Over Till It's Over     Footnotes 1     Please see Agreement on nuclear deal within reach but obstacles remain published by politico.com on August 8, 2022. 2     Please see Russia suspends oil exports via southern leg of Druzhba pipeline due to transit payment issues published by reuters.com on August 9, 2022. 3    Please see Oil drops on Druzhba pipeline news and U.S. inflation expectations published by reuters.com on August 10, 2022.  According to the International Association of Oil Transporters, the Druzhba pipeline capacity is ~ 1.3mm b/d.  In July, its southern leg supplying Hungary, the Czech Republic and was carrying ~ 230k b/d, according to OilX, a satellite service monitoring oil and shipping movements globally. 4    Please see Tighter Oil Markets On The Way, which we published on July 21, 2022, for additional detail. 5    Please see footnote #4. 6    The background factor in this situation is Russia’s involvement in Libya’s civil disorder.  We noted in our July 14, 2022 report Russia Pulls Oil, Gas Supply Strings: “Sporadic force majeure declarations and output losses in Libya, where Russian mercenaries actively support Khalifa Haftar’s Libyan National Army (LNA), continue to make supply assessments difficult.” 7     Please see How the EU Will Allow a Slight Increase in Russian Oil Exports published by Bloomberg.com on August 1, 2022. 8    Please see US warns of surge in fuel costs as it renews push for Russian oil price cap published by ft.com on July 26, 2022. 9    Please see Russian crude prices recover on strong India, China demand, and Column-Russian crude is more reliant on India and China, but signs of a peak: Russell | Reuters, published by reuters.com on August 7 and August 9, 2022. 10   After fuel oils, the 44% y-o-y increase in the gasoline price index was the largest contributor to the increase in the energy index. 11    Please see Surging Energy Prices in Europe in the Aftermath of the War: How to Support the Vulnerable and Speed up the Transition Away from Fossil Fuels, published by the IMF on July 29, 2022. 12    For an example of such policy, please see State aid: Commission approves Spanish and Portuguese measure to lower electricity prices amid energy crisis     Investment Views and Themes Strategic Recommendations Trades Closed in 2022

Executive Summary Realized Real Interest Rates Must Rise Realized Real Interest Rates Must Rise Realized Real Interest Rates Must Rise Policymakers must continue engineering higher real interest rates, and tighter financial conditions, to help cool off growth and bring down overshooting inflation. This will inevitably lead to inverted yield curves across most of the developed world, following the recent trend of US Treasuries. US growth expectations remain overly pessimistic, which opens up the potential for more near-term bond-bearish upside data surprises like the July employment and ISM Services reports. The Bank of England – under increasing political pressure for its relatively timid response to the massive UK inflation overshoot – is now forecasting a long policy-induced recession as the only way to tame UK inflation expected to reach 13% by year-end. Expect UK Gilts to be a relative outperformer within developed bond markets over the next 12-18 months. Bottom Line: Stay overweight UK Gilts versus US Treasuries in global bond portfolios, but increase exposure to yield curve flattening in both countries. The Fed and Bank of England are both on course to push monetary policy into restrictive, growth-damaging territory. Don’t Get TOO Comfortable Taking Risk In a bit of a summer surprise, global financial markets have been staging a mild recovery from the stagflationary doom that prevailed during the first half of 2022. In the US, the S&P 500 index is up 14% from the year-to-date intraday low reached on June 16, with the VIX index back down to low-20s zone last seen in April (Chart 1). High-yield corporate bond spreads in the US and euro area are down 97bps and 36bps, respectively, since that mid-June trough in US equities. Even emerging market equities and credit – the most unloved of asset classes in 2022 – have stabilized. Related Report  Global Fixed Income StrategyIt’s Time To Flip The Script - Upgrade UK Gilts Some of this risk rally is surely short-covering, but there are some valid reasons to be less pessimistic on growth-sensitive risk assets. In the US, where the back-to-back contractions in GDP in the first two quarters of the year have stoked recession fears, the latest data releases have seen upside surprises suggesting an expanding, not contracting, economy (Chart 2). The July ISM non-manufacturing (services) index rose +1.4 points in July to 56.7, a broad-based move that included increases in Production, New Orders and New Export Orders. Core durable goods orders rose +0.5% in June for the second straight month. The biggest surprise was the July Payrolls report, which showed a whopping +528,000 increase in employment – over twice the expected gain of +250,000 – with a downtick in the unemployment rate to 3.5%. Chart 1Stepping Back From The Recessionary Abyss Stepping Back From The Recessionary Abyss Stepping Back From The Recessionary Abyss ​​​​​​ Chart 2The US Recession Talk May Have Been Premature The US Recession Talk May Have Been Premature The US Recession Talk May Have Been Premature ​​​​​​ Chart 3Goods Inflation Pressures Easing Goods Inflation Pressures Easing Goods Inflation Pressures Easing There was also some good news on the inflation front in the latest US data. The Prices Paid components of both the ISM manufacturing and non-manufacturing indices showed big declines, 18.5pts and 7.8pts respectively, in July, continuing the downtrends that began in the latter half of 2021 (Chart 3). This is not just a US story. The Prices Paid components of the S&P Global manufacturing PMIs in the euro area, the UK, Japan and China have also been falling. Lower global commodity prices, particularly for oil, are playing a large role in the pullback in reported business input costs. The Supplier Deliveries components of both ISM reports also fell on the month, continuing a trend seen throughout 2022 as global supply chain pressures have eased. Combined with the drop in the Prices Paid data, global PMIs are sending a strong message - inflationary pressures on the traded goods side of the global economy are finally easing. Slower goods inflation, however, does not provide an all-clear for risk assets on a cyclical basis. Non-goods price pressures are showing little sign of peaking across most of the developed world. Labor markets remain tight, and both wage inflation and services inflation rates continue to accelerate in the major economies of the US, UK and euro area at a pace well above central bank inflation targets (Chart 4). Until these domestic sources of inflation show signs of peaking, central banks will continue to push up policy rates to slow growth, generate higher unemployment and, eventually, bring domestically driven inflation back down to central bank targets. Expect the so-called Misery Index, summing headline inflation and the unemployment rate, to remain elevated across the major developed economies until negative real interest rates begin to rise through a combination of more nominal rate hikes and, eventually, slower inflation (Chart 5). Chart 4Domestic Inflation Pressures Accelerating Domestic Inflation Pressures Accelerating Domestic Inflation Pressures Accelerating ​​​​​ Chart 5Realized Real Interest Rates Must Rise Realized Real Interest Rates Must Rise Realized Real Interest Rates Must Rise ​​​​​​As we discussed in last week’s report, bond markets were getting way ahead of themselves in pricing in aggressive rate cuts in 2023, especially in the US. This was setting up for a potential move higher in yields on any positive data news. Within the “Big 3” developed economies, US Treasuries look most vulnerable to a rebound in bond yield momentum, judging by what looks like a true bottom in the mean-reverting Citigroup US Data Surprise Index (Chart 6). The flow of data surprises is more mixed in the euro area and UK and is not yet at the stretched extremes that would signal a sustainable increase in bond yields. Taken at face value, this fits with our current recommendation to underweight the US, and overweight core Europe and the UK, within global government bond portfolios. With central banks now on track to push policy rates into restrictive territory, there is the potential for additional flattening of already very flat yield curves across the Big 3. Forward rates are not priced for additional curve flattening in those markets, looking at both the 2-year/10-year and 5-year/30-year government bond curves (Chart 7). This makes positioning for more curve flattening in the US, UK and euro area a positive carry trade by leaning against the pricing of forward rates. Chart 6Greater Potential For Bond-Bearish Data Surprises In The US Greater Potential For Bond-Bearish Data Surprises In The US Greater Potential For Bond-Bearish Data Surprises In The US ​​​​​​ Chart 7Increase Exposure To Curve Flattening In The 'Big 3' Increase Exposure To Curve Flattening In The 'Big 3' Increase Exposure To Curve Flattening In The 'Big 3' We are adjusting the positioning within the BCA Research Global Fixed Income Strategy Model Bond Portfolio this week to benefit from the trend towards additional curve flattening in the US, the UK and core Europe (Germany and France). With the 2-year/10-year curve already inverted by -45bps in the US, we see better value by adding flattening exposure between the 5-year and 30-year points – a curve segment that is not yet in inversion. In the UK and euro area, we see a case for positioning for flattening across the entire yield curve. Bottom Line: Stay overweight both UK Gilts and core European government bonds versus US Treasuries in global bond portfolios, but increase exposure to yield curve flattening in all countries. The Fed and Bank of England are both clearly on course to push monetary policy into restrictive, growth-damaging territory, and the ECB may be forced to do the same. Painful Honesty From The Bank Of England The Bank of England (BoE) delivered its largest rate hike since 1995 last week, raising Bank Rate by 50bps to 1.75%. Planned sales of UK Gilts accumulated by the BoE during the quantitative easing phase of pandemic stimulus, at a pace of £10bn per quarter starting in September, were also announced. While those moves were largely expected by markets, the BoE’s new set of economic forecasts contained quite a shocker – an expectation of recession starting in Q4 of this year, running through the end of 2023 (Chart 8). The UK unemployment rate is expected to rise substantially from the current 3.8% to 6.3% by Q3/2025. Chart 8Brutal Honesty In The Latest BoE Forecasts Brutal Honesty In The Latest BoE Forecasts Brutal Honesty In The Latest BoE Forecasts ​​​​​​ Chart 9Energy Prices Driving BoE Inflation Forecasts Energy Prices Driving BoE Inflation Forecasts Energy Prices Driving BoE Inflation Forecasts We are hard pressed to remember the last time a major central bank announced a forecast of a prolonged economic downturn as part of its baseline scenario to bring inflation to its target. Such is the predicament that the BoE finds itself in, with headline UK inflation expected to soar to 13% by the end of 2022 – a mere 11 percentage points above the central bank’s inflation target. The BoE has been forced to sharply ratchet up that expected peak in UK inflation at both the May and August policy meetings this year. This is largely due to the massive increase in UK energy prices with the Energy component of the UK CPI index up over 50% in year-over-year terms. According to analysis published in the BoE August 2022 Monetary Policy Report, the direct impact of higher energy prices was projected to account for roughly half of that expected 13% peak in UK inflation this year (Chart 9). At the same time, falling energy prices embedded into futures curves are expected to full unwind that effect in 2023. The BoE’s recession call is also conditioned on a market-implied path for interest rates, with a 2023 peak in Bank Rate of just over 3% priced into the UK OIS curve. Looking beyond the energy price surge, there are signs that the BoE will not have to tighten as aggressively as interest rate markets are currently expecting. Our BoE Monitor, constructed using growth, inflation and financial market variables that would typically pressure the central bank to tighten or loosen monetary policy, has clearly peaked (Chart 10). All three components of the Monitor have rolled over, although inflation pressures remain the strongest contributor to the elevated absolute level of the Monitor. From a growth perspective, there are many reasons to expect the UK economy to enter a recession without much more prodding from BoE rate hikes (Chart 11): Chart 10Our BoE Monitor Sees Easing Cyclical Pressure To Raise Rates Our BoE Monitor Sees Easing Cyclical Pressure To Raise Rates Our BoE Monitor Sees Easing Cyclical Pressure To Raise Rates ​​​​​​ Chart 11A Broad-Based Slowing Of UK Growth A Broad-Based Slowing Of UK Growth A Broad-Based Slowing Of UK Growth ​​​​​​ Both the S&P Global manufacturing and services PMIs are on target to soon fall below the 50 level that indicates positive growth (top panel) Consumer confidence has collapsed as surging inflation has overwhelmed household income growth, leading to a contraction in retail sales volume growth (middle panel) The BoE’s Agents’ Survey of individual businesses shows a sharp deterioration in business investment spending plans (bottom panel). Yet even with growth clearly slowing already, the sheer magnitude of the inflation overshoot is forcing markets to discount a fairly aggressive path for UK interest rates over the next year. This is not only evident in the OIS curve, but also in the BoE’s own Market Participants Survey (MPS) of UK investors. According to the just released August MPS, the median expectation is for Bank Rate to peak at 2.5% next year (Chart 12). This is a sizeable increase from the previous expected peak of 1.75% from the last MPS in May, but is still below the discounted peak in rates from the OIS curve of 3.1%. The bigger news is that the, according to the August MPS, the median survey participant now believes that the neutral range for Bank Rate is now 2-2.5%, up from the 1.5-2.0% range in the May MPS. Therefore, the August MPS forecasted peak Bank Rate of 2.5% is only at the high end of neutral and not restrictive. Yet both the OIS curve and the August MPS expect the BoE to immediately pivot from rate hikes to rate cuts in the second half of 2023. Chart 12UK Interest Rate Markets Have Adjusted Neutral Rate Expectations UK Interest Rate Markets Have Adjusted Neutral Rate Expectations UK Interest Rate Markets Have Adjusted Neutral Rate Expectations Chart 13The BoE Is Facing Severe Public Scrutiny The BoE Is Facing Severe Public Scrutiny The BoE Is Facing Severe Public Scrutiny The notion that the BoE would pivot so quickly next year, when their own forecasts still call for UK inflation to be over 9% in the third quarter of 2023, seem somewhat optimistic. Especially with the BoE under tremendous public and political pressure because of runaway UK inflation. The leading candidate to become the next UK Prime Minister, Foreign Secretary Liz Truss, has already gone on record stating that she would look to change the BoE’s remit as Prime Minister to focus solely on keeping inflation low. Meanwhile, the latest BoE Inflation Attitudes Survey shows more respondents are now dissatisfied with the BoE than satisfied (Chart 13). 1-year-ahead inflation expectations from that same survey are now at 4.6%, while 5-year/5-year forward breakevens from UK index-linked Gilts are still at 3.8%. With inflation expectations still so elevated, and with the BoE’s own forecasts calling for headline UK inflation to not fall back to the 2% BoE target until Q3/2024, it is unlikely that the BoE will revert to rate cuts as quickly as markets expect – especially given the accelerating wage dynamics in the UK labor market. According to the BoE’s measure of “underlying” wage growth, which adjusts headline wage inflation data for pandemic effects from furloughs and shifting labor composition, wages are growing at a 4.2% year-over-year rate (Chart 14). The BoE’s own modeling work indicates that 2.9 percentage points of that wage growth is due to the level of short-term inflation expectations, with only 0.9 percentage points coming from productivity growth. Thus, the BoE cannot let its foot off the monetary brake until short-term inflation expectations fall substantially from current elevated levels – especially with employment indicators still pointing to a very tight supply-constrained, post-COVID UK labor market. Chart 14A Wage-Price Spiral In The UK? Misery Loves Company Misery Loves Company Given that interplay of rising headline inflation, elevated inflation expectations and tight labor markets, the BoE will likely be forced to begin unwinding the current rate hiking cycle later than markets expect. This will eventually lead to an inversion of the UK Gilt yield curve as the BoE pushes policy rates to restrictive territory and the UK economy falls into recession faster than other countries (like the US). Chart 15Stay Overweight UK Gilts, With A Curve Flattening Bias Stay Overweight UK Gilts, With A Curve Flattening Bias Stay Overweight UK Gilts, With A Curve Flattening Bias We still believe that the Fed is more likely than the BoE to fully follow through on market-discounted rate hikes over the next year, which was a major reason why we upgraded our cyclical recommendation on UK Gilts to overweight back in May. However, with the BoE now under more pressure to wring high inflation out of the UK economy by keeping policy tighter for longer, we also see value in positioning for that eventual inversion of the UK Gilt curve (Chart 15). We see the sequencing as being inversion first, and relative Gilt outperformance later, although we do not expect the relative performance of Gilts to worsen with the UK economy set to enter recession before other major economies. Importantly, the forward rates in the Gilt curve are still priced for a somewhat steeper yield curve, making curve flattening trades along the entire curve attractive as positive carry trades that pay you to wait for the eventual policy driven inversion. The 2-year/10-year and 2-year/30-year flatteners look particularly attractive from that carry-focused perspective. Bottom Line: The BoE– under increasing political pressure for its relatively timid response to the massive UK inflation overshoot – is now forecasting a long policy-induced recession as the only way to tame UK inflation expected to reach 13% by year-end. Expect UK Gilts to be a relative outperformer within developed bond markets over the next 12-18 months, and enter positive carry Gilt curve flatteners now to benefit from the inevitable inversion of the curve.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Misery Loves Company Misery Loves Company The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Misery Loves Company Misery Loves Company

Executive Summary Italy’s right-wing alliance, led by Brothers of Italy, will likely outperform in  the upcoming election. The new government will prioritize the economy, posing a risk to the EU’s united front against Russia. It is conducive to an eventual ceasefire, which is marginally positive for risk assets in 2023. We recommend investors underweight Italian assets on a tactical basis. China’s political risks will remain elevated until Xi consolidates power this fall, positive news will come after, if at all. Geopolitical risk in the Taiwan Strait will remain high and persistent until China and the US reach a new understanding. Separately, we are booking a 9% gain on our long US equities relative to UAE equities trade. Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Tactical Recommendation Inception Date Return LONG US / UAE EQUITIES (CLOSED) 2022-03-11 9.0% Bottom Line: Italy’s political turmoil suggests a more pragmatic policy toward Russia going forward. Europe’s energy cutoff will also motivate governments to negotiate with Russia. Feature In this report we update our GeoRisk Indicators, with a special focus on Italy’s newest political turmoil. Italy Over the past several months, we have argued that Italy was a source of political risk within the European Union and that the market underestimated the probability of an early Italian election. In the past two weeks, this forecast has become a reality (Chart 1). Chart 1Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator The grand coalition under Prime Minister Mario Draghi had fulfilled its two main purposes – to distribute EU recovery funds and secure an establishment politician in the Italian presidency. At the same time, headline inflation hit 8.5% in June, the highest since 1986, even as the Italian and global economy slowed down, Italian government bonds sold off, and Russia induced an energy crisis. The stagflationary economic environment is biting hard and the different coalition members are looking to their individual interests ahead of election season. On July 14, Giuseppe Conte, the former prime minister, pulled its populist Five Star Movement (M5S) out of Mario Draghi’s national unity government, triggering a new round of political turmoil in Italy. Draghi’s first resignation was rejected by Italian President Mattarella later that day. However, on July 21, the League and Forza Italia also defected from the grand coalition. After Draghi’s plan of reviving the coalition collapsed, President Mattarella accepted his resignation and called for a snap election to be held on September 25, ten months ahead of the original schedule. Based on the latest public opinion polls, right-wing political parties are well-positioned for the upcoming election. The far-right Brothers of Italy is now the front runner in the election race and is expected to win around 23% of the votes. Another far-right party, the League, is the third most popular party, with nearly 15% support despite a drop in support during its time within the grand coalition. In addition, the center-right Forza Italia receives 8.5% of the support. Together, the right-wing conservative bloc amounts to 46.5% of voting intentions. There is still positive momentum for Brothers of Italy to harvest more support given that they are the flag-bearer for anti-incumbent sentiment amid the stagflationary economy. By contrast, the left-wing parties – the Democrats, the Left, and the Greens – only command about 27%. The possibility of an extended left-wing coalition, even with the inclusion of the M5S, is looking slim. On July 25, Enrico Letta, the leader of the Democratic Party, publicly expressed his anger against party leader Giuseppe Conte and ruled out any electoral pact with the M5S because of the recent political chaos they caused. He stressed that the Democratic Party would seek ties with parties that had remained loyal to Draghi’s national unity. However, there are not many parties left for the Democrats to partner with. Apart from the Left and the Greens, the Democrats’ best chance would be the center-left Action Party and Italia Viva, which is led by Matteo Renzi, who served as the secretary of the Democratic Party from 2013 to 2018. However, these four parties are small and will not enable the Democrats to form a government. Courting M5S is the Democrats’ only chance to set up an alternative to the right-wing bloc, but that will require the election to force the two parties together. Related Report  Geopolitical StrategyLe Pen And Other Hurdles (GeoRisk Update) The Democratic Party was the biggest supporter of Draghi’s government, while the Brothers of Italy were the sole major opposition. Thus the September 25 election will be a race between these two major parties. Both are expected to outperform current polling, as they will attract the most supporters from each side. The other right-wing parties, Forza Italia and the League, will at least perform in line with their polling, while the other left-wing parties will underperform. In the meantime, M5S’ popularity will continue to decline – the party is bruised over its role in Draghi’s coalition and divided over how to respond to the Ukraine war. Foreign policy is a major factor in this election. Italy has the highest share of citizens in the Eurozone who support solving the Russia-Ukraine conflict through peaceful dialogue (52% versus the Eurozone average of 35%). Italy has long maintained pragmatic relations with Russia, including the Putin administration, as it imported 40% of its natural gas from there prior to 2022. The EU is struggling to maintain a united front against Russia, and war policy will be a key focal point among the different parties. Draghi and the Democratic Party are the strongest supporters of the EU’s oil embargo on Russia and decision to send arms to support Ukraine. On the other side, the right-wing Forza Italia and the League have been more equivocal due to their traditional friendship with Russia. What’s more important is the stance of the Brothers of Italy on Russia, as it is the largest party now and will probably lead a right-wing government after the election. On July 27, the three right-wing parties struck a deal to officially form an alliance in the upcoming election and whichever party wins the most votes would determine the next prime minister if the alliance wins. This deal puts Giorgia Meloni, the leader of Brothers of Italy, one step closer to becoming Italy’s first female PM. Giorgia Meloni, unlike her right-wing peers, has endorsed Draghi’s hawkish stance towards Russia. Recently, she stressed that Italy would keep sending arms to Ukraine if her party forms a government after the election. However, Meloni’s speech could be a tactical move to win the election more than an unshakeable policy position. First, like the other two right-wing parties, the Brothers of Italy have had close connections with Russia. After the 2018 Russian presidential election, Meloni congratulated Putin and claimed his victory was “the unequivocal will of Russians.” In addition, she is close to Prime Minister Viktor Orban of Hungary and National Rally leader Marine Le Pen of France, both of whom have criticized the EU’s decision to provide military support to Kyiv. Hence her sharp change of stance this year seems calculated to avoid accusations of being pro-Russian. But that does not preclude a more pragmatic approach to Russia once in office. Second, Meloni has compromised other far-right positions to broaden her voter base. She has reversed the party’s original anti-EU stance and claimed it does not seek to leave the EU, as most European anti-establishment parties have had to do in order to make themselves electable. Being the only female in the election race, Meloni also pledged to protect women’s access to safe abortions in Italy, also a softer stance than before. Even if the Brothers of Italy distance themselves from some unpopular right-wing positions, including on Ukraine, they probably cannot form a government on their own. They will need to court Forza Italia and the League. These two parties prefer a more pragmatic approach to Russia and a peaceful resolution to the war. Thus while it will be hard to find a middle ground on the issue of Ukraine, the election will likely prevent Italy from taking a more confrontational stance toward Russia. It will probably do the opposite. Consider the context in which the next Italian government will operate. Russia declared on July 25 that it will further reduce natural gas supplies to Europe through Nord Stream 1, as we expected, bringing pipeline flows to 20% of its full capacity.  Energy prices will go up even as European economic activity and industry will suffer greater strains. If Meloni is elected as the new prime minister this September, she will have to keep talking tough on Russia while simultaneously seeking a solution to soaring energy prices and economic crisis. This solution will be diplomacy – unless Russia seeks to expand its invasion all the way to Moldova. A right-wing victory is the most likely outcome based on opinion polling, the negative cyclical economy, and the underlying structural factors supporting populism in Italy that we have monitored for years. Such a coalition will not be pro-Russian but it will be pragmatic and focused on salvaging Italy’s economy, which means it will be highly inclined toward diplomacy. If Russia halts its military advance – does not attempt to conquer southwestern Ukraine to Moldova – then this point will be greatly reinforced. Italy will become a new veto player within the European Union when it comes to any major new sanctions on Russia. While Europeans will continue diversifying their energy mix away from Russia, it will be much harder for the EU to implement a natural gas embargo in the coming years if Italy as well as Hungary oppose it. Even if we are wrong, and the Democratic Party or other left-wing parties surprise to the upside in the election, the new coalition will most likely have to focus on mitigating the economic crisis and thus pursuing diplomacy with Russia. That is, as long as Russia pushes for a ceasefire after it achieves its military aims in Donetsk, the last holdout within the south-southeastern territories Russia is trying to conquer. Bottom Line: Due to persistent political uncertainty, we recommend investors underweight Italian stocks and bonds at least until a new government takes shape, which could take months even after the election. However, government bonds will remain vulnerable if a right-wing coalition assumes power, since it will pursue loose fiscal policies and will eschew structural reforms. Overall Italy’s early elections will lead to a new government that is focused on short-term economic growth, likely including pragmatism toward Russia. From an investment point of view that will not be a negative development, though much depends on whether Russia expands its invasion or declares victory after Donetsk. Russia Market-based measures of Russian geopolitical risk are rebounding after subsiding from peak levels hit during the invasion of Ukraine in February (Chart 2). Chart 2Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia’s continued tightening of natural gas supplies (and food exports) this week is precisely what we predicted would happen despite a wave of wishful thinking from investors over the past month. The optimists claimed that Russia would resume Nord Stream 1 pipeline flows after a regular “maintenance” period. They also said that Canada’s cooperation in resolving some “technical” issues around turbines would stabilize natural gas supply. The truth is that Russia is seeking to achieve its war aims in Ukraine. Until it has achieved its aims, it will use a range of leverage, including tightening food and energy supplies. Most likely Russia will halt the advance after completing the conquest of the Donbas region and land-bridge to Crimea. Then it will seek to legitimize its conquests through a ceasefire agreement. However, it could launch a new phase of the war to try to take Odessa and Transniestria, which would cement European resolve, even in Italy, and trigger a new round of sanctions. Bottom Line: Russia faces a fork in the road once it completes the conquest of Donetsk. Most likely it will declare victory and start pushing for a ceasefire late this year or early next year. Movement toward a ceasefire would reduce geopolitical risk for global financial markets in 2023. But there is still a substantial risk that Russia could expand the invasion to eastern Moldova, which would escalate the overarching Russia-West conflict and sustain the high level of geopolitical risk for markets. China Chinese political and geopolitical risk will continue to rise and the bounce in Chinese relative equity performance is faltering as we expected (Chart 3). Chart 3China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator China’s leaders will hold their secretive annual meeting at Beidaihe in August ahead of the critical Communist Party national congress this fall. General Secretary Xi Jinping is attempting to cement himself as the paramount leader in China, comparable to Chairman Mao Zedong, transforming China’s governance from that of single-party rule to single-person rule. The reversion to autocratic government is coinciding with a historic economic slowdown consisting of cyclical factors (weak domestic demand, weakening foreign demand, draconian Covid-19 restrictions) and structural factors (labor force contraction, property sector bust, social change and unrest). Both Xi and US President Biden face major domestic political challenges in the coming months with the party congress and the US midterm election. Hence they are holding talks to try to stabilize relations. But we do not think they will succeed. China cannot reject Russia’s strategic overture, while the US cannot afford to re-engage with a China that is partnering with Russia in a challenge to the liberal-democratic world order. In addition, US policies are erratic and the US cannot credibly promise China that it will not pursue a containment strategy even if China offers trade concessions. Bottom Line: China-related political and geopolitical risks will remain very high until at least after the twentieth party congress. At that point we expect President Xi to loosen a range of policies to stabilize the economy and foreign trade relations. These policies may bring positive news in 2023, though China’s biggest macroeconomic and geopolitical problems remain structural in nature and we remain underweight Chinese assets. Taiwan For many years we have warned of a “fourth Taiwan Strait crisis” due to the unsustainable geopolitical situation between China, Taiwan, and the United States. After the war in Ukraine we argued that the US would try to boost its strategic deterrence around Taiwan, since it failed to deter Russia from invading Ukraine, but that the increased commitment to Taiwan would in fact provoke China (Chart 4). Chart 4Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Until the US and China reach a new understanding over Taiwan, we argued that the region would be susceptible to rising tensions and crisis points that would send investors fleeing from risky assets, especially risky regional assets. It is possible that we have arrived at this crisis now, with House Speaker Nancy Pelosi making preparations to visit Taiwan, China pledging “forceful” countermeasures if she does, President Biden suggesting that the US military thinks Pelosi should not visit, and Biden and Xi preparing for a phone conversation. In essence China is giving an ultimatum and setting a new bar, and a very low bar, for taking some kind of action on Taiwan, i.e. the mere visit of a US House speaker, which has happened before (House Speaker Newt Gingrich in 1997). China’s purpose is to lay the groundwork for preventing the US from upgrading Taiwan relations in any more substantial way, whether political or military. If the Biden administration calls off the Pelosi visit, then American relations with Taiwan will have been curtailed, at least for this administration. If Biden goes forward with the visit, then Beijing will need to respond with an aggressive show of force to prevent any future president from repeating the exercise or building on it. And if this show threatens US personnel or security, a full-blown diplomatic or military crisis could ensue. While we doubt it would lead to full-scale war, it could lead to a frightening confrontation. Biden may want to stabilize relations with China, since he is primarily focused on countering Russia, but his options are limited. China cannot save him from inflation but it can solidify the public perception that he is weak. Hence he is more likely to maintain his administration’s hawkish approach. Biden’s approval rating is 38% and his party faces a drubbing in the midterm elections. A confrontation with Russia, China, Iran, or anyone else would likely help his party by producing a public rally around the flag. Any unilateral concessions will merely strengthen Xi’s power consolidation at the party congress, which is detrimental to US interests. Only if the Biden administration pursues a dovish policy of re-engagement that is subsequently confirmed by the 2024 presidential election will there be potential for a substantial US-China economic re-engagement. We are pessimistic. Bottom Line: Taiwan-related geopolitical risk will rise in the short run. If there is a new US-China understanding over Taiwan, then regional and global geopolitical risk will decline over the medium term. But we remain short Taiwanese assets. Investment Takeaways Investors should remain defensively positioned until the US midterm election ends with congressional gridlock; the Chinese party congress is over and Xi Jinping launches a broad pro-growth policy; and Russia starts pushing for a ceasefire in Ukraine. We also expect that markets will need to get over new, unexpected oil supply shocks arising from the failure of US-Iran nuclear negotiations, which remains off the radar and therefore a source of negative surprises. Any US-Iran nuclear deal would be a major positive surprise that postpones this risk for a few years. Having said that, we are booking a 9% gain on our long US versus UAE equity trade for technical reasons. Democrats have reached a deal to pass a budget reconciliation bill in an effort to mitigate midterm election losses. This development reinforces the 65% odds of passage that we have maintained for this bill’s passage in our US Political Strategy reports since last year.   Yushu Ma Research Analyst yushu.ma@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Appendix UK Chart 5UK: GeoRisk Indicator United Kingdom: GeoRisk Indicator United Kingdom: GeoRisk Indicator Germany Chart 6Germany: GeoRisk Indicator Germany: GeoRisk Indicator Germany: GeoRisk Indicator France Chart 7France: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator Spain Chart 8Spain: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator Canada Chart 9Canada: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator Australia Chart 10Australia: GeoRisk Indicator Australia: GeoRisk Indicator Australia: GeoRisk Indicator Korea Chart 11Korea: GeoRisk Indicator Korea: GeoRisk Indicator Korea: GeoRisk Indicator Brazil Chart 12Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Turkey Chart 13Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator South Africa Chart 14South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades Geopolitical Calendar

Executive Summary   EU Will Prioritize Natgas Storage Energy Security Rolls Over EU's ESG Agenda Energy Security Rolls Over EU's ESG Agenda Russia’s reduction in natural gas flows through the Nord Stream 1 (NS1) pipeline to 20% of capacity will test the EU’s ability to keep the lights on going into winter. The EU’s plan to voluntarily reduce natgas consumption by 15% has a higher likelihood of becoming mandatory, following Russia’s cut in NS1 flows. Coal-fired generation in the EU will come online sooner on the back of the NS1 cutoff.  This will allow more natgas supplies to be directed to storage injection ahead of winter.  Global natgas supplies will remain tight until 2025, as liquified natural gas (LNG) export capacity is developed ex-EU. Bottom Line: EU energy security will be paramount going into the winter, particularly if Russia keeps gas flows through NS1 at or below 20% of capacity going into winter.  Russia most likely is seeking a significant reduction or the complete elimination of EU oil sanctions, which were imposed after it invaded Ukraine.  If fully enacted, the EU’s embargo will remove more than 3mm b/d of Russian oil exports to the continent by 1Q23.  The EU’s coal reserves and its 15% cut in demand could allow the bloc to get through the winter without a massive recession.  If, as we believe, these measures are successful, a strong rally in European equities and bonds could ensue. Feature Following Russia’s halving of NS1 gas flows to 20% of capacity yesterday – taking shipments to ~ 33mm cm/d – the EU will be forced to increase its reliance on coal-fired electricity generation sooner than expected, to ensure as much natgas as possible is directed to filling storage ahead of the coming winter. And it will have to count on high levels of cooperation in reducing natgas demand between August and March by 15%.1 There is nothing that more dramatically illustrates the bind the EU finds itself in than rolling over its ESG agenda to ensure it has sufficient gas supplies to heat homes, hospitals and other critical services over the course of the coming winter. Russia’s cutoff of NS1 supplies is being done to focus EU member states on their precarious energy position just as they are scrambling to fill natgas storage. The sense of urgency in this effort is heightened by relatively high odds (67%) of another La Niña event, which usually is accompanied by colder-than-normal winter temperatures in the Northern Hemisphere.2 Russia appears to be seeking a significant reduction or the complete elimination of EU oil import sanctions, which were imposed after it invaded Ukraine. If fully enacted as approved, this will embargo more than 3mm b/d of Russian oil exports to the continent by 1Q23. The EU was Russia’s largest oil customer prior to the sanctions being approved.3 Russia Deploys Its Gas Weapon The EU is aiming to have 80% of its gas storage capacity filled by November, to ensure it has sufficient supplies for the coming winter (Chart 1).4 Achieving this target will prove difficult and uncertain, since it hinges on 1) gas flows from Russia not dropping precariously low or completely cutting off; 2) higher non-Russian flows; and 3) reduced gas consumption, which, as we noted above, likely will become mandatory. We ran different simulations altering these variables to see how inventories could move for the rest of 2022 and into the winter (Chart 2). Chart 1EU Will Prioritize Natgas Storage Energy Security Rolls Over EU's ESG Agenda Energy Security Rolls Over EU's ESG Agenda Chart 2The EU Could Face A Cold Winter The EU Could Face A Cold Winter The EU Could Face A Cold Winter   In the simulations, if a variable changes more than we expect – e.g. Russian supplies drop by more than projected – one or both of the other variables will need to adjust to ensure the EU can sufficiently fill gas storage. This adjustment is not guaranteed, since all three variables will likely not move in accordance with policymakers’ expectations, especially gas flows from Russia as it seeks to imperil the bloc’s energy security. On the supply side, Russian flows can drop with little or no warning, while non-Russian supplies will need to remain ~ 30-35% higher relative to 2021, for the rest of the year to get natgas inventories to or slightly above 80%. On the demand side, the EU deal to cut gas consumption by 15% over the course of August-March was accepted with caveats for some member states. The debate and member states’ dissatisfaction over the initial agreement signals states may not implement this policy until they must, which could be too little too late. Of course, a complete cutoff of natural gas flows on the NS1 pipeline would result in inventories being pulled much harder and earlier, and likely would induce further rationing measures. This would produce a sharper economic contraction, since coal-fired generation and other energy usage likely would have maxed out prior to the sharp fall-off in natgas storage. Higher Coal Usage Buys EU Time Global natural gas markets are expected to remain tight into 2025, given the 5-year lead times required to develop LNG capacity export capacity.5 This is forcing EU member states – particularly Austria, France, Germany and the Netherlands – to place an additional 14 GW of coal-fired generation capacity into its reserve fleet in the event of a complete cutoff of Russian supplies.6 Fossil fuels accounted for 34% of EU generation in 2021, or 1,069 TWh. The largest share of this generation was accounted for by coal (Chart 3). Fossil fuels and renewables provide the largest shares of electricity generation overall in the EU (Chart 4). Chart 3Coal Folded Back Into EU Power Stack Energy Security Rolls Over EU's ESG Agenda Energy Security Rolls Over EU's ESG Agenda The EU would like to see its natgas inventories 80% full by November. This translates to ~ 3.2 TCF of natgas in storage, which would put inventories at the higher end of the 5-year range for November. That’s a big assumption, but it does indicate why the combination of higher coal usage and – critically – the 15% cut in demand (vs. five-year average demand) in our simulations is so important. Together, these measures mean the EU will save almost 1.3 TCF of storage gas from August – March. This assumes, of course, that EU member states pull their weight on the conservation front in this economic war with Russia. If everything goes according to plan for the EU (scenario 2 in the Chart 2), then March 2023 inventories will be at the level of 2.5 Tcf. Compared to last year, that means inventories will be 1.3 Tcf higher. Of course that’s impossible to forecast, but there are realistic outcomes close to this outcome. Chart 4Fossil Fuels, Renewables Provide Most Of EU’s Power Energy Security Rolls Over EU's ESG Agenda Energy Security Rolls Over EU's ESG Agenda Investment Implications The EU and Russia are at a critical juncture as winter approaches. Our analysis indicates the EU can – using its coal reserves and getting full buy-in on the 15% conservation measures adopted this week – weather this storm without experiencing a massive recession. Markets will be watching this evolution carefully. By late January or early February, it will be apparent how well the EU managed this challenge. If, as we believe, these measures are successful, we could expect a strong rally in European equities and bonds.   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       Commodities Round-Up Energy: Bullish The US became the largest exporter of LNG in 1H22 with outbound shipments averaging 11.2 Bcf/d, according to the EIA (Chart 5). US liquefaction peak capacity is estimated at 13.9 Bcf/d, with average capacity at 11.4 Bcf/d. The EU and UK are receiving most of the US LNG, which averaged 7.3 Bcf/d, or 64% of total exports over the January-May 2022 interval. Over 1H22, US exports accounted for close to half of the 15 Bcf/d imported by the EU and UK, making it the largest single exporter to Europe. Export volumes were dented in June with the loss of volumes from the Freeport LNG facility in Texas; this is expected to be restored by year-end. We are expecting exports to Europe to remain strong in the wake of the Russia-Ukraine war, especially as demand from Europe to replace Russian supplies stays strong. Base Metals: Bullish Chinese property stocks rallied on news that the government created a $44.4 billion fund to help alleviate the state’s property sector woes. Housing accounts for ~ 30% of copper consumption in China, and the fund should provide positive price action for the red metal in the face of slowing global growth this year and next. We remain bullish copper on the back of supply disruptions in Peru; increasing concern higher taxes in Chile will no longer support returns to miners that are sufficient to encourage capex, and extremely low global copper inventories, which have remained more than 25% below year-ago levels for more than a year (Chart 6). We will be updating our copper view next week. Ags/Softs: Neutral Russia and Ukraine signed a deal brokered by Turkey and the United Nations aimed at allowing some 22mm tons of grain exports from Ukraine, and some Russian grain and fertilizers to transit the Black Sea to end-use markets. These grain supplies are critically important to Middle East and North African markets. However, it could take weeks for Ukrainian ports to be cleared of mines and other obstacles – and, importantly, for a true cessation in Russian attacks on Black Sea port facilities – to resume operations.7 Chart 5 Energy Security Rolls Over EU's ESG Agenda Energy Security Rolls Over EU's ESG Agenda Chart 6 Global Copper Inventories Rebuilding But Still Down Y/Y Global Copper Inventories Rebuilding But Still Down Y/Y     Footnotes 1     Please see EU allows get-out clause in Russian gas cut deal - BBC News, published by bbc.co.uk on July 27, 2022. 2     Please see the US Climate Prediction Center's most recent forecast, posted on July 14, 2022. 3    lease see Higher Gasoline, Diesel Prices Ahead, for discussion of the embargo on Russian crude and product imports to the EU.  Our assessment was published on June 2, 2022, and is available at ces.bcaresearch.com. 4    As of July 25, EU natgas inventories were ~ 67% full at 2.5 TCF. 5    The IEA estimates growth in global LNG supply will slow over its five-year 2021-25 forecast horizon, due to low capex, and COVID-19-induced delays.  Please see the IEA’s Gas Market Report, Q3-2022. 6    Please see Coal is not making a comeback: Europe plans limited increase, published by the European think tank Ember on July 13, 2022. 7     Please see Ukraine, Russia Sign Black Sea Grain Export Deal published by University Of Illinois, July 22, 2022.   Investment Views and Themes Strategic Recommendations Trades Closed In 2022

Executive Summary The ECB finally exited negative interest rates last week. In exchange for higher rates, the doves received an ambitious anti-fragmentation tool, the TPI. The ECB deposit rate is likely to reach between 1% and 1.5% by the summer of 2023. The ECB’s number one problem remains the widely different neutral rates across the Eurozone’s largest economies. Our r-star estimates suggest that the German neutral rate is significantly above that of Spain, Italy, and even France. This divergence in r-star means that the TPI will be activated, but its presence alone is not enough to tame the peripheral bond markets when the ECB hikes rates. While the near-term remains fraught with risks, BTPs are increasingly attractive for long-term investors. The TPI also creates a bullish long-term backdrop for the euro. Many R-Star In The European Sky ECB Policy: One Size Doesn’t Fit All ECB Policy: One Size Doesn’t Fit All Bottom Line: Diverging neutral rates across the Eurozone’s main economies will impair the ECB’s ability to normalize interest rates over the next twelve months without also activating the new anti-fragmentation tool, the TPI. BTPs have become attractive for long-term rather than short-term investors.   Last week, the European Central Bank (ECB) increased interest rates by 50bps, the first hike in eleven years and the third time in its history that it has tightened policy by such a large increment. In exchange for this abrupt end to negative interest rates, the doves on the Governing Council (GC) extracted the creation of the Transmission Protection Instrument (TPI), a new facility designed to limit fragmentation risk on sovereign bond yields in the Eurozone. These two moves raise three key questions: Will the ECB continue to increase rates this aggressively in the coming months? Have peripheral spreads peaked? Will the threat of TPI buying be enough to put a ceiling on spreads, or will the ECB actually need to activate the program in the coming months? To answer these questions, we evaluate where r-star (the neutral real rate of interest) stands in the four largest Euro Area economies. While there is scope for the ECB to push policy rates higher, the wide differences in r-star across European nations indicate that the TPI will need to be activated to stabilize peripheral bond markets, most importantly, Italian government debt. This makes BTPs attractive for long-term investors, although near-term volatility will remain elevated as the markets test the ECB’s resolve. What Happened? Related Report  European Investment StrategyLooking Beyond Europe’s Inflation Peak In terms of interest rates, the most important conclusion from last’s week policy meeting was that forward guidance has been abandoned. The ECB is now fully data dependent, and each policy meeting will be a live one. Another rate hike is certain for the September meeting, ranging from 25bps to potentially 75bps if the ECB wishes to further “front-load” tightening. The single guiding principle will be the outlook for inflation.   ​​​​​​​ Chart 1Incoming Inflation Peak Incoming Inflation Peak Incoming Inflation Peak We do expect inflation to peak soon in the Eurozone, mostly because of the decline in the commodity impulse and slowing food inflation (Chart 1).  Additionally, the one-month impulse of our Trimmed-Mean CPI is weakening. However, as of June, headline and core inflation stand at 8.6% and 3.7%, respectively. Inflation is unlikely to slow enough by the September meeting to prompt the ECB to forecast inflation falling below its 2% target by 2024.  In this context, our base case remains that the GC will opt for a 50bps hike in September. Beyond September, we expect the ECB to revert to 25bps rate hikes and the policy rate to settle between 1% and 1.5% by the summer of 2023, which is broadly in line with the current pricing of the €STR curve (Chart 2). We are somewhat less hawkish than the market for the month of October, because we expect inflation to roll over this fall. Moreover, the European economy continues to decelerate, as highlighted by the declines in the ZEW growth expectations and the PMIs (Chart 3). This deceleration will allow the ECB to revise down its inflation outlook over time. Chart 2Appropriate Pricing Appropriate Pricing Appropriate Pricing Chart 3Growth Is Slowing Growth Is Slowing Growth Is Slowing The announcement of the TPI was the other crucial development from the last ECB meeting. The TPI was unanimously supported. In addition, its asset purchases will be unlimited, and the GC will have much discretion with respect to its implementation. These are three important features that give it ample credibility. However, the program has yet to be activated. Chart 4PEPP Reinvestment Doing Little PEPP Reinvestment Doing Little PEPP Reinvestment Doing Little We do not share the optimism of the GC members who believe that the TPI’s existence alone will narrow peripheral spreads without the ECB having to purchase a single bond. The market will have to figure out what the GC deems as “unwarranted” and “disorderly” moves, especially in a context in which the Draghi government has collapsed and Italy’s commitment to reform will be challenged exactly as interest rates begin to rise. Moreover, the flexible re-investment of PEPP redemptions has not prevented BTP/Bund spreads from widening (Chart 4). As a result, we expect the market to test the ECB’s resolve over the coming weeks, which is likely to result in volatility and wider spreads until the TPI is activated. Bottom Line: Last week’s ECB meeting was a seminal moment. The ECB not only abandoned eight years of negative rates in one go, but it also implemented an ambitious program that aims to restrict peripheral spreads, albeit with some near-term volatility. European policy rates are set to rise to between 1% and 1.5% by the summer of 2023. In Search Of A Neutral Rate During Thursday’s press conference, President Christine Lagarde refused to respond to a question about the neutral rate of interest in Europe. We have sympathy for her predicament. The ECB’s biggest problem is that there is not one neutral interest rate for the entire euro area, but nineteen individual neutral rates for each Eurozone country, with wild differences among them.1  The differences between the neutral rates across the Eurozone are the key factor limiting how far and how fast the ECB may increase rates. It is also the main reason why the ECB resorts to an alphabet soup of non-interest rate policy measures (APP, PEPP, LTRO and, now, TPI) to maintain appropriate monetary conditions across the bloc. But exactly how wide are the differences between the neutral rates? To answer this question, we expand on the methodology developed by Holston, Laubach and Williams (HLW) from the San Francisco Fed  to estimate the neutral real interest rate – or “r-star” - in Germany, France, Italy, and Spain. These are the four largest economies in the Euro Area, accounting for 70% of its GDP. Specifically, we run regressions between the real interest rates in those countries versus trend GDP growth and current account balances, which approximates the savings-investment balance. Mimicking the HLW methodology, the inflation expectations used to extract real interest rates from nominal short rates reflect an adaptative framework whereby inflation expectations are a function of the ten-year moving average core CPI. Our methodology produces estimates of r-star that range from 0% in Germany, to -0.8% in Italy, or a GDP-weighted average of -0.3% for the Eurozone (Table 1). When incorporating last week’s ECB rate hike, Europe’s real deposit rate falls to -1.2% if we use the smoothing procedure from HLW to compute inflation expectations, or -3.7% if we use current core CPI. In either case, policy remains accommodative for everyone. Table 1Many R-Star In The European Sky ECB Policy: One Size Doesn’t Fit All ECB Policy: One Size Doesn’t Fit All We also ran a second set of estimates for r-star, which includes total nonfinancial debt-to-GDP. The logic reflects the notion that adverse debt dynamics was a key force behind the 2011/12 European sovereign debt crisis, which obligated the ECB to reverse course after pushing up the repo rate twice in 2011. Moreover, heavy debt loads not only constrain the ability of various countries to withstand higher rates, but they are also linked to misallocated capital and are therefore likely to depress trend GDP growth over time compared to countries with lighter debt loads. This adjustment changes the picture considerably. While Germany’s real neutral rate of interest remains around 0%, those of Italy and Spain plunge to -1.8% and -2.4%, respectively. France has also experienced a large decline in its r-star to -2.1% in response to the heavy debt load carried by its private and public sectors. Using this method, the GDP-weighted Euro Area r-star falls to -1.4% (Table 1). So which version of the model is more accurate? We believe the most realistic estimate for r-star in each of the four countries is the simple average of both the unadjusted and the debt-adjusted r-star. This implies that the inflation-adjusted neutral rate is close 0% in Germany, -1.2% in France, -1.2% in Spain and -1.3% in Italy (Table 1). Are those results consistent with reality? A country-by-country evaluation suggests that this ranking is correct. To arrive at this judgment, we evaluated each country based on the following four dimensions: Private sector debt accumulation since 2010. If policy is particularly easy for one country, the private sector will be incentivized to take on debt at a more rapid pace than if monetary conditions were tighter. House price appreciation since 2010. Housing is the part of the economy most sensitive to monetary conditions. Larger real estate price gains will materialize in economies where monetary policy is particularly loose. Profit growth since 2010. Easy monetary policy will subsidize corporate profitability, either through faster domestic activity or a cheaper exchange rate (or both). Unemployment rate. The unemployment rate is a crude measure of slack in the economy. An easier policy setting in one country will reduce the unemployment rate compared to a country where policy rates are high relative to r-star. Germany Chart 5Loosest Monetary Conditions In Germany Loosest Monetary Conditions In Germany Loosest Monetary Conditions In Germany Germany exhibits all the evidence of monetary policy being much more accommodative for that country than the other four countries, for the following reasons: Since 2010, German private debt has been expanding much faster than the average of the four countries (Chart 5, top panel). Germany is experiencing the fastest house price appreciation (Chart 5, second panel). Germany’s profits have grown much faster (Chart 5, third panel). Germany’s unemployment rate stands at only 3%, compared to an average rate of 8% for the four nations together (Chart 5, bottom panel). France Chart 6French Monetary Conditions Are Tighter French Monetary Conditions Are Tighter French Monetary Conditions Are Tighter France is a mixed bag. Monetary policy has been easy for France, but the French economy lags Germany on three of the four aforementioned dimensions: Since 2010, French private debt is growing at the fastest pace of the four economies studied, outpacing even that of Germany (Chart 6, top panel). While French house prices have grown slightly faster than the average of the four nations, they lagged German real estate prices (Chart 6, second panel). While French profits have also bested the average of the four nations, they nonetheless trail German profits (Chart 6, third panel). France’s unemployment rate is in line with the average of the four countries under observation (Chart 6, bottom panel). Spain For most of the period following 2010, Spain has suffered from the scars of the disastrous deleveraging that was required in the wake of the sovereign debt crisis. Its trend growth collapsed, and the ECB’s common policy was never as accommodative as it was for its northern neighbors. However, in recent years, the Spanish economy seems to be catching up, a result of the impact of previous structural reforms and the improved competitiveness brought about by collapsing real unit labor costs: Chart 7Spain Still Grapples With Problems Spain Still Grapples With Problems Spain Still Grapples With Problems Since 2010, Spanish private debt has contracted by 20% compared to a 33% expansion for the European average (Chart 7, top panel). Spanish real estate prices have also lagged far behind those of the other countries put together (Chart 7, second panel). However, since 2015, Spanish house prices have begun to recover, and they are now moving at the same pace as the Euro Area average. Spanish profit growth remains weak compared to the average of the four countries studied in this report (Chart 7, third panel). The Spanish unemployment continues to tower at 13%, well above the average of the four largest Euro Area economies (Chart 7, bottom panel). Italy Italy has a similar profile to that of Spain. While its worst performance is solidly in the rear-view mirror, the recent period of easy monetary policy has allowed for some recovery. Nonetheless, Italy still lags far behind other Eurozone countries, which suggests that policy in Italy is not nearly as accommodative as in the rest of the Eurozone. Chart 8Italy Shows Little Improvements Italy Shows Little Improvements Italy Shows Little Improvements Burdened by very large nonperforming loans, the Italian banking sector has been unable to provide adequate credit to the Italian private sector, which already had a limited appetite for debt. As a result, since 2010, Italian private credit has lagged far behind the European average (Chart 8, top panel). Italian real estate prices have not recovered meaningfully from their contraction between 2011 and 2019. Consequently, Italian housing prices lag substantially behind the average of the largest Euro Area countries (Chart 8, second panel). Italian profits remain weak (Chart 8, third panel). While not as elevated as the Spanish unemployment rate, at 8%, Italy’s rate is comparable to the four-country average (Chart 8, bottom panel). Generalizations These observations about individual countries confirm that Germany’s r-star is significantly higher than those of Spain and Italy. When compared to France, the German r-star is also higher, but the gap is much narrower than that between Germany and the two southern nations. The recent ECB Euro Area Bank Lending Survey confirms that France’s r-star is well below that of Germany. French lending standards are tightening as fast as those in Italy (Chart 9). In effect, France’s heavy private sector debt load is proving to be a burden as the ECB begins to tighten policy, which implies a lower French r-star. Chart 9Lending Standard Are Tightening Most In France And Italy ECB Policy: One Size Doesn’t Fit All ECB Policy: One Size Doesn’t Fit All ​​​​​​​ Bottom Line: Among the four largest economies in the Eurozone, a modeling exercise based on the HWL approach reveals that there is a large gap in neutral real interest rates, with Germany on one side around 0%, and Italy, Spain, and even France on the other side with r-star estimates ranging between -1.2% and -1.3%. A survey of current economic activity in these four nations confirms the results from the modeling exercise. Investment Implications The main consequence of the differing r-star across the Eurozone is that the ECB will need to remain an active player in the sovereign bond market. The German, Dutch, and Baltic economies are overheating, and policy needs to be tightened. This means that the ECB will continue to hike rates over the coming months. However, it cannot raise rates much more before they become problematic in Italy, Spain, and even France. Thus, the ECB will activate the TPI in the coming months in order to ease monetary conditions in those economies relative to the stronger group by limiting policy-induced increases in bond yields. In fact, using the r-star estimates adjusted for the debt-to-GDP ratios, the ECB would need to absorb roughly 30% of the Italian total debt to bring Italy’s r-star closer to Germany’s levels. This will not happen, which means that in the foreseeable future, Italy will not be able to withstand the levels of interest rate needed to cool down the German economy. Nonetheless, the TPI can help the ECB in fine-tuning monetary conditions across the Eurozone as it hikes policy rates. For now, Italian bonds are likely to remain volatile until the TPI is activated, especially considering the political situation in Italy, where the outlook for structural reform seems compromised by political uncertainty. This volatility will result in the activation of the TPI before year-end. Once the TPI is activated, BTP/Bund spreads are likely to move back toward 100bps, the level historically consistent with the ECB’s involvement in the sovereign debt market during the APP/PEPP era. The activation of the TPI will also be a positive development for the European corporate bond market, especially investment grade bonds. In last week’s post-conference press release, the ECB revealed that the TPI will also be able to buy private issuer securities. Thus, the ECB is likely to return as a potential buyer in this market. Moreover, investment grade bonds already price in a European recession and therefore offer a large value cushion with 12-month breakeven spreads trading in their 79th historical percentile (Chart 10). We especially like European investment grade corporate bonds relative to US ones on a USD-hedged basis. Relative valuations are in favor of Europe, and the ECB is not tightening policy as much as the Fed. Related Report  European Investment StrategyTo Parity And Beyond The euro will ultimately benefit from the activation of the TPI. The narrowing of both sovereign and corporate spreads resulting from the program represents a very bullish development for EUR/USD (Chart 11), especially because the ECB will likely sterilize the bonds purchased under the program (i.e. the ECB’s balance sheet will not expand because of the TPI). The TPI will also allow the ECB to deliver higher interest rates, which further supports the euro. Nonetheless, we continue to see substantial (roughly 20%) odds of a break below parity in the near-term, especially if wider BTP-Bund spreads in the coming three months are the key catalyst behind the TPI’s activation.  Chart 10Eurozone IG Debt Is Attractive Eurozone IG Debt Is Attractive Eurozone IG Debt Is Attractive Chart 11The TPI Will Help The Euro, Eventually The TPI Will Help The Euro, Eventually The TPI Will Help The Euro, Eventually Finally, last week’s policy development is unlikely to affect the absolute performance of European stocks. European equities remain mostly impacted by the fluctuations in global stock prices and the shifting probability of a recession in Europe this winter in response to the evolving energy crisis on the continent. European equities are inexpensive, and the probability of a recession is declining as a result of the resumption of natural gas flows from Russia. Crucially, the broadening trend toward coal utilization this winter and the growing list of deals that Europe is striking to secure non-Russian gas supplies suggest the impact of Russian cutoffs this winter could be more limited than once feared. Moreover, we expect European governments to hose their economies with stimulus if a crisis does emerge, which would both limit the depth of the crisis and prompt a rapid rebound in activity once winter ends. However, the inattention of the ECB to recession risks suggests that European equities could lag US equities in the near term. Bottom Line: The differences in r-star across Europe mean that the ECB will be forced to activate the TPI before year-end in order to hike interest rates further. Practically, this means that medium- to long-term investors should overweight Italian bonds at the current level of spreads. Short-term investors should remain on the sidelines; the political situation in Italy is still dangerous, and speculators are likely to test the ECB’s resolve. This also means that the euro is attractive as a long-term play, but it still carries large left-tail risk in the near term. While investors should favor European investment-grade bonds in USD-hedged terms relative to the US, European equities are likely to continue to suffer headwinds compared to US stocks.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes   1     In fact, it will soon be 20 r-star since Croatia will join the euro on January 1, 2023.

Listen to a short summary of this report.     Executive Summary The odds of a recession in the US are lower than widely perceived. The probability of a recession is higher in Europe, although this week’s partial resumption of gas flows through the Nord Stream 1 pipeline, along with increased use of coal-fired power plants, should soften the blow. Chinese growth should rebound in the second half of the year. However, the specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening property sector will continue to weigh on activity. With the Twentieth Party Congress slated for later this year, it is increasingly likely that the authorities will open up a firehose of stimulus. Fading recession risks will buoy stocks in the near term. However, a brighter economic outlook also means that the Fed, and several other central banks, may see little need to cut policy rates in 2023, as the markets are currently discounting. The end result is that government bond yields will rise from current levels, implying that stock valuations will not return to last year’s levels even if a recession is averted. After Rapidly Raising Rates, Markets Expect Some DM Central Banks To Start Easing Next Year The Downside Of A Soft Landing The Downside Of A Soft Landing Bottom Line: We recommend a modest overweight on global equities for now but would turn neutral if the S&P 500 were to rise above 4,050.   Dear Client, I am delighted to announce that Ritika Mankar, CFA, has joined the Global Investment Strategy team. Ritika will be writing occasional special reports on a variety of topical issues. Next week, she will make the case that the US economy’s ability to spawn mega-sized companies may become increasingly compromised over the next decade. Best regards, Peter Berezin, Chief Global Strategist The Case for a Soft Landing in the US Chart 1Cyclicals Underperformed Defensives As Recession Risks Intensified Cyclicals Underperformed Defensives As Recession Risks Intensified Cyclicals Underperformed Defensives As Recession Risks Intensified Over the last few months, investors have become concerned that the Fed and many other central banks will need to engineer a recession in order to bring inflation down to more comfortable levels. While these fears have abated over the past trading week, they still continue to dominate market action (Chart 1). We place the odds of a US recession at about 40%. This is arguably more optimistic than the consensus view. According to Bank of America, the majority of fund managers saw recession as likely in this month’s survey. Not surprisingly, investors consider recession to be a major risk for equities over the next 12 months (Chart 2). Chart 2Many Investors Now See Recession As Baked In The Cake The Downside Of A Soft Landing The Downside Of A Soft Landing Even if a recession does occur, we have contended that it will likely be a mild one, perhaps so mild that it will be difficult to distinguish it from a soft landing. A number of things make a soft landing in the US more probable than in the past: Labor supply has scope to increase. The labor participation rate is still 1.2 percentage points below its pre-pandemic level, two-thirds of which is due to decreased participation among workers under the age of 55 (Chart 3). The share of workers holding multiple jobs is also below its pre-pandemic level (Chart 4). The number of multiple job holders has been rising briskly lately. That is one reason why job growth in the payroll survey – which double counts workers if they hold more than one job – has been stronger than job growth in the household survey. Increased labor supply would obviate the need for the Fed to take drastic actions to curtail labor demand in its effort to restore balance to the labor market. Chart 3Labor Supply Has Scope To Rise Labor Supply Has Scope To Rise Labor Supply Has Scope To Rise Chart 4The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels A high level of job openings creates a moat around the labor market. There are almost two times as many job openings as there are unemployed workers in the US (Chart 5). Many firms are likely to pull job openings before they cut jobs in response to a slowing economy. A high level of job openings will also allow workers who lose their jobs to find employment more quickly than usual, thus limiting the rise in so-called frictional unemployment. It is worth noting that the job openings rate has declined from a record 7.3% in March to a still-high 6.9% in May, with no change in the unemployment rate over this period. Chart 5A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market A steep Phillips curve implies that only a modest increase in unemployment may be necessary to knock down inflation towards the Fed’s target. Just as was the case in the 1960s, the Phillips curve has proven to be kinked near full employment (Chart 6). Unlike in the late 1960s, however, when rising realized inflation caused long-term inflation expectations to reset higher, expectations have remained well anchored this time around (Chart 7). Chart 6The Phillips Curve Is Kinked At Very Low Levels Of Unemployment The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 7Long-Term Inflation Expectations Are Well Anchored Long-Term Inflation Expectations Are Well Anchored Long-Term Inflation Expectations Are Well Anchored   The unwinding of pandemic and war-related dislocations should push down inflation. A recent study by the San Francisco Fed estimates that about half of May’s PCE inflation print was the result of supply-side disturbances (Chart 8). While the ongoing war in Ukraine and the threat of another Covid wave in China will continue to unsettle global supply chains, these problems should fade over time. Falling inflation would allow real wages to start rising again. This would bolster confidence, making a soft landing more likely (Chart 9). Chart 8Supply Factors Explain Half Of The Increase In Prices Over The Past Year The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 9Positive Real Wage Growth Will Bolster Consumer Confidence Positive Real Wage Growth Will Bolster Consumer Confidence Positive Real Wage Growth Will Bolster Consumer Confidence A lack of major financial imbalances makes the US economy more resilient to economic shocks. As a share of disposable income, US household debt is 34 percentage points below its 2008 peak (Chart 10). Relative to net worth, household debt is at multi-decade lows. About two-thirds of mortgages carry a FICO score above 760 compared to only one-third during the housing bubble (Chart 11). Non-mortgage consumer credit also remains in good shape, as my colleague Doug Peta elaborated in this week’s US Investment Strategy report. While corporate debt has risen over the past decade, the ratio of corporate debt-to-assets today is still below where it was during the 1990s. Moreover, thanks to stronger corporate profitability, the interest coverage ratio is near an all-time high (Chart 12).   Chart 10AUS Household Debt Is Not Especially High Anymore (I) US Household Debt Is Not Especially High Anymore (I) US Household Debt Is Not Especially High Anymore (I) Chart 10BUS Household Debt Is Not Especially High Anymore (II) US Household Debt Is Not Especially High Anymore (II) US Household Debt Is Not Especially High Anymore (II) Chart 11FICO Scores For Residential Mortgages Have Improved Considerably Since The Pre-GFC Housing Bubble The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 12Corporate Balance Sheets Are In Decent Shape Corporate Balance Sheets Are In Decent Shape Corporate Balance Sheets Are In Decent Shape Chart 13Tight Supply Limits The Downside Risks To Housing Tight Supply Limits The Downside Risks To Housing Tight Supply Limits The Downside Risks To Housing Just like the US does not suffer from major financial imbalances, it does not suffer from any major economic imbalances either. The homeowner vacancy rate is near a record low, which should put a floor under residential investment (Chart 13). Outside of investment in intellectual property, which is not especially sensitive to the business cycle, nonresidential investment is still below pre-pandemic levels and not much above where it was as a share of GDP during the Great Recession (Chart 14). Spending on consumer durable goods has retraced four-fifths of its pandemic surge, with little ill-effect on aggregate employment (Chart 15). Chart 14Outside Of IP, Nonresidential Investment Is Still Low Outside Of IP, Nonresidential Investment Is Still Low Outside Of IP, Nonresidential Investment Is Still Low Chart 15Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Europe: A Deep Freeze Will Likely Be Avoided Chart 16Russia Can Potentially Cause Significant Economic Damage In The EU If It Closes The Taps The Downside Of A Soft Landing The Downside Of A Soft Landing The macroeconomic picture is less benign outside the US. Four years ago, German diplomats laughed off warnings that their country had become dangerously dependent on Russian energy. They are not laughing anymore. German industry, just like industry across much of Europe, is facing a major energy crunch. The IMF estimates that output losses associated with a full Russian gas shutoff over the next 12 months could amount to as much as 2.7% of GDP in the EU (Chart 16). In Central and Eastern Europe, output could shrink by 6%. Among the major economies, Germany and Italy are the most at risk. Fortunately, Europe is finally stepping up to the challenge. The highly ambitious REPowerEU plan seeks to displace two-thirds of Russian gas by the end of 2022. The plan does not include any additional energy that could be generated by increased usage of coal-fired power plants, a strategy that the European political establishment (including the German Green Party!) has only recently begun to champion. It is possible that EU leaders felt the need to generate a crisis mentality to justify the decision to burn more coal. Dire warnings about how Europe is prepared to ration gas also send a message to Russia that the EU is ready to suffer in order to thwart Putin’s despotic regime. Whether Europe actually follows through is a different story. It is worth noting that the Nord Stream 1 pipeline resumed operations this week after Germany received, over Ukrainian objections, a repaired turbine from Canada. The resumption of partial flows through the pipeline, along with increased fiscal support for households and firms, reduces the risks of a “deep freeze” recession in Europe. The unveiling of the ECB’s new Transmission Protection Instrument (TPI) this week should also help anchor sovereign credit spreads across the euro area. While the exact conditions under which the TPI will be engaged have yet to be fleshed out, we expect the terms to be fairly liberal, reflecting not only the lessons learned from last decade’s euro debt crisis, but also to serve as a powerful bulwark against Putin’s efforts to destabilize the EU economy. China: Government’s Growth Target Looks Increasingly Unrealistic Stronger growth in China would help European exporters (Chart 17). Chinese real GDP grew by just 0.4% in the second quarter from a year earlier as the economy was battered by Covid lockdowns. Activity should pick up in the second half of the year, but at this point, the government’s 5.5% growth target looks completely unachievable. The specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening Chinese property sector are all weighing on the economy (Chart 18). Chart 17European Exporters Would Welcome A Stronger Chinese Economy European Exporters Would Welcome A Stronger Chinese Economy European Exporters Would Welcome A Stronger Chinese Economy The authorities will likely seek to stimulate the economy by allowing local governments to bring forward $220 billion in bond issuance that had been originally slated for 2023. The problem is that land sales – the main source of local government revenue – have collapsed. Worried about the ability of local governments to service their obligations, both retail investors and banks have shied away from buying local government debt. Chart 18A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy Meanwhile, the inability of property developers to secure adequate financing to complete construction projects has left a growing number of home buyers in the lurch. In most cases, these properties were purchased off-the-plan. Understandably, home buyers have balked at the prospect of having to make mortgage payments on properties that they do not possess.  With the Twentieth Party Congress slated for later this year, it is increasingly likely that the authorities will open up a firehose of stimulus, including increased assistance for property developers and banks, as well as income-support measures for households. While such measures will not address China’s myriad structural problems, they will help keep the economy afloat. Equity Valuations in a Soft-Landing Scenario A few weeks ago, the consensus view was that stocks would tumble in the second half of the year as the global economy fell into recession but would then rally in 2023 as central banks began lowering rates. We argued the opposite, namely that stocks would likely rebound in the second half of the year as the economy outperformed expectations but would then face renewed pressure in 2023 as it became clear that the Fed and several other central banks had no reason to cut rates (Chart 19). Chart 19After Rapidly Raising Rates, Markets Expect Some DM Central Banks To Start Easing Next Year The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 20Real Rates Have Jumped This Year Real Rates Have Jumped This Year Real Rates Have Jumped This Year In a baseline scenario where a recession is averted, we argued that the S&P 500 could rise to 4,500 (60% odds). In contrast, we noted that the S&P 500 could fall to 3,500 in a mild recession scenario (30% odds) and to 2,900 in a deep recession scenario (10% odds). It is worth stressing that even at 4,500, the S&P 500 would still be 11% lower in real terms than it was on January 4th. At the stock market’s peak in January, the 10-year TIPS yield stood at -0.91%, while the 30-year TIPS yield stood at -0.27%. Today, they stand at 0.58% and 0.93%, respectively (Chart 20). If real rates do not return to their prior lows, it is unlikely that equity valuations will return to their prior highs. This limits the upside for stocks, even in a soft-landing scenario. The sharp rally in stocks over the past week has priced out some of this recession risk, moving equity valuations closer towards what we regard as fair value. As we noted last week, we will turn neutral on equities if the S&P 500 were to rise above 4,050. As we go to press, we are only 1.3% from that level.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on         LinkedIn & Twitter Global Investment Strategy View Matrix The Downside Of A Soft Landing The Downside Of A Soft Landing Special Trade Recommendations Current MacroQuant Model Scores The Downside Of A Soft Landing The Downside Of A Soft Landing    

Executive Summary Upside Oil Price Risk Dominates Upside Oil Price Risk Dominates Upside Oil Price Risk Dominates Despite global recession fears and uncertainty over Russia’s retaliation for the EU embargo against its exports, oil markets will continue to tighten. After breaching $15/bbl in June, the Dec22 vs Dec23 Brent backwardation – our preferred seasonal indicator for inventory tightness – is back above $10/bbl and rising.  There is an increasing risk Russia will cut crude output, if G7 states impose a price cap on its oil sales.  Our modeling indicates the loss of an additional 2mm b/d of Russian output vs our base case beginning in 4Q22 would lift prices above $220/bbl by 4Q23. On the downside, our modeling indicates the loss of 2mm b/d of demand vs our base case – i.e., essentially wiping out this year’s expected growth – would push average Brent prices toward $60/bbl next year. Our base case forecast for Brent crude oil is unchanged.  We expect 2022 Brent to average $110/bbl, and for 2023 prices to average $117/bbl.  WTI will trade $3-$4/bbl below Brent. Bottom Line: We expect markets to continue to tighten as the EU embargo of Russia oil progresses.  A price cap on Russian oil sales could lead to a production cut that takes prices above $220/bbl by 4Q23.  An economic collapse could push Brent toward $60/bbl.  Risks remain skewed to the upside.  Our base case Brent price forecast remains unchanged: $110/bbl on average this year and $117/bbl in 2023. Feature The global oil market is tightening even with China demand restrained by its zero-Covid-19 tolerance policy, and parts of Europe almost surely facing recession if Russian pipeline gas supplies are cut off or tighten significantly between now and the approach of winter. Upside price risk dominates, in our view. Our Brent price forecast remains unchanged, averaging $110/bbl this year and $117/bbl in 2023. Markets remain tight: Oil supply will remain below demand, which will force inventories to draw (Chart 1). Related Report  Commodity & Energy StrategyRecession Unlikely To Batter Oil Prices This will push Brent into a steeper backwardation going into year-end, forcing the Dec22 v Dec23 Brent spread higher (Chart 2). High levels of backwardation – i.e., prompt-delivery futures trading above deferred-delivery futures – is how inventory tightness manifests itself: Refiners are willing to pay more for prompt delivery than deferred delivery, because they need oil now to meet demand. This is occurring despite weaker demand coming out of China and EU states, as the latter begins to ration energy supplies ahead of the coming winter. Chart 1Inventories Will Tighten Inventories Will Tighten Inventories Will Tighten Chart 2Markets Will Backwardate Further Markets Will Backwardate Further Markets Will Backwardate Further Russia Risk Is Increasing The supply-side risks that we outlined in last week's report — chiefly the risk Russia will unilaterally cut oil supply if a price cap is imposed by G7 states led by the US – remain in place. We expect the EU to follow through on its commitment to phase out all Russian oil and refined product imports in 2H22 and 1Q23. The EU formally agreed to cut 90% of its Russian oil imports by the end of this year. The EU’s goal is to be completely out of ~ 2.3mm b/d of seaborne crude oil imports and 800k b/d of pipeline imports this year. In 1Q23, the EU will be reducing its refined product imports (e.g., diesel fuel) from Russia as well. Russia will lose more than 4mm b/d of crude and product exports to the EU as a result of these embargoes. We continue to expect the cutoffs in EU exports will result in Russia being forced to shut in 1.6mm b/d of production this year and another 500k b/d next year. In our base case, we expect this to take Russian crude production down from more than 10.5mm b/d prior to its invasion of Ukraine to something close to 8.0mm b/d by the end of next year. Spare capacity remains tight. Almost all of OPEC 2.0’s spare capacity is in the Kingdom of Saudi Arabia (KSA) and the United Arab Emirates (UAE). These are the only two OPEC 2.0 states that are able to increase production and maintain it at higher levels for an indefinite period of time. Despite repeated pleas from the US, these states continue to indicate they do not see the need to sharply increase oil production, even after US President Joe Biden made a trip to the region last week to ask them in person to do so. With ~ 2-3mm b/d of spare capacity available – the exact level is not public knowledge – digging into spare capacity now would leave nothing in the tank, so to speak, to meet another supply shock (e.g., a unilateral cut-off of Russian supplies in response to a G7 price cap on oil sales). KSA, as a matter of policy, maintains a minimal level of spare capacity (1.0 – 1.5mm b/d) to handle unforeseen supply shocks. In addition, the OPEC 2.0 agreement to return production removed from the market during the COVID-19 pandemic agreed last July, and the US release of 1mm b/d of inventories out of its Strategic Petroleum Reserve (SPR) both expire in September.1 The US SPR has not indicated it will extend its release of inventory beyond September. Markets will tighten. The return of barrels from OPEC 2.0 is largely moot, since only KSA and the UAE – which we dub Core OPEC 2.0 – have been able to consistently raise output since the July 2021 agreement to return barrels to the market. The other OPEC 2.0 member states – the “Other Guys” – have consistently missed their production quotas this past year (Chart 3). Lastly, the odds of the US and Iran reaching a rapprochement continue to fade, almost to the point of vanishing. Iran reportedly will supply Russia with drones for its war in Ukraine. This indicates the Iranian government has all but capitulated on reviving its nuclear deal with the US, which would have brought an additional 1mm b/d back on the market.2 Outside of OPEC 2.0, we expect US production in the Lower 48 states ex-US Gulf will increase 0.8mm b/d this year, and 0.75mm b/d next year, given price levels and the shape of the WTI forward curve (Chart 4). This is mostly unchanged from previous production expectations. Chart 3Lower OPEC 2.0 Production ex-KSA, UAE Tighter Oil Markets On The Way Tighter Oil Markets On The Way Chart 4Capital Discipline Drives US Shale Production Growth Capital Discipline Drives US Shale Production Growth Capital Discipline Drives US Shale Production Growth We continue to expect US shale-oil producers will maintain capital discipline, and will continue to prioritize shareholder interests by returning capital to investors via share buybacks and strong dividend distributions. Besides, boosting output over the balance of this year is becoming increasingly difficult, given oil-services equipment shortages and lack of capital.3 In our base case, we continue to anticipate demand will rise by 2.0mm b/d this year and 1.8mm b/d next year. This is lower than our estimates at the start of the year by close to 3mm b/d. This is all down to the sharp GDP growth slowdown forecast by the World Bank last month, which pushed our oil-demand estimates lower.4 Oil demand continues to grow, albeit it slowly, which, against a backdrop of tightening supplies, means the risk to prices remains to the upside. In our base case, the supply-demand fundamentals are largely balanced (Chart 5). These fundamentals (Table 1) are driving our forecast for $110/bbl Brent this year and $117/bbl next year (Chart 6). Chart 5Markets Remain Finely Balanced Markets Remain Finely Balanced Markets Remain Finely Balanced Chart 6Brent Backwardation Will Steepen Brent Backwardation Will Steepen Brent Backwardation Will Steepen Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Tighter Oil Markets On The Way Tighter Oil Markets On The Way Uncertain Evolutions: Between $60 And $220/bbl We have noted the heightened uncertainty surrounding our oil-price expectations, which makes forecasting more tentative than usual.5 This week, we consider larger supply and demand shocks via econometric simulations to at least define possible price paths consistent with our assumptions and modeling. To the upside, we estimate a 2mm b/d loss of output resulting from a cutoff of Russian crude oil production. Relative to the status quo ante – i.e., prior to Russia’s invasion of Ukraine in February – this would remove a total of ~ 4mm b/d of Russian production from the market (2mm in our base case plus an additional 2mm b/d). Our modeling indicates this could push prices above $220/bbl by 4Q23, depending on how the additional 2mm b/d production cut is implemented – i.e., suddenly or staged pro-rata (Chart 7).6 This high-price scenario would be difficult for markets to adjust to, given the short-term inelasticity of global oil demand. In its wake, we would expect demand destruction on a large scale. Chart 7Upside Oil Price Risk Dominates Upside Oil Price Risk Dominates Upside Oil Price Risk Dominates On the downside, we simulate a sharp contraction in oil consumption that removes an additional 2mm b/d of demand vs our base case – i.e., essentially wiping out this year’s expected growth. This would push average 2023 prices toward $60/bbl in our modeling. Losing this much demand would amount to a global economic collapse. A deep global recession cannot be ruled out, as markets have been reminding us over the past couple of weeks. However, the downside risks are not as pronounced as the upside risks in our estimation. There has not been an excessive accumulation of inventory in the OECD, as Chart 1 indicates. In the non-OECD economies, inventory accumulation in China appears to be intentional and policy driven. In addition, the supply response to sharply lower prices would be met by sharply lower production by KSA and the UAE, along with the US shale-oil producers over the course of a couple of months. This would arrest the down leg a demand shock produced in previous oil-price collapses when production was not as flexible, and inventories adjusted with longer lags. Economic growth in the EU could slow in some but not all of the member states, according to recent IMF estimates.7 The US may slow, and is at risk to a hard landing due to poorly calibrated Fed tightening. This could usher in a deep recession. However, the US also might even benefit from the EU going into recession, since it is not as resource constrained as the EU. Lastly, the EU’s been getting ready for this Russian energy cut-off and has lined up alternative energy sources (LNG and coal mostly). In addition, states already have begun asking their citizens to conserve energy, particularly natural gas. This forced conservation can achieve significant energy savings and is not new to the world: It was demonstrated by Japan after the Fukushima disaster in 2011 and the US in the late 1970s. Investment Implications Our base case oil-price forecast remains $110/bbl and $117/bbl on average for this year and next. Simulations of uncertain prices evolutions – i.e., evolutions we cannot attach a probability to at present – indicate upside price risk is dominant. This inclines us to remain long oil equities via the XOP ETF. We were tactically long 4Q22 and 1Q23 TTF futures until stop losses on both trades were elected on July 15th, generating returns of 89.6% and 83.1% respectively.   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     Commodities Round-Up Energy: Bullish Markets will await the conclusion of maintenance on the Nord Stream 1 (NS1) pipeline scheduled for this week. We continue to expect a cut-off of Russian natgas shipments to Europe, in addition to the 60% of volumes that already have been cut. In its latest GDP forecasts, the IMF expects EU GDP growth of 2.9% and 2.5% in 2022 and 2023, respectively. In and of itself, this would support our expectation for oil prices averaging $110/bbl and $117/bbl this year and next, as it is in line with the GDP forecast expected by the World Bank, which drives our forecasts. However, EU GDP still could contract in response to a complete shut-off of Russian gas imports in 2H22, particularly if it is sudden and prompts the EU to go to Phase 3 of its energy emergency plan and invoke gas rationing. EU gas inventories continue to build going into winter (Chart 8). Markets are critically dialed in to how the inventory builds ahead of winter proceed following NS1 maintenance: If it is delayed for technical reasons the storage fill rate will slow. Base Metals: Bullish China formally created a state-backed company to oversee all of its iron ore imports and overseas ore assets on Tuesday. The purpose of this company is to wrest pricing power away from iron ore suppliers – most of which are based in Australia – and reduce its reliance on Australian iron ore imports. A single buying entity will effectively create a monopsony, since China imports ~70% of global iron ore to supply its steel making industry, the largest in the world. Precious Metals: Bullish We have tactically downgraded our gold view on the back of continued USD strength. Reports of civil unrest in China – which was forecast by BCA’s Geopolitical Strategy - arising from the unfolding mortgage crisis likely will boost demand for gold, but it will boost demand for USD even more, in our view (Chart 9). We are closely monitoring this situation, along with possible increases in systemic financial risk in Chinese banks, which also would support USD demand. We remain strategically bullish gold. Chart 8 Tighter Oil Markets On The Way Tighter Oil Markets On The Way Chart 9 Nominal Broad US Dollar Index Going Up Nominal Broad US Dollar Index Going Up       Footnotes 1     Please see OPEC+ agrees oil supply boost after UAE, Saudi reach compromise and U.S. to sell up to 45 mln bbls oil from reserve as part of historic release published by reuters.com on July 19, 2021 and June 14, 2022, respectively. OPEC 2.0 is our moniker for the producer coalition led by KSA and Russia; it also is referred to as OPEC+ in the media. 2     This could presage an unravelling of the status quo in the Middle East, as our colleagues at BCA Research’s Geopolitical Strategy highlight in their most recent report Questions From The Road published on July 15, 2022. 3    Please see Fracking Growth ‘Almost Impossible’ This Year, Halliburton Says, published by bloomberg.com on July 19, 2022. 4    Please see Recession Unlikely To Batter Oil Prices, which we published on June 16, 2022. It is available at ces.bcaresearch.com. 5    Running simulations is a good way to identify risks and at least have an intuition for where prices might go given difference evolutions of fundamentals. Please see Russia Pulls Oil, Gas Supply Strings for discussions and simulations of prices in response to different supply and shocks we ran last week. 6    The timing and depth of the shocks we simulate here are not assigned a probability to express our view of their likelihood. This reflects our belief that these are highly uncertain outcomes. That said, having an intuition for what to expect should the markets evolve in such a way as to create a probability one of these outcomes has become likely is useful. 7     The smaller EU economies are most at risk to sharp economic downturns from a cutoff in Russian gas exports, according to the IMF. The Fund estimates that in “Hungary, the Slovak Republic and the Czech Republic—there is a risk of shortages of as much as 40 percent of gas consumption and of gross domestic product shrinking by up to 6 percent.” Please see How a Russian Natural Gas Cutoff Could Weigh on Europe’s Economies published by the IMF on July 19, 2022. Investment Views and Themes Recommendations We were stopped out of our Long 4Q22 TTF Futures trade on July 15, with a return of 89.6%. We were stopped out of our Long 1Q23 TTF Futures trade on July 15, with a  return of 83.1%.  Strategic Recommendations Trades Closed in 2022

Executive Summary China's Unemployment Questions From The Road Questions From The Road Over the past week we have been visiting clients along the US west coast. In this report we hit some of the highlights from the most important and frequently asked questions. Xi Jinping is seizing absolute power just as the country’s decades-long property boom turns to bust. He will stimulate the economy but Chinese stimulus is less effective than it used to be. The US and Israel are underscoring their red line against Iranian nuclear weaponization. If Iran does not freeze its nuclear program, the Middle East will begin to unravel again. The UK’s domestic instability is returning, with Scotland threatening to leave the union. Brexit, the pandemic, and inflation make a Scottish referendum a more serious risk than in the past. Shinzo Abe’s assassination makes him a martyr for a vision of Japan as a “normal country” – i.e. one that is not pacifist but capable of defending itself. Japan’s rearmament, like Germany’s, points to the decline of the WWII peace settlement and the return of great power competition. Bottom Line: Investors need a new global balance to be achieved through US diplomacy with Russia, China, and Iran. That is not forthcoming, as the chief nations face instability at home and a stagflationary global economy. Feature The world is becoming less stable as stagflation combines with great power competition. Global uncertainty is through the roof. From a macroeconomic perspective, investors need to know whether central banks can whip inflation without triggering a recession. From a geopolitical perspective, investors need to know whether Russia’s conflict with the West will expand, whether US-China and US-Iran tensions will escalate in a damaging way, and whether domestic political rotations in the US and China this fall will lead to more stable and productive economies. China: What Will Happen At The Communist Party Reshuffle? General Secretary Xi Jinping will cement another five-to-10 years in power while promoting members of his faction into key positions on the Politburo and Politburo Standing Committee. By December Xi will roll out a pro-growth strategy for 2023 and the government will signal that it will start relaxing Covid-19 restrictions. But China’s structural problems ensure that this good news for global growth will only have a fleeting effect. China’s governance is shifting from single-party rule to single-person rule. It is also shifting from commercially focused decentralization to national security focused centralization. Xi has concentrated power in himself, in the party, and in Beijing at the expense of political opponents, the private economy, and outlying regions like Hong Kong, the South China Sea, and Xinjiang. The subordination of Taiwan is the next major project, ensuring that China will ally with Russia and that the US and China cannot repair or deepen their economic partnership. Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Xi and the Communist Party began centralizing political power and economic control shortly after the Great Recession. At that time it became clear that a painful transition away from export manufacturing and close relations with the United States was necessary. The transition would jeopardize China’s long-term economic, social, political, and geopolitical stability. The Communist Party believed it needed to revive strongman leadership (autocracy) rather than pursuing greater liberalization that would ultimately increase the odds of political revolution (democratization). The Xi administration has struggled to manage the country’s vast debt bubble, given that total debt standing has surged to 287% of GDP. The global pandemic forced the government to launch another large stimulus package, which it then attempted to contain. Corporate and household deleveraging ensued. The property and infrastructure boom of the past three decades has stalled, as the regime has imposed liquidity and capital requirements on banks and property developers to try to avoid a financial crisis. Regulatory tightening occurred in other sectors to try to steer investment into government-approved sectors and reduce the odds of technological advancement fanning social dissent. China’s draconian “zero Covid” policy sought to limit the disease’s toll, improve China’s economic self-reliance, and eliminate the threat of social protest during the year of the twentieth party congress. But it also slammed the brakes on growth. China is highly vulnerable to social instability for both structural and cyclical reasons. Chinese social unrest was our number one “Black Swan” for this year and it is now starting to take shape in the form of angry mortgage owners across the country refusing to make mortgage payments on houses that were pre-purchased but not yet built and delivered (Chart 1). Chart 1China: Mortgage Payment Boycott Questions From The Road Questions From The Road The mortgage payment boycott is important because it is stemming from the outstanding economic and financial imbalance – the property sector – and because it is a form of cross-regional social organization, which the Communist Party will disapprove. There are other social protests emerging, including low-level bank runs, which must be monitored very closely. Local authorities will act quickly to stop the spread of the mortgage boycott. But unhappy homeowners will be a persistent problem due to the decline of the property sector and industry. China’s property sector looks uncomfortably like the American property sector ahead of the 2006-08 bust. Prices for existing homes are falling while new house prices are on the verge of falling (Chart 2). While mortgages only make up 15% of bank assets, and household debt is only 62% of GDP, households are no longer taking on new debt (Chart 3). Chart 2China's Falling Property Prices China's Falling Property Prices China's Falling Property Prices ​​​​​​ Chart 3China's Property Crisis China's Property Crisis China's Property Crisis ​​​​​​ Chart 4China's Unemployment China's Unemployment China's Unemployment Most likely China’s property sector is entering the bust phase that we have long expected – if not, then the reason will be a rapid and aggressive move by authorities to expand monetary and fiscal stimulus and loosen economic restrictions. That process of broad-based easing – “letting 100 flowers bloom” – will not fully get under way until after the party congress, say in December. Unemployment is rising across China as the economy slows, another point of comparison with the United States ahead of the 2008 property collapse (Chart 4). Unemployment is a manipulated statistic so real conditions are likely worse. There is no more important indicator. China’s government will be forced to ease policy, creating a positive impact on global growth in 2023, but the impact will be fleeting. Bottom Line: The underlying debt-deflationary context will prevail before long in China, weighing on global growth and inflation expectations on a cyclical basis. Middle East: Why Did Biden Go And What Will He Get? President Biden traveled to Israel and now Saudi Arabia because he wants Saudi Arabia and the Gulf Arab members of OPEC to increase oil production to reduce gasoline prices at the pump for Americans ahead of the midterm elections (Chart 5). Chart 5Biden Goes To Israel And Saudi Arabia Biden Goes To Israel And Saudi Arabia Biden Goes To Israel And Saudi Arabia True, fears of recession are already weighing on prices, but Biden embarked on this mission before the growth slowdown was fully appreciated and he is not going to lightly abandon the anti-inflation fight before the midterm election. Biden also went because one of his top foreign policy priorities – the renegotiation of the 2015 nuclear deal with Iran – is falling apart. The Iranians do not want to freeze their nuclear program because they want regime survival and security. While Biden is offering a return to the 2015 deal, the conditions that produced the deal are no longer applicable: Russia and China are not cooperating with the US and EU to isolate Iran. Russia is courting Iran, oil prices are high and sanction enforcement is weak (unlike 2015). The Iranians now know, after the Trump administration, that they cannot trust the Americans to give credible security guarantees that will last across parties and administrations. The war in Ukraine also underscores the weakness of diplomatic security guarantees as opposed to a nuclear deterrent. Hence the joint US and Israeli declaration that Iran will never be allowed to obtain nuclear weapons. The good news is that this kind of joint statement is precisely what needed to occur – the underscoring of the red line – to try to change Ayatollah Ali Khamenei’s calculus regarding his drive to achieve nuclear breakout. In 2015 Khamenei gave diplomacy a chance to try to improve the economy, stave off social unrest, prepare the way for his eventual leadership succession process, and secure the Islamic Republic. The bad news is that Khamenei probably cannot make the same decision this time, as the hawkish faction now runs his government, the Americans are unreliable, and Russia and China are offering an alternative strategic orientation. The Saudis will pump more oil if necessary to save the global business cycle but not at the beck and call of a US president. The drop in oil prices reduces their urgency. The Americans can reassure the Saudis and Israel as long as the deal with Iran is not going forward. That looks to be the case. But then the US and Israel will have to undertake joint actions to underline their threat to Iran – and Iran will have to threaten to stage attacks across the region so as to deter any attack. Bottom Line: If a US-Iran deal does not materialize at the last minute, Middle Eastern instability will revive and a new source of oil supply constraint will plague the global economy. We continue to believe a US-Iran deal is unlikely, with only 40% odds of happening. Europe: Will Russia Turn Back On The Natural Gas? Russia’s objective in cutting off European natural gas is to inflict a recession on Europe. It wants a better bargaining position on strategic matters. Therefore we assume Russia will continue to squeeze supplies from now through the winter, when European demand rises and Russian leverage will peak. If Russia allows some flow to return, then it will be part of the negotiating process and will not preclude another cutoff before winter. It is possible that Russia is merely giving Europe a warning and will revert back to supplying natural gas. The problem is that Russia’s purpose is to achieve a strategic victory in Ukraine and in negotiations over NATO’s role in the Nordic countries. Russia has not achieved these goals, so natural gas cutoff will likely continue. Russia also hopes that by utilizing its energy leverage – while it still has it – it will bring forward the economic pain of Europe’s transition away from reliance on Russian energy. In that case European countries will experience recession and households will begin to change their view of the situation. European governments will be more likely to change their policies, to become more pragmatic and less confrontational toward Russia. Or European governments will be voted out of power and do the same thing. Other states could join Hungary in saying that Europe should never impose a full natural gas embargo on Russia. Russia would be able to salvage some of its energy trade with Europe over the long run, despite the war in Ukraine and the inevitable European energy diversification. In recent months we highlighted Italy as the weakest link in the European chain and the country most likely to see such a shift in policy occur. Italy’s national unity coalition had lost its reason for being, while the combination of rising bond yields and natural gas prices weighed on the economy. The Italian bond spread over German bunds has long served as our indicator of European political stress – and it is spiking now, forcing the European Central Bank to rush to plan an anti-fragmentation strategy that would theoretically enable it to tighten monetary policy while preventing an Italian debt crisis (Chart 6). The European Union remains unlikely to break up – Russian aggression was always one of our chief arguments for why the EU would stick together. But Italy will undergo a recession and an election (due by June 2023 but that could easily happen this fall), likely producing a new government that is more pragmatic with regard to Russia so as to reduce the energy strain. Chart 6Italy's Crisis Points To EU Divisions On Russia Italy's Crisis Points To EU Divisions On Russia Italy's Crisis Points To EU Divisions On Russia Italy’s political turmoil shows that European states are feeling the energy crisis and will begin to shift policies to reduce the burden on households. Households will lose their appetite for conflict with Russia on behalf of Ukrainians, especially if Russia begins offering a ceasefire after completing its conquest of the Donetsk area. If Russia expands its invasion, then Europe will expand sanctions and the risk of further strategic instability will go up. But most likely Russia will seek to quit while it is ahead and twist Europe’s arm into foisting a ceasefire onto Ukraine. Bottom Line: A change of government in Italy will increase the odds that the EU will engage in diplomacy with Russia in the coming year, if Russia offers, so as to reach a new understanding, restore natural gas flows, and salvage the economy. This would leave NATO enlargement unresolved but a shift in favor of a ceasefire in Ukraine in 2023 would be less negative for European assets and the euro. UK: Who Will Replace Boris Johnson? Last week UK Prime Minister Boris Johnson fell from power and now the Conservative Party is engaging in a leadership competition to replace him. We gave up on Johnson after he survived his no-confidence vote and yet it became clear that he could not recover in popular opinion. The inflation outburst destroyed his premiership and wiped away whatever support he had gained from executing Brexit. In fact it reinforced the faction that believed Brexit was the wrong decision. Going forward the UK will be consumed with domestic political turmoil as the cost of stagflation mounts, and geopolitical turmoil as Scotland attempts to hold a second independence referendum, possibly by October 2023. Global investors should focus primarily on Scotland’s attempt to secede, since the breakup of the United Kingdom would be a momentous historical event and a huge negative shock for pound sterling. While only 44.7% of Scots voted for independence in 2014, now they have witnessed Brexit, Covid-19, and stagflation, producing tailwinds for the Scots nationalist vote (Chart 7). Chart 7Forget Bojo's Exit, Watch Scotland Questions From The Road Questions From The Road There are still major limitations on Scotland exiting, since its national capabilities are limited, it would need to join the European Union, and Spain and possibly others will threaten to veto its membership in the European Union for fear of feeding their own secessionist movements. But any new referendum – including one done without the approval of Westminster – should be taken very seriously by investors. Bottom Line: Johnson’s removal will only marginally improve the Tories’ ability to manage the rebellion brewing in the north. A snap election that brings the Labour Party back into power would have a greater chance of keeping Scotland in the union, although it is not clear that such a snap election will happen in time to affect any Scottish decision. The UK faces economic and political turmoil between now and any referendum and investors should steer clear of the pound. (Though we still favor GBP over eastern European currencies). Britain will remain aggressive toward Russia but its ability to affect the Russian dynamic will fall, leaving the US and EU to decide the fate of Russian relations. Japan: What Is The Significance Of Shinzo Abe’s Assassination? Former Japanese Prime Minister Shinzo Abe was assassinated by a lone fanatic with a handmade gun. The significance of the incident is that Abe will become a martyr for a certain vision of Japan – his vision of Japan, which is that Japan can become a “normal country” that moves beyond the shackles of the guilt of its imperial aggression in World War II. A normal country is one that is economically stable and militarily capable of defending itself – not a pacifist country mired in debt-deflation. Abe stood for domestic reflation and a proactive foreign policy, along with the normalization of the Japanese Self-Defense Forces (JSDF). True, economic policy can become less dovish if necessary to deal with inflation. Some changes at the Bank of Japan may usher in a less dovish shift in monetary policy in particular. But monetary policy cannot become outright hawkish like it was before Abe. And Abe’s fiscal policy was never as loose as it was made out to be, given that he executed several hikes to the consumption tax. Japan’s structural demographic decline and large debt burden will continue to weigh on economic activity whenever real rates and the yen rise. The government will be forced to reflate using monetary and fiscal policy whenever deflation threatens to return. Debt monetization will remain an option for future Japanese governments, even if it is restrained during times of high inflation. Chart 8Shinzo Abe's Legacy Questions From The Road Questions From The Road ​​​​​​​ This is not only because Japanese households will become depressed if deflation is left unchecked but also because economic growth must be maintained in order to sustain the nation’s new and growing national defense budgets. Japan’s growing need for self defense stems from China’s strategic rise, Russia’s aggression, and North Korea’s nuclearization, plus uncertainty about the future of American foreign policy. These trends will not change anytime soon. Indeed the Liberal Democratic Party’s popularity has increased under Abe’s successor, Prime Minister Fumio Kishida, who will largely sustain Abe’s vision. The Diet still has a supermajority in favor of constitutional revision so as to enshrine the self-defense forces (Chart 8). And the de facto policy of rearmament continues even without formal revision. Bottom Line: Any Japanese leader who attempts to promote a hawkish BoJ, and a dovish JSDF, will fail sooner rather than later. The revolving door of prime ministers will accelerate. As Japan’s longest-serving prime minister, Shinzo Abe opened up the reliable pathway, which is that of a dovish BoJ and a hawkish foreign policy. This is important for the world, as well as Japan, because a more hawkish Japan will increase China’s fears of strategic containment. The frozen conflicts in Asia will continue to thaw, perpetuating the secular rise in geopolitical risk. We remain long JPY-KRW, since the BoJ may adjust in the short term and Chinese stimulus is still compromised, but that trade is on downgrade watch. Investment Takeaways Russia’s energy cutoff is aimed at pushing Europe into recession so as to force policy changes or government changes in Europe that will improve Russia’s position at the negotiating table over Ukraine, NATO, and other strategic disputes. Hence Russia is unlikely to increase the natural gas flow until it believes it has achieved its strategic aims and multiple veto players in the EU will prevent the EU from ever implementing a full-blown natural gas embargo. Chinese stimulus cannot be fully effective until it relaxes Covid-19 restrictions, likely beginning in December or next year when Xi Jinping uses his renewed political capital to try to stabilize the economy. However, China’s government powers alone are insufficient to prevent the debt-deflationary tendency of the property bust. The Middle East faces rising geopolitical tensions that will take markets by surprise with additional energy supply constraints. The implication is continued oil volatility given that global growth is faltering. Once global demand stabilizes, the Middle East’s turmoil will add to existing oil supply constraints to create new price pressures. The odds are not very high of the Federal Reserve achieving a “soft landing” in the context of a global energy shock and a stagflationary Europe and China.   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 "Batting Average": Geopolitical Strategy Trades () Section II: Special (EDIT this Header) Section III: Geopolitical Calendar