Euro Area

Executive Summary Our recommended model bond portfolio outperformed its custom benchmark index by +24bps in Q2/2022, improving the year-to-date outperformance to a solid +72bps. The Q2 outperformance came entirely from the credit side of the portfolio (+35bps), led by underweights to US investment grade corporates (+28bps) and EM hard currency debt (+24bps). The rates side of the portfolio was down slightly (-11bps), with gains from underweights in US and UK inflation-linked bonds (a combined +24bps) helping offset the hit from overweights to German and French government bonds (a combined -30bps). Looking ahead, we continue to see more defensive positioning in growth-sensitive credit sectors like US investment grade corporate bonds and EM hard currency debt, rather than duration management, as providing the better opportunity to generate alpha in bond portfolios over the latter half of 2022. GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Bottom Line: In our model bond portfolio, we are maintaining an overall neutral duration stance and a moderate underweight of spread product versus developed market sovereign bonds. We are, however, reducing the recommended tilts in inflation-linked bonds by upgrading US TIPS to neutral and downgrading Canadian linkers to neutral. Feature Dear Client, We are about to take a mid-summer publishing break, as this humble bond strategist moves his family into a new home in a new city. Next week, you will be receiving a report written by BCA Research’s Chief US Bond Strategist, Ryan Swift. The following week, there will be no Global Fixed Income Strategy report published. Our next report will be published on July 26, 2022. Regards, Rob Robis Bond investors are running out of places to hide to avoid losses in 2022. The total return on the Bloomberg Global Aggregate index (hedged into USD) in the second quarter of this year was -4%, nearly matching the -6% loss seen in Q1. No sector, from government bonds to corporate debt to emerging market credit, could avoid the damage caused by hawkish central bankers belated responding to the worst bout of global inflation since the 1970s. Related Report  Global Fixed Income StrategyGFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Global inflation rates will soon peak, led by slowing growth of goods prices and commodity prices. However, inflation will remain well above central bank targets across the bulk of the developed world, supported by more domestic sources like services prices, housing costs and wages. This will limit the ability for important central banks like the Fed and ECB to quickly pivot in a more dovish direction to support weakening growth – and bail out foundering bond markets. With that backdrop in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio for the second quarter of 2022. We also present our recommended positioning for the portfolio for the next six months, as well as portfolio return expectations for our base case and alternative investment scenarios. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q2/2022 Model Bond Portfolio Performance: All About Credit Chart 1Q2/2022 Performance: Gains From Defensive Credit Positioning Q2/2022 Performance: Gains From Defensive Credit Positioning Q2/2022 Performance: Gains From Defensive Credit Positioning The total return for the GFIS model portfolio (hedged into US dollars) in the second quarter was -4.3%, outperforming the custom benchmark index by +24bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -11bps of underperformance versus our custom benchmark index while the latter outperformed by +35bps. In our previous quarterly portfolio performance review in April, we noted that the greater opportunities to generate outperformance for fixed income investors would come from more defensive allocations to spread product, rather than big directional moves in government bond yields. That forecast largely panned out, as global credit markets moved to price in the growing risk of a deep economic downturn. Declining nominal government bond yields provided some modest relief at the end of June, with markets modestly pricing out some of the rate hikes discounted over the next year amid deepening global recession fears. While we maintained a neutral stance on overall portfolio duration during the quarter, we did benefit from the fact that the decline in global bond yields in late June was concentrated more in lower inflation expectations than falling real yields. Thus, our underweight positioning in inflation-linked bonds, focused on the US and UK, helped add a combined +25bps of outperformance versus the benchmark (Table 1). Table 1GFIS Model Bond Portfolio Q2/2022 Overall Return Attribution GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense The bar charts showing the total and relative returns for each individual government bond market and spread product sector in our model portfolio are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q2/2022 Government Bond Performance Attribution GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 3GFIS Model Bond Portfolio Q2/2022 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Biggest Outperformers: Underweight US investment grade Industrials (+19bps) Underweight UK index-linked Gilts (+15bps) Underweight US TIPS (+9bps) Underweight US investment grade Financials (+7bps) Underweight US MBS (+6bps) Underweight US Treasuries with maturities beyond ten years (+6bps) Biggest Underperformers: Overweight euro area investment grade corporates (-19bps) Overweight German government bonds with maturities beyond ten years (-14bps) Overweight French government bonds with maturities beyond ten years (-8bps) Overweight UK Gilts with maturities beyond ten years (-6bps) Overweight US CMBS (-4bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q2/2022. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q2 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q2/2022 GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. That pattern largely held true in Q2/2022, especially at the tail ends of the chart. During a quarter where all the major asset classes in our portfolio lost money on a hedged and duration-matched basis, we outperformed by selectively underweighting the worst performers within the credit side of the benchmark portfolio universe. Notably, we were underweight EM USD-denominated Sovereigns (-1099bps), EM USD-denominated corporates (-816bps) and US investment grade corporates (-686bps) on the extreme right side of the chart. Some of our key overweight positions did relatively well, led by overweights in US CMBS (-148bps), Australian government bonds (-288bps) and euro area investment grade corporates (-378bps), all of which were on the left side of Chart 4. One of our key recommendations throughout the first half of 2022 - overweighting German government bonds (-517bps) and French government bonds (-657bps) versus underweighting US Treasuries (-283bps) - performed poorly in Q2. This was due to investors rapidly pricing in a far more aggressive series of ECB rate hikes than we expected, resulting in some convergence of US-European bond yield differentials. Importantly, core European bond yields have pulled back substantially over the last month, and by much more than US yields have declined. Most notably, the 2-year German yield, which began Q2 at minus-7bps and hit a peak of 1.2% on June 14, has now fallen all the way back to 0.4% as this report went to press. The 2-year US-Germany yield differential has already widened by 35bps in the first week of July, suggesting that our overweight core Europe/underweight US allocation is already contributing positively to the model bond portfolio returns for Q3. Bottom Line: Our model bond portfolio outperformed its benchmark index in the second quarter of the year by +24bps – a positive result coming largely from underweight positions in US corporate bonds, EM spread product and inflation-linked bonds in the US and UK. Future Drivers Of Model Bond Portfolio Returns Just as in Q2/2022, the performance of the model bond portfolio in Q3/2022 will be driven more by relative allocations between countries and spread product sectors, rather than big directional moves in bond yields or credit spreads. Overall Duration Exposure Chart 5A More Stable Backdrop For Global Bond Yields A More Stable Backdrop For Global Bond Yields A More Stable Backdrop For Global Bond Yields In terms of portfolio duration, we still see a stronger case for global bond yields to be more rangebound than trending, especially in the US. There has already been a major downward adjustment to global bond yields via lower inflation expectations and reduced rate hike expectations. A GDP-weighted average of major developed market 10-year inflation breakevens has already fallen from an April 2022 peak of 281bps to 216bps (Chart 5). That aggregate breakeven is now back to the levels that began 2022, before the Russian invasion of Ukraine that triggered a surge in global energy prices. We anticipate that additional declines in global inflation expectations – and the associated reductions in central bank rate hike expectations – will be harder to achieve over the latter half of 2022. “Stickier” inflation from services, housing costs and wages will remain strong enough to keep overall inflation rates above central bank targets, even as decelerating goods and commodity price inflation act to slow headline inflation rates. Our Global Duration Indicator, which is comprised of growth indicators like the ZEW expectations index for the US and Europe as well as our own global leading economic indicator, has fallen substantially and is signaling a decline in global bond yield momentum once realized inflation rates peak (Chart 6). Chart 6Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum ​​​​​​ Chart 7Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral We see that as signaling more of a sideways action in bond yields over the next six months, rather than a big downward move, especially in the US. Thus, we are keeping the duration of the model bond portfolio close to that of the benchmark index (Chart 7). Government Bond Country Allocation We are sticking with our view that, for countries with active central banks (i.e. everyone but Japan), favoring markets where interest rate expectations are above plausible estimates of neutral policy rates should lead to outperformance from country allocation. In Chart 8, we show 10-year bond yields and 2-years-forward 1-month Overnight Index Swap (OIS) rates for the US, euro area, UK, Canada and Australia. The shaded regions in the chart represent estimates of the range of neutral policy rates. In the case of the US, rate expectations and Treasury yields are now below the upper level of the range of neutral fed funds rates estimates, between 2-3%, taken from the latest set of FOMC economic projections. Hence, we are sticking with an underweight stance on US Treasuries with yields offering less protection against the Fed following through on its current guidance and lifting the funds rate into restrictive territory above 3%. In the other countries, rate expectations are above the range of neutral rate estimates, which suggests that bond yields have a bit more protection against hawkish central bank actions. That leads us to stay overweight core Europe, the UK and Australia in the government bond portion of the model bond portfolio. We are only keeping Canada at neutral, however, as we suspect that the Bank of Canada is more willing than other central banks to follow the Fed’s lead on taking rates to a restrictive level to help bring down elevated Canadian inflation. For other countries, we are staying neutral on Italian government bond exposure, for now, and underweight Japan (Chart 9). Chart 8Favor Countries Where Markets Expect Above-Neutral Rates Favor Countries Where Markets Expect Above-Neutral Rates Favor Countries Where Markets Expect Above-Neutral Rates ​​​​​​ Chart 9Underweight JGBs, Stay Neutral Italy (For Now) Underweight JGBs, Stay Neutral Italy (For Now) Underweight JGBs, Stay Neutral Italy (For Now) ​​​​​​ For Italy, we await news from the July 21 ECB meeting on the details of a proposal to help support Italian bond markets in the event of additional yield increases or spread widening versus Germany. It is clear from the history of the past decade that Italian bond returns suffer when the ECB is either hiking rates or slowing the growth of its balance sheet (top panel). In other words, it is difficult to recommend overweighting Italian bonds without the support of easy ECB monetary policy. Chart 10Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations For Japan, our recommendation is strictly related to our view on the move in overall global bond yields. The Bank of Japan is bucking the worldwide trend to tighten monetary policy because core Japanese inflation remains weak. This makes Japanese government bonds (JGBs) a good place for bond investors to “hide out” in when global bond yields are rising. Given our view that global bond yield momentum will slow – in line with the signal from our Global Duration Indicator – we do not see a strong cyclical case for overweighting low-yielding JGBs. On inflation-linked bonds, we are maintaining a cautious overall stance, with commodity prices decelerating, realized inflation momentum set to soon peak and central banks signaling more tightening ahead (Chart 10). This week, we are closing out our lone overweight recommendation on inflation-linked bonds in Canada, where we downgrading to neutral (3 out of 5, see the model bond portfolio table on page 24).2 At the same time, we are neutralizing our underweight stance on US TIPS, moving the allocation to neutral. We still see shorter-term TIPS breakevens as having downside from here, but longer-maturity breakevens have already made enough of a downward adjustment, in our view. Global Spread Product Turning to credit markets, we are maintaining our moderately cautious view on the overall allocation to credit versus government bonds. Slowing global growth momentum and tightening global monetary policy is not an environment where credit spreads can narrow, especially for growth-sensitive credit like corporate bonds and high-yield (Chart 11). Having said that – the spread widening seen in US and European corporate bond markets has introduced a better valuation cushion into spreads. Our preferred measure of spread product valuation – the historical percentile ranking of the 12-month breakeven spread – shows that investment grade spreads in the euro area are now in the top quartile (85%) of its history on a risk-adjusted basis (Chart 12). US investment grade spreads are now up into the second quartile (64%), which is a big improvement from the start of 2022 but not as much as seen in Europe. Chart 11Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit ​​​​​ Chart 12Corporate Spread Valuations Have Improved In The US & Europe Corporate Spread Valuations Have Improved In The US & Europe Corporate Spread Valuations Have Improved In The US & Europe ​​​​​ European credit spreads likely need to be wide as a risk premium against the numerous risks the region is facing right now – slowing growth, an increasingly hawkish ECB, soaring energy prices and the lingering uncertainties stemming from the Ukraine war. However, a lot of bad news is now discounted in European spreads and, as a result, we are maintaining our overweight stance on European investment grade corporates, especially versus US investment grade where we remain underweight. High-yield spreads on both sides of the Atlantic look more attractive on a 12-month breakeven spread basis, but also on a default-adjusted spread basis (Chart 13). Assuming a moderate increase in the high-yield default rates in the US and Europe - consistent with a sharp slowing of economic growth but no deep recession - the current level of high-yield spreads net of expected default losses over the next year is above long-run averages. It is too soon to move to an overweight stance on high-yield, with the Fed and ECB set to tighten more amid ongoing growth uncertainty, but given the improved valuation cushion we see a neutral allocation to junk in both the US and Europe as appropriate in our model portfolio. Chart 13Junk Spreads Offer Value If Recession Can Be Avoided Junk Spreads Offer Value If Recession Can Be Avoided Junk Spreads Offer Value If Recession Can Be Avoided Finally, we remain comfortably underweight emerging market USD-denominated sovereign and corporate debt. The backdrop is poor for emerging market bond returns, given slowing global growth, softening commodity prices, a tightening Fed and a strengthening US dollar (Chart 14). Chart 14Staying Cautious On EM Debt Exposure Staying Cautious On EM Debt Exposure Staying Cautious On EM Debt Exposure ​​​​​​ Summing It All Up The full list of our recommended portfolio allocations can be seen in Table 2. The portfolio enters the second half of 2022 with the following high-level characteristics: Table 2GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 15Overall Portfolio Allocation: Underweight Spread Product Vs Governments GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense the overall duration exposure remains at-benchmark (i.e. neutral) the portfolio has an underweight allocation to overall spread products versus government bonds, equal to four percentage points of the portfolio (Chart 15) the tracking error of the portfolio, or its expected volatility in excess of that of the benchmark, is 77bps – below our self-imposed 100bps tracking error limit (Chart 16) the portfolio now has a yield below that of the custom benchmark index, equal to -31bps on a currency-unhedged basis but a more modest “carry gap” of -10bps on a USD-hedged basis given the gains from hedging into USD (Chart 17). Chart 16Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate ​​​​​​ Chart 17Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark ​​​​​​ Bottom Line: Looking ahead, our model bond portfolio performance will continue to be driven by the same factors in Q3/2022 as in the previous quarter: the relative performance of US bonds versus European equivalents for both government debt and corporate bonds, and the path for emerging market credit spreads. Portfolio Scenario Analysis For The Next Six Months After making the modest changes to our inflation-linked bond allocations in the US and Canada, which can be seen in the tables on pages 23-24, we now turn to our regularly quarterly scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 3A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 3B). Table 3AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Table 3BEstimated Government Bond Yield Betas To US Treasuries GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. In the current environment, our scenarios center around the pace of global growth. Base Case (Slow Global Growth) Global growth momentum slows substantially, with firms cutting back on hiring and investing activity due to slowing corporate profit growth. An outright recession is avoided because softening energy prices help ease the drag on real spending power for consumers. China introduces more monetary and fiscal stimulus measures to boost growth. Global inflation peaks and eases on the back of slowing growth of goods prices and commodity prices, but the floor on inflation in the US and other developed markets is higher than central bank inflation targets due to sticky domestic price pressures. The Fed continues to hike at every policy meeting in H2/2022. There is a very mild bear flattening of the US Treasury curve, but with longer-term yields remain broadly unchanged over the full six month scenario period with the Fed not hiking by more than currently discounted. The Brent oil price retreats by -10%, the US dollar modestly appreciates by 2%, the VIX stays close to current levels at 28 and the fed funds rate reaches 3.25% by year-end. Resilient Growth Scenario Consumer spending surprises to the upside in the US and even Europe, as softer momentum of energy prices eases the relentless downward pressure on real incomes. Labor demand remains sold across the developed world, particularly with firms reluctant to do mass layoffs because of a perceived scarcity of quality labor. China enacts more policy stimulus with growth likely to fall below 2022 government targets. The Fed is forced to be more aggressive on rate hikes, given resilient US growth and inflation staying well above the Fed’s 2% target. The US Treasury curve bear-flattens into outright inversion, but with Treasury yields rising across the curve. The Brent oil price rises +20%, the VIX index climbs to 30, the US dollar appreciates by +3% thanks to a more aggressive Fed that lifts the funds rate to 3.75% by year-end. Recession Scenario A toxic combination of contracting corporate profits and negative real income growth drags the major developed economies into outright recession. Global inflation rates slow rapidly from current elevated levels, fueled by a rapid decline in commodity prices, but remain above central bank targets making it hard for the Fed and other major central banks to pivot dovishly to support growth. Chinese policymakers belatedly act to ease monetary and fiscal policy, but not by enough to offset the slow response from developed market policymakers. The Treasury curve moderately bull-steepens, although the absolute decline in nominal Treasury yields is relatively modest as the Fed will not pivot quickly to signaling policy easing with inflation still likely to remain above 2%. The Brent oil price falls -20%, the VIX index soars to 35, the US dollar depreciates by -3% (as lower US rates win out over slowing global growth) and the Fed pushes the funds rate to 2.75% before pausing after September. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 4A. The US Treasury yield assumptions are shown in Table 4B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 18 and Chart 19, respectively. Table 4AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Table 4BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense Chart 18Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis ​​​​​ Chart 19US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis ​​​​​​ Given our neutral overall duration stance, the return scenarios will be driven by mostly by the credit side of the portfolio. In the recession scenario where Treasury yields decline, there is a modest projected outperformance from the rates side of the portfolio coming through the underweight to low-beta JGBs. In all scenarios, financial market volatility is expected to stay at, or above, current levels as central banks will be unable to ease policy, even in the event of an actual recession, because of lingering high inflation. Thus, the return on the credit side of the model portfolio will be the main driver of performance, delivering a range of excess return outcomes between +47bps and +60bps. Bottom Line: The model bond portfolio should benefit in H2/2022 from the ongoing cautious stance on global spread product, focused on underweights to US investment grade corporates and EM hard currency debt.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2     We are also closing out our Canadian breakeven widening trade in our Tactical Overlay portfolio. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense GFIS Model Bond Portfolio Q2/2022 Review & Outlook: Winning By Playing Defense

Executive Summary China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator A new equilibrium between NATO, which now includes Sweden and Finland, and Russia needs to be reestablished before geopolitical risks in Europe subside. Russia aims to inflict a recession on the EU which will revive dormant geopolitical risks embedded in each country. Investors should ignore the apparent drop in China’s geopolitical risk as it could rise further until Xi Jinping consolidates power at the Party Congress this fall. Stay on the sideline on Brazilian, South African, Australian, and Canadian equities despite the commodity bull market, at least until China’s growth stabilizes. Korean risk will rise, albeit by less than Taiwanese risk. The US political cycle ensures that Biden may take further actions against adversaries in Europe, Middle East, and East Asia, putting a floor under global geopolitical risk. Tactical Recommendation Inception Date Return LONG GLOBAL AEROSPACE & DEFENSE / BROAD MARKET EQUITIES 2020-11-27 9.3% Bottom Line: Geopolitical risk will rise in the near term. Stay long gold and global defensive stocks. Feature This month we update our GeoRisk Indicators and make observations about the status of political risk for each territory, and where risks are underrated or overrated by global financial markets. Russia GeoRisk Indicator Our “Original” quantitative measure of Russian political risk – the Russian “geopolitical risk premium” shown in the dotted red line below – has fallen to new lows (Chart 1). One must keep in mind that this geopolitical premium is operating under the assumption of a “free market” but the Russian market in the past few months had been anything but free. The Russian government and central bank had been manipulating the ruble and preventing capital outflows. Hence, Russian assets and any indicator derived from it does not reflect its true risk premium, merely the resolve of its government in the geopolitical struggle. Chart 1Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator While the Russia Risk Premium accurately detected the build-up in tensions before the invasion of Ukraine this year, today it gives the misleading impression that Russian geopolitical risk is low. In reality the risk level remains high due to the lack of strategic stability between Russia and the West, particularly the United States, and particularly over the question of NATO enlargement. Our “Old” Russia GeoRisk Indicator remains elevated but has slightly fallen back. This measure failed to detect the rise in risk ahead of this year’s invasion of Ukraine. We predicted the war based on non-market variables, including qualitative analysis. As a result of the failure of our indicator, we devised a “New” Russia GeoRisk Indicator after this year’s invasion, shown as the green line below. This measure provides the most accurate reading. It is pushing the upper limits, which we truncated at 4, as it did during the invasion of Georgia in 2008 and initial invasion of Ukraine in 2014. Related Report  Geopolitical StrategyThird Quarter Geopolitical Outlook: Thunder And Lightning Has Russian geopolitical risk peaked for Europe and the rest of the world? Not until a new strategic equilibrium is established between the US and Russia. That will require a ceasefire in Ukraine and a US-Russia understanding about the role of Finland and Sweden within NATO. However, Hungary is signaling that the EU should impose no further sanctions on Russia. Russia’s cutoff of natural gas exports to Europe will create economic hardship that will start driving change in European governments or policies. A full ban on Russian natural gas may not be implemented in the coming years due to lack of EU unanimity. Still, the EU cannot lift sanctions on Russia because that would enable economic recovery and hence military rehabilitation, which could enable new aggression. Also, Russia will not relinquish the territories it has taken from Ukraine even if President Putin exits the scene. No Russian leader will have the political capital to do that given the sacrifices that Russia has made. Bottom Line: Russia’s management of the ruble is distorting some of our risk indicators. Russia remains un-investable for western investors. Substantial sanction relief will not come until late in the decade, if at all. UK GeoRisk Indicator British political risk is rising, and it may surpass the peaks of the Brexit referendum period in 2016 now that Scotland is pursuing another independence referendum (Chart 2). Chart 2United Kingdom: GeoRisk Indicator United Kingdom: GeoRisk Indicator United Kingdom: GeoRisk Indicator New elections are not due until January 25, 2025 and the ruling Conservative Party has every reason to avoid an election over the whole period so that inflation can come down and the economy can recover. But an early election is possible between now and 2025. Prime Minister Boris Johnson has become a liability to his party but he is still a more compelling leader than the alternatives. If Johnson is replaced, then the change of leadership will only temporarily boost the Tories’ public approval. It will ultimately compound the party’s difficulties by dividing the party without resolving the Scottish question.  Regardless, the Tories face stiff headwinds in the coming referendum debate and election, having been in power since 2010 and having suffered a series of major shocks (Brexit, the pandemic, inflation). Bottom Line: The US dollar is not yet peaking against pound sterling, As from a global geopolitical perspective it can go further. Investors should stay cautious about the pound in the short term. But they should prefer the pound to eastern European currencies exposed to Russian instability. Germany GeoRisk Indicator German political risk spiked around the time of the 2021 election and has since subsided, including over the course of the Ukraine war (Chart 3). However, risk will rise again now that Germany has declared that it is under “economic attack” from Russia, which is cutting natural gas in retaliation to Germany’s oil embargo. Chart 3Germany: GeoRisk Indicator Germany: GeoRisk Indicator Germany: GeoRisk Indicator This spike in strategic tensions should not be underrated. Germany is entering a new paradigm in which Russian aggression has caused a break with the past policy of Ostpolitik, or economic engagement. Germany will have to devote huge new resources to energy security and national defense and will have to guard against Russia for the foreseeable future. Domestic political risk will also rise as the economy weakens and industrial activity is rationed. Germany does not face a general election until October 26, 2025. Early elections are rare but cannot be ruled out over the next few years. The ruling coalition does not have a solid foundation. It only has a 57% majority in the Bundestag and consists of an ideological mix of parties (a “traffic light” coalition of Social Democrats, Greens, and Free Democrats). Still, Germany’s confrontation with Russia will keep the coalition in power for now. Bottom Line: From a geopolitical point of view, there is not yet a basis for the dollar to peak and roll over against the euro. That is not likely until there is a ceasefire in Ukraine and/or a new NATO-Russia understanding. France GeoRisk Indicator French political risks are lingering at fairly high levels in the wake of the general election and will only partially normalize given the likelihood of European recession and continued tensions around Russia (Chart 4). Chart 4France: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator President Emmanuel Macron was re-elected, as expected, but his Renaissance party (previously En Marche) lost its majority and Macron will struggle to win over 39 deputies to gain a majority of 289 seats in the Assembly. He will, however, be able to draw from an overall right-wing ideological majority – especially the Republicans – when it comes to legislative compromises. The election produced some surprises. The right-wing, anti-establishment National Rally of Marine Le Pen, which usually performs poorly in legislative elections, won 89 seats. The left-wing alliance (NUPES) underperformed opinion polls and has not formed a unified bloc within the Assembly. Still, the left will be a powerful force as it will command 151 seats (the sum of the left-wing anti-establishment leader Jean-Luc Mélenchon’s La France Insoumise party and the Communists, Socialists, and Greens). Macron’s key reform – raising the average retirement age from 62 to 65 – will require an ad hoc majority in the Assembly. The Republicans, with 74 seats, can provide the necessary votes. But some members have already refused to side with Macron on this issue. Macron will most likely get support from the populist National Rally on immigration, including measures to make it harder to be naturalized or obtain long-term residence permits, and measures making it easier to expel migrants whose asylum applications have been refused. France will remain hawkish on immigration, but Macron will be able to rein in the populists. On energy and the environment, Macron may be able to cooperate with the Left on climate measures, but ultimately any cooperation will be constrained by the fact that Mélenchon opposes nuclear power. The Republicans and the National Rally will support Macron’s bid to shore up France’s nuclear energy sector. Popular opinion will hold up for France’s energy security in the face of Russian weaponization of natural gas. Macron and Mélenchon will clash on domestic security. Police violence has emerged as a major source of controversy since the Yellow Vest protests. Macron and the Right will protect the police establishment while the Left will favor reforms, notably the concept of “proximity police,” which would entail police officers patrolling in a small area to create stronger, more personal links between the police and the population; officers being under the control of the mayor and prefect; and ultimately most officers not carrying lethal weapons, and the ban of physically dangerous arrest techniques. Grievances over the police as well as racial inequality will likely erupt into significant social unrest in the coming years. As a second-term president without a single-party majority, Macron will increasingly focus on foreign policy. He will aim to become the premier European leader on the world stage. He will seek to revive France’s historic role as a leading diplomatic power and arbiter of Europe. He will strengthen France’s position in the EU and NATO, keep selling arms to the Middle East, and maintain a French military presence in the Sahel. Macron will favor Ukraine’s membership in the EU but also a ceasefire with Russia. He will face a difficult decision on whether to join Israeli and American military action against Iran should the latter reach nuclear breakout capacity and pursue weaponization. Bottom Line: The outperformance of French equities is stretched relative to EMU counterparts. But France will not underperform until the EU’s natural gas crisis begins to subside and a new equilibrium is established with Russia. Italy GeoRisk Indicator Italy is perhaps the weakest link in Europe both economically and strategically (Chart 5). Elections are due by June 2023 but could come earlier as the ruling coalition is showing strains. A change of government would likely compromise the EU’s attempt to maintain a unified front against Russia over the war in Ukraine. Chart 5Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Before the war Italy received 40% of its natural gas from Russia and maintained pragmatic relations with the Putin administration. Now Russia is reducing flows to Italy by 50%, forcing the country into an energy crisis at a time when expected GDP growth had already been downgraded to 2.3% this year and 1.7% in 2023. Meanwhile Italian sovereign bond spreads over German bunds have risen by 64 basis points YTD as a result of the global inflation. The national unity coalition under Prime Minister Mario Draghi came together for two purposes. First, to distribute the EU’s pandemic recovery funds across the country, which amounted to 191.5 billion euros in grants and cheap loans for Italy, 27% of the EU’s total recovery fund and 12% of Italy’s GDP. Second, to elect an establishment politician in the Italian presidency to constrain future populist governments (i.e. re-electing President Sergio Mattarella). Now about 13% of the recovery funds have been distributed in 2021, the economy is slowing, Russia is cutting off energy, and elections are looming. The coalition is no longer stable. Coalition members will jockey for better positioning and pursue their separate interests. The anti-establishment Five Star Movement has already split, with leader Luigi di Maio walking out. Five Star’s popular support has fallen to 12%. The most popular party in the country is now the right-wing, anti-establishment Brothers of Italy, who receive 23% support in polling. Matteo Salvini, leader of the League, another right-wing populist party, has seen its public support fall to 15% and will be looking for opportunities. On the whole, far-right parties command 38% of popular voting intentions, while far-left parties command 17% and centrist parties command 39%. Italy’s elections will favor anti-incumbent parties, especially if the country falls into recession. These parties will be more pragmatic toward Russia and less inclined to expand the EU’s stringent sanctions regime. Implementing a ban on Russian natural gas by 2027 will become more difficult if Italy switches. Italy will be more inclined to push for a ceasefire. A substantial move toward ceasefire will improve investor sentiment, although, again, a durable new strategic equilibrium cannot be established until the US and Russia come to an understanding regarding Finland, Sweden, and NATO enlargement. Bottom Line: Investors should steer clear of Italian government debt and equities until after the next election. Spain GeoRisk Indicator Infighting and power struggles within the People’s Party (PP) have provided temporary relief for the ruling Socialist Worker’s Party (PSOE) and Spanish Prime Minister Pedro Sanchez. However, with Alberto Nunez Feijoo elected as the new leader of PP on April 2, the People’s Party quickly recovered from its setback. It not only retook the first place in the general election polling, but also scored a landslide victory in the Andalusia regional election. Andalusia is the most populous autonomous community in Spain, contributing 17% of the seats in the lower house. The Andalusian regional election was a test run for the parties before next year’s general election. Historically, Andalusia was PSOE’s biggest stronghold, but it was ousted by the center-right People’s Party-Citizens coalition in 2018. Since then, the People’s party has consolidated their presence and popularity in Andalusia. The snap election in June, weeks after Feijoo was elected as the new national party leader, expanded PP’s seats in the regional parliament. It now has an absolute majority in the regional parliament while the Socialists suffered its worst defeat. With the sweeping victory in Andalusia, the People’s Party is well positioned for next year’s general election. In addition, the ruling Socialist Worker’s Party continues to suffer from the stagflationary economic condition. In May, Spain recorded the second highest inflation figure in more than 30 years, slightly below its March number. Furthermore, the recent deadly Melilla incident which resulted in dozens of migrants’ death, also caused some minor setbacks within Sanchez’s ruling coalition. His far-left coalition partner joined the opposition parties in condemning Sanchez for being complacent toward the Moroccan police. The pressure is on the Socialists now, and political risk will rise in the coming months, till after the election (Chart 6). Chart 6Spain: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator Bottom Line: Domestic political risk will remain elevated in this polarized country, as elections are due by December 2023 and could come sooner. Populism may return if Europe suffers a recession. Russia aims to inflict a recession on the EU which is negative for cyclical markets like Spain, but Spain benefits from Europe’s turn to liquefied natural gas and has little to fear from Russia. Investors should favor Spanish stocks relative to Italian stocks. Turkey GeoRisk Indicator Turkey faces extreme political and economic instability between now and the general election due by June 2023 (Chart 7). Chart 7Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Almost any country would see the incumbent ruling party thrown from power under Turkey’s conditions. The ruling Justice and Development Party has been in charge since 2002, the country’s economy has suffered over that period, and today inflation is running at 73% while unemployment stands at 11%. However, President Recep Tayyip Erdoğan is doing everything he can with his recently expanded presidential powers to stay in office. He is making amends with the Gulf Arab states and seeking their economic support. He is also warming relations with Israel, as Turkey seeks to diversify away from Russian gas and Israel/Egypt are potential suppliers. He is doubling down on military distractions across the Middle East and North Africa. And he waged a high-stakes negotiation with the West over Finnish and Swedish accession to NATO. Russian aggression poses a threat to Turkish national interests. Turkey ultimately agreed to Finnish and Swedish membership after a show of Erdoğan strong hands in negotiating with the West over their membership, to show his domestic audience that he is one of the big boys ahead of the election. A risk to this view is that Erdoğan stages military operations against Greek-controlled Cyprus. This would initiate a crisis within NATO and put Finnish and Swedish accession on hold for a longer period. Bottom Line: Investors should not attempt to bottom-feed Turkish lira or stocks and should sell any rallies ahead of the election. A decisive election that removes Erdoğan from power is the best case for Turkish assets, while a decisive Erdoğan victory is second best. Worse scenarios include indecisive outcomes, a contested or stolen election, a constitutional breakdown, or a military coup. China GeoRisk Indicator China’s geopolitical risk is falling and relative equity performance is picking up now that the government has begun easing monetary, fiscal, and regulatory policy to try to secure the economic recovery (Chart 8). Chart 8China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator Easing regulation on Big Tech has spurred a rebound in heavily sold Chinese tech shares, while the Politburo will likely signal a pro-growth turn in policy at its July economic meeting. The worst news of the country’s draconian “Covid Zero” policy is largely priced, while positive news regarding domestic vaccines, vaccine imports, or anti-viral drugs could surprise the market. However, none of these policy signals are reliable until Xi Jinping consolidates power at the twentieth national party congress sometime between September and November (likely October). Chinese stimulus could fail to pick up as much as the market hopes and policy signals could reverse or could continue to contradict themselves. After the party congress, we expect the Xi administration to intensify its efforts to stabilize the economy. The economic work conference in December will release a pro-growth communique. The March legislative session will provide more government support for the economy if needed. However, short-term measures to stabilize growth should not be mistaken for a major reacceleration, as China will continue to struggle with debt-deflation as households and corporations deleverage and the economic model transitions to a post-manufacturing model. Bottom Line: A Santa Claus rally in the fourth quarter, and/or a 2023 rally, is likely, both for offshore and onshore equities. But long-term investors, especially westerners, should steer clear of Chinese assets. China’s reversion to autocracy and confrontation with the United States will ultimately result in tariffs and sanctions and geopolitical crises and will keep risk premiums high. Taiwan GeoRisk Indicator Taiwan’s geopolitical risk has spiked as expected due to confrontation with China. Tensions will remain high through the Taiwanese midterm election on November 26, the Chinese party congress, and the US midterm (Chart 9). But China is not ready to stage a full-scale military conflict over Taiwan yet – that risk will grow over in the later 2020s and 2030s, depending on whether the US and China provide each other with adequate security assurances. Chart 9Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Still, Taiwan is the epicenter of global geopolitical risk. China insists that it will be unified with the mainland eventually, by force if not persuasion. China’s potential growth is weakening so it is losing the ability to absorb Taiwan through economic attraction over time. Meanwhile the Taiwanese people do not want to be absorbed – they have developed their own identity and prefer the status quo (or independence) over unification. Taiwan does not have a mutual defense treaty with the United States and yet the US and Taiwan are trying to strengthen their economic and military bonds. This situation is both threatening to China and yet not threatening enough to force China to forswear the military option. At some point China could believe it must assert control over Taiwan before the US increases its military commitment. Meanwhile China, the US, Japan, South Korea, and Europe are all adopting policies to promote semiconductor manufacturing at home, and/or outside Taiwan, so that their industries are not over-reliant on Taiwan. That means Taiwan will lose its comparative advantage over time. Bottom Line: Structurally remain underweight Taiwanese equities. Korea GeoRisk Indicator The newly elected President Yoon reaffirmed the strong military tie between Korea and the US, when he hosted President Biden in Seoul in May. Both Presidents expressed interests in expanding cooperation into new areas like semiconductors, economic security, and stability in the Indo-Pacific region. The new administration is also finding ways to improve relations with Japan, which soured in the past few years over the issue of forced labor during the Japanese occupation of Korea. A way forward is yet to be found, but a new public-private council will be launched on July 4 to seek potential solutions before the supreme court ruling in August which could further damage bilateral ties. President Yoon’s various statements throughout the NATO summit in Madrid on wanting a better relationship with Japan and to resolve historical issues showed this administration’s willingness towards a warming of the relations between the two countries, a departure from the previous administration. On the sideline of the NATO summit, Yoon also engaged with European leaders, dealing Korean defense products, semiconductors, and nuclear technologies, with a receptive European audience eager to bolster their defense, secure supply chain, and diversify energy source. North Korea ramped up its missile tests this year as it tends to do during periods of political transitions in South Korea. It is also rumored to be preparing for another nuclear test. Provocations will continue as the North is responding to the hawkish orientation of the Yoon administration. Investors should expect a rise in geopolitical risk in the peninsular, but on a relative basis, due to its strong alliance network, Korean risk will be lower compared to Taiwan (Chart 10). Korea will benefit from a rebound in China in the near term, but in the long-term, it is a secure source of semiconductors and high-tech exports, as Greater China will be mired in long-term geopolitical instability. Chart 10Korea: GeoRisk Indicator Korea: GeoRisk Indicator Korea: GeoRisk Indicator Bottom Line: Overweight South Korean equities relative to emerging markets as a play on Chinese stimulus. Overweight Korea versus Taiwan. Australia GeoRisk Indicator Australia’s Labor Party ultimately obtained a one-seat majority in the House of Representatives following the general election in May (77 seats where 76 are needed). It does not have a majority in the Senate, where it falls 13 seats short of the 39 it needs. It will rely on the Green Party (12 seats) and a few stragglers to piece together ad hoc coalitions to pass legislation. Hence Prime Minister Anthony Albanese’s domestic agenda will be heavily constrained. Pragmatic policies to boost the economy are likely but major tax hikes and energy sector overhauls are unlikely (Chart 11). Chart 11Australia: GeoRisk Indicator Australia: GeoRisk Indicator Australia: GeoRisk Indicator Fortunately for Albanese, his government is taking power in the wake of the pandemic, inflation, and Chinese slowdown, so that there is a prospect for the macroeconomic context to improve over his term in office. This could give him a tailwind. But for now he is limited. Like President Biden in the US, Albanese can attempt to reduce tensions with China after Xi Jinping consolidates power. But also like Biden, he will not have a basis for broad and durable re-engagement, since China’s regional ambitions threaten Australian national security over the long run. Global commodity supply constraints give Australia leverage over China. Bottom Line: Stay neutral on Australian currency and equities until global and Chinese growth stabilize. Brazil GeoRisk Indicator It would take a bolt of lightning to prevent former President Lula da Silva from winning re-election in Brazil’s October 2 first round election. Lula is more in line with the median voter than sitting President Jair Bolsonaro. Bolsonaro’s term has been marred with external shocks, following on a decade of recession and malaise. Polls may tighten ahead of the election but Lula is heavily favored. While ideologically to the left, Lula is a known quantity to global investors (Chart 12). However, Bolsonaro may attempt to cling to power, straining the constitutional system and various institutions. A military coup is unlikely but incidents of insubordination cannot be ruled out. Once Lula is inaugurated, a market riot may be necessary to discipline his new administration and ensure that his policies do not stray too far into left-wing populism. Chart 12Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil’s macroeconomic context is less favorable than it was when Lula first ruled. During the 2000s he rode the wave of Chinese industrialization and a global commodity boom. Today China is slipping into a balance sheet recession and the next wave of industrialization has not yet taken off. Brazil’s public debt dynamics discourage a structural overweight on Brazil within emerging markets. At least Brazil is geopolitically secure – far separated from the conflicts marring Russia, East Europe, China, and East Asia. It also has a decade of bad news behind it that is already priced. Bottom Line: Stay neutral Brazilian assets until global and Chinese growth stabilize and the crisis-prone election season is over. South Africa GeoRisk Indicator South Africa’s economy continues to face major headwinds amid persistent structural issues that have yet to be adequately addressed and resolved by policy makers. The latest bout of severe energy supply cuts by the state-run energy producer, Eskom, serve as a reminder to investors that South Africa’s economy is still dealing with a major issue of generating an uninterrupted supply of electricity. Each day that electricity supply is cut to businesses and households, the local economy stalls. Among other macroeconomic issues such as high unemployment and rising inflation, low-income households which are too the median voter, are facing increasing hardships. The political backdrop is geared toward further increases in political risk going forward (Chart 13). Chart 13South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Fiscal reform and austerity are underway but won’t last long enough to make a material difference in government finances. The 2024 election is not that far out and the ruling political party, the ANC, will look to quell growing economic pressures to shore up voter support and reinforce its voter base. Fiscal austerity will unwind. Meanwhile, the bull market in global metal prices stands to moderate on weakening global growth, which reduces a tailwind for the rand, South African equities relative to other emerging markets, and government coffers, reducing our reasons for slight optimism on South Africa until global growth stabilizes. Bottom Line: Shift to a neutral stance on South Africa until global and Chinese growth stabilize. Canada GeoRisk Indicator Canadian political risk has spiked since the pandemic (Chart 14). Populist politics can grow over time in Canada, especially if the property sector goes bust. However, the country is geopolitically secure and benefits from proximity to the US economy. Chart 14Canada: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator Global commodity supply constraints create opportunities for Canada as governments around the world pursue fiscal programs directed at energy security, national defense, and supply chain resilience. Bottom Line: Stay neutral Canadian currency and equities. While Canada benefits from the high oil price and robust US economy, rising interest rates pose a threat to its high-debt model, while US growth faces disappointments due to Europe’s and China’s troubles.     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Yushu Ma Research Analyst yushu.ma@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com Guy Russell Senior Analyst GuyR@bcaresearch.com Alice Brocheux Research Associate alice.brocheux@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Section III: Geopolitical Calendar

In this <i>Strategy Outlook</i>, we present the major investment themes and views we see playing out for the rest of the year and beyond.

Executive Summary ECB & Inflation: Whatever It Takes? Pricey Industrials Pricey Industrials Inflation is the European Central Bank’s single focus. This single-mindedness heightens the risks to Euro Area growth, especially because wider peripheral spreads do not seem to worry the ECB yet. Italian spreads will widen further, which will contribute to weaker financials, especially in the periphery. The money market curve already prices in the path of the ECB; the upside in Bund yields is therefore capped. Cyclical assets, including stocks, are vulnerable to the confluence of weaker growth and tighter monetary policy. Industrials are fragile. Downgrade to neutral for now. German industrials will outperform Italian industrials.     Bottom Line: The ECB will do whatever it takes to slow inflation, which will further hurt an already brittle European economy. This backdrop threatens European stocks and peripheral bonds. Downgrade industrials to neutral and go long German / short Italian industrials. Feature Last week, the European Central Bank’s Governing Council sided with the hawks. The doves have capitulated. This development creates mounting risks this summer for European assets, especially when global growth is slowing. Worryingly, the ECB has given speculators the green light to widen peripheral and credit spreads in the near term. Cyclical assets remain at risk. We are downgrading industrials and financials. Hawkish Chart 1Higher Inflation Forecast = Hawkish ECB Don’t Fight The ECB Don’t Fight The ECB The ECB’s forward guidance proved more hawkish than anticipated by the market, as highlighted by the 16bps increase in the implied rate of the December 22 Euribor contract following the press conference. The ECB also refused to sooth investors’ nerves regarding fragmentation risk in the periphery. A large part of the ECB move was already anticipated. The ECB will lift its three interest rate benchmarks by 25bps at its July meeting. It also increased its headline inflation forecasts to 6.8% from 5.1% in 2022, to 3.5% from 2.1% in 2023, and most importantly, it raised its long-term HICP forecast to 2.1% from 1.9% (Chart 1). The ECB now expects medium-term inflation to be above its 2% target. The true hawkish shock came in response to the higher-than-target medium-term inflation forecast. By September, if the 2024 inflation forecast does not fall back below 2%, then a 50bps hike that month will be inevitable. The whole interest rate curve moved up in response to that guidance. The most concerning part of the statement was the lack of clarity about the fragmentation fighting tool. The ECB specified that it will re-invest the principal of its holdings under the APP and PEPP until 2024, at least. However, the program to prevent stress in peripheral bond markets was not revealed and was presented as an eventuality to be deployed only if market conditions deteriorate further. Investors may therefore assume that the ECB is still comfortable with Italian bond yields above 3.5% and high-yield spreads of 464bps (Chart 2). Ultimately, the ECB’s single-minded focus is inflation, even though it is mostly an imported shock. The ECB cares little for the effect of its actions on growth. It will therefore remain very hawkish until it sees enough evidence that the medium-term inflation outlook will fall back below 2%. Before the ECB can tabulate a decline in the inflation outlook, the following developments must take place: The economy must slow in order to extinguish domestic inflationary pressures. The labor market, to which President Christine Lagarde referred often in the press conference, must cool. Specifically, the very elevated number of vacancies must decline relative to the low number of unemployed persons (Chart 3). A weaker economy will cause this shift. Energy inflation must recede to choke secondary effects on prices. Chart 2Tight But Not Tight Enough For The Hawks Tight But Not Tight Enough For The Hawks Tight But Not Tight Enough For The Hawks Chart 3The Labor Market Must Cool The Labor Market Must Cool The Labor Market Must Cool The good news is that the decline in commodity inflation is already underway. Last week, we argued that if energy prices remain at their current levels, (or if Brent experiences the additional upside anticipated by BCA’s Commodity and Energy strategists), then energy inflation will decelerate significantly. Already, the inflationary impact of commodities is dissipating (Chart 4). European growth has not slowed enough to hurt the labor market, but it will decline further. Real disposable income is falling, and the manufacturing sector is decelerating globally. Moreover, European terms of trade are tumbling, which hurts the Euro Area’s growth outlook, especially compared to the US where the terms of trade are improving (Chart 5). Chart 4Dwindling Commodity Impulse Dwindling Commodity Impulse Dwindling Commodity Impulse Chart 5Europe's Terms-of-Trade Problem Europe's Terms-of-Trade Problem Europe's Terms-of-Trade Problem The European periphery, especially Italy, faces particularly acute problems. We argued two months ago that Italian yields of 4.5% would not cause a sovereign debt crisis if economic activity were strong. As we go to press, Italian yields stand at 3.7%, or higher than those in Canada and Australia. Yet, Italy suffers from poor demographic and productivity trends; its neutral rate of interest is lower than that of both Canada and Australia. Moreover, Canada and Australia today enjoy robust terms-of-trades. Meanwhile, Italy is among the European economies most hurt by surging energy prices. Consequently, a vicious circle of higher yields and lower growth is likely to develop. Chart 6The BTP-EUR/USD Valse The BTP-EUR/USD Valse The BTP-EUR/USD Valse Italy’s economic problems imply that investors will continue to push Italian spreads higher until the ECB provides a clear signal of support for BTPs, which could happen after spreads reach 300bps over German 10-year yields. Italy’s weakness is a major handicap for the monetary union as well. The higher Italian spreads widen, the weaker the euro will be (Chart 6). However, a depreciating euro is inflationary, which invites higher rates for the Euro Area and tighter financial conditions. The great paradox is that, if the ECB were more pro-active about the fragmentation risk, it could fight inflation with less danger to the economy and thus, the Eurozone could achieve higher rates down the road. Weaknesses in global and European growth, risks of higher Italian and peripheral spreads, and an ECB solely focused on inflation will harm European risk assets further. Specifically, credit spreads will widen more and cyclical stocks will remain vulnerable. Within cyclical stocks, Italian and Spanish financials are the most exposed to the fragmentation threat in Euro Area bond markets. We have held an overweight recommendation on industrial equities. We maintain a positive long-term bias toward this sector, but a neutral stance is warranted in the near term. Finally, Bund yields have limited upside from here. The curve already anticipates 146bps of tightening by the end of this year and 241bps by June 2023. The ECB is unlikely to increase rates more than is anticipated, which caps German yields. Instead, the ECB is likely to undershoot the €STR curve pricing if it increases interest rates once a quarter after the September 50bps hike. Bottom Line: Don’t fight the ECB. The Governing Council is single-mindedly focused on fighting inflation. Growth must slow significantly to cool the labor market and allow the ECB to cut back its medium-term inflation forecast to 2%. Therefore, European assets will remain under stress in the coming months as global growth deteriorates. Italian and peripheral spreads are particularly vulnerable, which will also weigh on financials because of Spanish and Italian banks. Chart 7Pricey Industrials Pricey Industrials Pricey Industrials Neutral On Industrials Industrials stocks have outperformed other cyclicals and have moved in line with the Euro Area broad market. However, relative forward EPS have not tracked prices; industrials are now expensive and vulnerable to shocks (Chart 7). The increase in the relative valuations of industrials reflects their robust pricing power. Normally, the economic weakness pinpointed by the Global Growth Expectations component from the ZEW Survey results in falling valuations for industrials, since it is a growth-sensitive sector (Chart 8). However, this year, the earnings multiples of industrials relative to the broad market have followed inflation higher (Chart 8, bottom panel). This paradox reflects the strong pricing power of the industrial sector, which allows these firms to pass on a greater share of their increasing input-costs and protect their profits (Chart 9). Chart 8Ignore Growth, Loving Inflation Ignore Growth, Loving Inflation Ignore Growth, Loving Inflation Chart 9Pricing Power Is The Savior Pricing Power Is The Savior Pricing Power Is The Savior The ability of industrials to weather a growth slowdown is diminishing: European inflation will peak in response to the decline in commodity inflation (see Chart 4, on page 4). Already, the waning inflation of metal prices is consistent with lower relative multiples for industrials (Chart 10) Last week, we argued that global PMIs have greater downside because of the tightening in global financial conditions. Weaker global manufacturing activity hurts the relative performance of industrials. Capex in advanced economies is likely to drop in the coming quarters. US capex intentions are rapidly slowing, which has hurt European industrials. European capex intentions have so far withstood this headwind; however, the outlook is worsening. European final domestic demand is weakening, and European inventories are growing rapidly (Chart 11). Capex is a form of derived demand; the challenges to European growth translate into downside for investment. Chart 10The Commodity Paradox The Commodity Paradox The Commodity Paradox Chart 11The Inventory Buildup Threat The Inventory Buildup Threat The Inventory Buildup Threat The Euro Area Composite Leading Economic Indicator is already contracting and will fall further. The ECB’s focus on inflation and its neglect of financial conditions will drag the LEI lower. Moreover, central banks across the world are also tightening policy, which will filter through to weaken global and Europe LEIs. A declining LEI hurts industrials (Chart 12). The relative performance of European industrials is positively correlated to that of US industrials (Chart 13). BCA’s Global Asset Allocation has recently downgraded industrials to neutral from overweight. Chart 12Weaker LEIs Spell Trouble Weaker LEIs Spell Trouble Weaker LEIs Spell Trouble Chart 13Where the US Goes, So Does Europe Where the US Goes, So Does Europe Where the US Goes, So Does Europe Despite these risks, we are reluctant to go underweight industrials because financials are more exposed to the ECB’s neglect of financial conditions. Moreover, the headwinds against the industrial complex are temporary, especially when it comes to China. Chinese authorities have greatly stimulated their economy, and Beijing is softening its stance on the tech sector. A loosening of the regulatory crackdown would revive animal spirits and credit demand. Moreover, the aerospace and defense industry, which is a large component of the industrial sector, still offers attractive prospects. Instead, we express our concerns for industrials via the following pair trade: Long German industrials / short Italian Industrials. This is a relative value trade. German industrials have underperformed their relative earnings, while Italian ones have moved significantly ahead of their earning power. Thus, German industrials are very cheap and oversold relative to their southern neighbors (Chart 14). Interestingly, this derating took place despite the widening in Italian government bond spreads, which normally explains this price ratio well (Chart 15). This disconnect presents a trading opportunity. Chart 14A Relative Value Trade A Relative Value Trade A Relative Value Trade Chart 15An Unusual Disconnect An Unusual Disconnect An Unusual Disconnect Chart 16German Industrials And Growth Expectations German Industrials And Growth Expectations German Industrials And Growth Expectations While global growth has yet to bottom, the performance of German relative to Italian industrials fluctuates along growth expectations (Chart 16). Germany seats earlier in the global supply chain than Italy. The Global Growth Expectations component from the ZEW Survey is extremely depressed and approaching levels where a rebound would be imminent. German industrials suffer more from the energy crunch than Italian ones. They will therefore benefit more from the decline in energy inflation. Historically, German industrials outperform Italian ones when commodity prices rise, but this relationship normally reflects the strong global demand that often lifts natural resource prices (Chart 17). Today, commodities are skyrocketing because of supply constraints, not strong demand. Therefore, they are hurting rather than mimicking growth. This inversion in the relationship between the performance of German compared to Italian industrials and natural resources prices is particularly evident when looking at European energy prices (Chart 18). Consequently, once the constraint from commodities and global supply chains ebb, German industrials will outshine their Italian counterparts. Chart 17Commodities: From Friends To Foes Commodities: From Friends To Foes Commodities: From Friends To Foes Chart 18Energy: From Friend To Foe Energy: From Friend To Foe Energy: From Friend To Foe German industrials suffer when stagflation fears expand (Chart 19). The ECB’s focus on inflation will assuage the apprehension of entrenched inflation in Europe. The recent improvement in our European Stagflation Sentiment Proxy will continue to the advantage of German industrials. Additionally, a firm ECB stance will push European inflation expectations lower, which will help German industrials compared to their Italian competitors (Chart 20). Chart 19Stagflation Hurts Germany More Stagflation Hurts Germany More Stagflation Hurts Germany More Chart 20The ECB"s Inflation Focus Helps German Industrials The ECB"s Inflation Focus Helps German Industrials The ECB"s Inflation Focus Helps German Industrials German PMIs are improving relative to Italian ones. The trend in Germany’s industrial activity compared to that of Italy dictates the evolution of industrials relative performance between the two countries (Chart 21). The tightening in financial conditions in Italy due to both wider BTP spreads and their negative impact on the Italian banking sector will accentuate the outperformance of Germany’s manufacturing sector. German industrials are more sensitive than Italian ones to the gyrations of the Chinese economy. BCA’s Geopolitical Strategy service anticipates an improvement in China’s economy for the next 18 months or so in response to previous stimuli and the easing regulatory burden. The close link between the performance of German industrials relative to Italian ones and the yuan’s exchange rate indicates that a stabilizing Chinese economy will undo most of the valuation premium of Italian industrials (Chart 22). An improvement in China’s economy will also lift its marginal propensity to consume (which the spread between the growth rate of M1 and M2 approximates). A rebound in Chinese marginal propensity to consume will boost comparative rates of returns in favor of Germany (Chart 22, bottom panel). Chart 21Relative Growth Matters Relative Growth Matters Relative Growth Matters Chart 22The China Factor The China Factor The China Factor Bottom Line: Industrials have become expensive relative to the rest of the market, but they are still too exposed to the global economy’s downside risk. This tug-of-war warrants a downgrade to neutral for now. Going long German industrials / short Italian industrials is an attractive pair trade within the sector. German industrials are cheap and they will benefit from both the ECB’s policy tightening and the upcoming decline in European inflation. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades

Executive Summary Competing Forces On Global Bond Yields Competing Forces On Global Bond Yields Competing Forces On Global Bond Yields Bond yields in the developed world have ticked higher recently, due to a renewed increase in oil prices and the spillover effect from more hawkish policy expectations out of Europe. The competing forces of slowing global growth momentum and geopolitical uncertainty on one side, and high inflation with tightening monetary policies on the other, will keep global government bond yields rangebound over the next several months. UK investment grade corporate bonds now offer an intriguing combination of higher yields, attractive spread valuations and strong financial health. By maturity, shorter-maturity corporates offer the best value. At the industry level, spreads look most attractive for Financials. A hawkish Bank of England, both through rate hikes and upcoming outright sales of corporate debt the central bank has purchased via quantitative easing, remains a major headwind to UK corporate bond returns. Sectors most at risk to central bank sales are Water, Consumer Cyclicals and Consumer Non-Cyclicals. Bottom Line: Stay neutral on overall duration exposure in global bond portfolios. Maintain a neutral stance on UK corporates, favoring shorter-maturity bonds and Financial names, but look to upgrade once UK inflation peaks and the Bank of England pauses on tightening. Trendless, Friendless Bond Markets Chart 1Recovering From The Ukraine War Shock... Recovering From The Ukraine War Shock... Recovering From The Ukraine War Shock... Although it may not feel like it given the ferocity of some daily price swings, many important financial markets have not moved all that much, cumulatively, since the first major shock of 2022 – the start of the Russian invasion of Ukraine on February 24. For example, the S&P 500 is only down around -2% from the pre-invasion level, while the VIX index of equity option volatility is at 24, seven points below the closing level on February 23 (Chart 1). The Bloomberg US investment grade corporate bond index spread is only 12bps above its pre-invasion level, down 20bps from the peak seen in mid-May. More recently, even US bond yields have shown signs of stabilization. The 10-year US Treasury yield has traded in a 2.70-3.15% range since the start of April, while the MOVE index of US Treasury option volatility has fallen by one-quarter since its most recent peak in early May. Not all markets, however, have seen this kind of relative stability. Global oil prices are trading close to post-invasion highs, as are government bond yields in Germany and the UK. High-yield credit spreads in the US and Europe are both still around 50bps above where they were pre-invasion. The DXY US dollar index is 6% above the pre-invasion level, led by the USD/JPY currency pair that has appreciated to levels last seen in 2002. Given the mix of slowing global growth momentum and ongoing geopolitical uncertainty, but with persistent high inflation and tightening global monetary policy, it is unsurprising that financial markets are having a difficult time formulating a consistent message. This is especially true for global government bond yields. Chart 2Competing Forces On Global Bond Yields Competing Forces On Global Bond Yields Competing Forces On Global Bond Yields Even as market-based inflation expectations have eased a bit in recent weeks, bond yields across the developed world have been unable to decline because markets continue to discount more rate hikes (Chart 2). Yet with such a significant amount of monetary tightening now priced in across all countries, global bond yields are more likely to stay rangebound over the next 3-6 months than begin a new trend. Chart 3DM Bond Yields Discounting Tight Monetary Policy DM Bond Yields Discounting Tight Monetary Policy DM Bond Yields Discounting Tight Monetary Policy 10-year government bond yields and 2-year-ahead interest rate expectations in overnight index swap (OIS) curves are trading in lockstep in the US, Europe, UK, Canada and Australia (Chart 3). This correlation indicates that longer-term bond yields have become a pure play on future policy rate expectations, rather than a reflection of rising inflation expectations as was the case in 2021. However, both yields and rate expectations are now trading close to, or even well above, plausible estimates of neutral nominal policy rates in all regions - including estimates provided by central bankers themselves. For example, in Australia, where the RBA just delivered a 50bp rate hike this week, markets are pricing in a peak Cash Rate between 3.5-4%, even with RBA Governor Philip Lowe stating that the neutral rate is likely in the 2-3% range – a view that we agree with. The situation is even more extreme in the euro area, with the euro area OIS curve now pricing in a peak policy rate between 1.5-2%, with most of that increase coming over the next 12 months. While we expect the ECB to fully exit the negative (deposit) rate era by September, rate hikes beyond that are far less likely given slowing euro area growth momentum and still-moderate euro area inflation beyond the spillover effects from energy costs. Only in the US are markets potentially underestimating the potential peak in the fed funds rate for this tightening cycle. Estimates of the longer-run (neutral) funds rate from the latest set of FOMC projections back in March ranged from 2.0-3.0%. Thus, the current level of 10-year bond yields, and 2-year-ahead rates discounted in the US OIS curve, are only at the top end of that range. It is possible that the Fed will have to raise rates to restrictive levels (i.e. above 3%) given the size of the current US inflation overshoot. More importantly, the US neutral rate is likely higher than the Fed thinks it is, possibly as high as 4% according to BCA Research’s Chief Global Strategist, Peter Berezin. We continue to see the US as the one major government bond market where there is a risk that markets are underestimating the neutral policy rate. For that reason, we remain underweight US Treasuries in the BCA Research Global Fixed Income Strategy model bond portfolio. Don’t Dismiss The QT Effect One other factor that has likely kept global bond yields elevated, even as global growth has softened, has been the shift away from central bank asset purchases towards quantitative tightening (QT). As policymakers have moved to slow, or even stop, the buying of government bonds, the term premium component of longer-term bond yields has risen. The moves have been quite large. Using our own in-house estimates, the term premium on 10-year government bond yields have jumped by about 100bps on average in the US, UK, Canada, Australia and Europe since the lows seen during the 2020 COVID global recession (Chart 4). The jump in term premiums is occurring at the same time as markets have moved to price in more rate hikes and a higher path for real interest rates (bottom panel). Chart 4Yields Repricing As QE Moves To QT Yields Repricing As QE Moves To QT Yields Repricing As QE Moves To QT ​​​​​​ Chart 5Stay Neutral Global Duration Exposure Stay Neutral Global Duration Exposure Stay Neutral Global Duration Exposure ​​​​​​ That combined effect of the upward repricing of term premiums – especially as more price-sensitive private investors replace the demand for bonds from price-insensitive central banks - but with less upward movement in already elevated interest rate expectations will keep longer-term bond yields in trading ranges during the “Global QT Phase” over at least the next six months and likely longer. That message is reinforced by our Global Duration Indicator, which is heralding a peak in global bond yield momentum over the latter half of 2022 (Chart 5). Bottom Line: Stay neutral on overall duration exposure in global bond portfolios, with yields in the major developed markets likely to stay rangebound over the next few months. Assessing The Value In UK Investment Grade Corporates Chart 6A Big Jump In UK Investment Grade Corporate Yields A Big Jump In UK Investment Grade Corporate Yields A Big Jump In UK Investment Grade Corporate Yields Global credit markets have had a rough time in 2022, and UK corporate debt is no exception. The Bloomberg UK Corporate index of investment grade corporate debt has delivered a year-to-date total return of -11%, as the index yield-to-maturity rose 174bps to 4% - the highest level since 2014 (Chart 6). Relative to UK Gilts, the results have also been grim as corporate credit spreads have widened, with the Bloomberg UK corporate index realizing an excess return of -3% since the start of the year. We have maintained a neutral stance on UK corporate bond exposure in our global model bond portfolio during the selloff. This was the result of a relative value opinion, as we have concentrated our more defensive view on global investment grade corporate debt with an underweight to US corporates. However, after the significant repricing of UK investment grade credit, it is now a good time to reassess our opinion on the asset class. Spread Valuation From a pure spread valuation perspective, UK investment grade now looks more attractive. Our preferred valuation metric – 12-month breakeven spreads - shows that the UK investment grade corporate index spread, on a duration-adjusted basis, is now in the 75th percentile of its history over the past 25 years (Chart 7). Chart 7UK Corporate Spreads Now Offer Some Value UK Corporate Spreads Now Offer Some Value UK Corporate Spreads Now Offer Some Value We find 12-month breakevens to a useful spread valuation measure, as they show how much spreads would need to widen to make the expected one-year-ahead return on a credit product equal to that of a duration-matched position in government bonds. In other words, breakevens measure the spread “cushion” against excess return losses from spread widening. What makes the current attractive reading on UK investment grade spread valuation so interesting is that the absolute level of spreads is still relatively low. The Bloomberg UK investment grade corporate index spread is currently 170bps, but during previous episodes where the 12-month breakeven as near the top quartile ranking – as is currently the case – the index spread ranged from 200-350bps. The reason for that relates to the index duration which, at 7.3 years, is down 1.5 years from the 2020 peak and at the lowest level since 2011. Some of that lower duration is related to the convexity effect from higher corporate bond yields. But there has also been a reduction in the average maturity of the UK investment grade corporate bond universe, with the index average maturity now at 10.4 years, down a full year lower over the past 12 months and the lowest average maturity since 1999. UK companies appear to have shortened up the maturity profile of their bond issuance, which helped reduce the riskiness (duration) of corporate bond returns to rising yields. Thus, the message from the 12-month breakevens is correct – UK investment grade corporate bond yields are attractive from a historical perspective, on a duration-adjusted basis. Chart 8UK Credit Curves Are Relatively Flat UK Credit Curves Are Relatively Flat UK Credit Curves Are Relatively Flat When looking within the UK investment grade universe, the messages on valuation are a bit more mixed. The UK credit curve is not particularly steep, when looking at the spread differences by credit rating within the benchmark index universe (Chart 8). There is a similar message when looking at 12-month breakevens broken down by credit rating, where there is little difference between the percentile rankings (Chart 9). However, the 12-month breakeven percentile rankings broken down by maturity buckets show that shorter-maturity bonds have noticeably higher percentile rankings than longer-maturity UK corporates (top panel). From a cross-country perspective, UK corporate breakeven percentile rankings are much higher than equivalent rankings for US corporates, but are lower than those of the euro area. Chart 9Shorter-Maturity UK Spreads Are More Attractive Mixed Messages & Range-Bound Bond Yields Mixed Messages & Range-Bound Bond Yields Corporate Financial Health Our top-down UK Corporate Health Monitor (CHM) - which uses data on non-financial corporate sector revenues, expenses and balance sheets taken from GDP accounts – has shown a very strong improvement in UK corporate financial health over the past few years (Chart 10). The biggest improvements are in the categories related to debt service, with interest coverage at the highest level since 2002 and debt coverage is at the highest level since 1999. Chart 10UK Corporates Can Withstand Higher Borrowing Rates UK Corporates Can Withstand Higher Borrowing Rates UK Corporates Can Withstand Higher Borrowing Rates ​​​​​​ Chart 11Stay Neutral UK Corporates Until The BoE Is Done Stay Neutral UK Corporates Until The BoE Is Done Stay Neutral UK Corporates Until The BoE Is Done ​​​​​ The message from our top-down UK CHM is similar to the conclusions from an October 2021 BoE report that analyzed the UK corporate sector from a financial stability perspective. In that report, the BoE used a bottom-up sample of 500 UK companies and concluded that corporate borrowing rates could rise as much as 400bps before the share of companies with a “distressed” interest coverage ratio below 2.5 would rise to the past historical peak. Within our top-down UK CHM, relatively wide corporate profit margins are also contributing to the strong reading on UK corporate health. Like the interest/debt coverage ratios, those margins provide some cushion to profits in the current environment of high inflation and elevated input costs for businesses. The all-in message from our UK CHM is that financial health is a fundamental tailwind for UK corporate bond performance. Monetary Policy Attractive spread valuations and strong financial health metrics would normally justify an overweight stance on any corporate bond market. However, the monetary policy cycle is also an important factor that drives corporate bond performance. Currently, with the BoE not only hiking rates but also moving to QT on asset purchases, monetary policy is a severe headwind to UK corporate bond returns. Related Report  Global Fixed Income StrategyIt’s Time To Flip The Script - Upgrade UK Gilts The annual growth rate of the BoE’s balance sheet has proven to be a reliable leading indicator of UK corporate bond annual excess returns. With the growth in the balance sheet set to turn negative in the latter half of 2022 (Chart 11), it will prove difficult for UK credit spreads to narrow in a way that will boost excess returns. The BoE’s aggressive (by its standards) rate hiking cycle, in response to UK inflation that is nearing 10% alongside a very tight labor market, remains a threat to UK economic growth that is already losing some momentum. As we discussed in a recent Special Report, the UK neutral interest rate is likely no more than 1.5-2%. If the BoE were to follow current market pricing and push Bank Rate toward 2.5%, this would be a restrictive policy stance that would likely result in a sharp growth slowdown if not a full-blown recession. Importantly, our UK Central Bank Monitor is showing signs of peaking (bottom panel), due to signs of slower economic growth and tightening financial conditions. A peak in UK inflation would help reduce the Monitor even further, and would likely correspond to a pause on BoE rate hikes – a necessary condition before we would upgrade our recommended stance on UK investment grade corporates to overweight. Some Final Thoughts On Industry Sector Valuation Our UK investment grade corporate sector valuation model is a cross-sectional analysis of individual industry/sector corporate credit spreads, after controlling for differences in duration, convexity and credit rating. The model is currently signaling that there are few compelling valuation stories with positive “risk-adjusted” spreads (Chart 12). Only Financials look cheap, while Consumer Cyclicals, Consumer Non-Cyclicals and Capital Goods are all trading at expensive risk-adjusted spreads. Chart 12Not Many Compelling Values Within UK Corporates By Industry Mixed Messages & Range-Bound Bond Yields Mixed Messages & Range-Bound Bond Yields An additional risk to UK corporate bond performance relates to the BoE’s decision to unwind its corporate bond portfolio. The BoE has announced that there will be outright sales from the corporate holdings accumulated over the past couple of years, with a goal of having the stock of debt fully unwound by the end of 2023. This is important for much of the UK investment grade corporate bond universe, where the BoE holds between 8-10%, on average, of outstanding debt (Chart 13).1 Chart 13The BoE Has Become An Important Corporate Bondholder Mixed Messages & Range-Bound Bond Yields Mixed Messages & Range-Bound Bond Yields When we compare our risk-adjusted spreads versus the BoE ownership share by sector, we conclude that Consumer Cyclicals, Consumer Non-Cyclicals and Other Utilities offer the most unattractive combination of expensive spreads and high BoE concentration (Chart 14). We recommended underweight allocations to those sectors within an overall neutral allocation to UK corporates. Chart 14BoE Asset Sales Are A Major Risk For Some UK Corporate Sectors Mixed Messages & Range-Bound Bond Yields Mixed Messages & Range-Bound Bond Yields Bottom Line: Maintain a neutral stance on UK corporates, given the mix of attractive valuations but tighter monetary policy. Favoring shorter-maturity bonds and Financial names, but look to upgrade once UK inflation peaks and the Bank of England pauses on tightening.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1      In Chart 13, we use the market capitalization of each sector from the Bloomberg UK corporate bond index in the numerator of all ratios shown, as a proxy for outstanding debt. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Mixed Messages & Range-Bound Bond Yields Mixed Messages & Range-Bound Bond Yields The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) Mixed Messages & Range-Bound Bond Yields Mixed Messages & Range-Bound Bond Yields

Executive Summary Crude Oil Prices Will Remain High Crude Oil Prices Will Remain High Crude Oil Prices Will Remain High The EU embargo on Russian seaborne oil imports will tighten global crude oil and refined-product markets further.  Pipeline imports are due to phase out by year-end.  This will translate to a 90% decrease in Russian crude and product exports to the EU, representing ~ 3mm b/d of lost sales. Russian crude oil production will fall to 7-8mm b/d by year-end 2023, unless the state pre-emptively cuts output before that.  This would push crude oil above $140/bbl.  We expect Russia to reduce natural gas exports to the EU in the wake of the oil embargo. Refined-product markets will remain tight, given refining capacity losses, tight crude oil markets and still-strong gasoline and diesel demand. OPEC 2.0 is expected to maintain its policy to nominally increase oil supply by 432k b/d at its meeting this week.  Actual oil output returned to the market by the coalition is ~ 1.5mm – 1.7mm b/d below nominal levels. Bottom Line: Oil markets will continue to tighten in the wake of the EU’s embargo on Russian imports this week.  Refined-product markets will remain well bid, with prices of gasoline, jet and diesel fuel close to or above record levels.  We remain long oil producers and refiners via the XOP and CRAK ETFs, along with the S&P GSCI and COMT ETF, to retain exposure to higher commodity prices and backwardation. Feature Global refined-product markets are tight and getting tighter. Related Report  Commodity & Energy StrategyOil, Natgas Prices Set To Surge As the Northern Hemisphere driving season gets underway, gasoline and diesel prices in the US are at record levels – up 56.55% and 70.17% respectively yoy. So are jet-fuel prices, which are up 107.97% yoy in the US. Prices are similarly robust ex-US and trading at or close to record levels. During the COVID-19 pandemic, the US permanently lost ~ 5% of total refining capacity. Currently, three of the largest refineries in the US are working on replenishing less than half of that loss by end-2023, which will take total US refining capacity to under 18.5mm b/d. US gasoline stocks are low for this time of the year. Markets expect higher demand this driving season, which unofficially ends in early September with the Labor Day weekend in the US. The US went into the Memorial Day Weekend – the start of the summer driving season – with record high motor gas prices (Chart 1). Gasoline stocks normally build in the off-season winter months. However, this year inventories are depleted (Chart 2) because of relatively high distillate “crack spreads” – gross refining margins – which incentivized refiners to produce more diesel, jet and marine fuels.1 This meant gasoline output was sacrificed in the process, which left markets tight going into the summer driving season.2 Chart 1High Gas Prices Bring In US Driving Season High Gas Prices Bring In US Driving Season High Gas Prices Bring In US Driving Season US distillate crack spreads are at record highs, after stocks hit a 14-year low last month (Chart 3). Reduced oil refinery capacity will constrict future supply, keeping prices elevated, which will feed into inflation. Demand destruction will be required to balance markets and bring prices lower. Chart 2Depleted Stocks Due To Low Gasoline Margins Higher Gasoline, Diesel Prices Ahead Higher Gasoline, Diesel Prices Ahead Chart 3Low Distillate Stocks Produce Record Cracks Higher Gasoline, Diesel Prices Ahead Higher Gasoline, Diesel Prices Ahead Tight Supply-Demand Fundamentals, High Prices US refined-product prices have been strengthening since 2021 due to high crude oil prices, rising demand and lower refinery capacity and utilization rates. This keeps the level of demand for refined products consistently above the level of supply, which forces refiners to pull down inventories or increase imports to cover the supply-demand gaps. Higher refined-product prices ensue as inventories fell. As a result, crack spreads were pushed higher to encourage higher output, which remains problematic because of supply-side pressure in global crude-oil markets (Chart 4). Crude oil prices account for 60% of gasoline and 49% of diesel costs, respectively.3 Last year OPEC 2.0’s production-management strategy kept the level of crude oil supply below demand, but this year additional forces are constraining output. Supply disruptions following Russia’s invasion of Ukraine, lower OPEC 2.0 production, and non-OPEC capital discipline, particularly from US shale-oil producers, have combined to constrain crude-oil production. We expect continued production restraint by core OPEC 2.0 (Saudi Arabia and the UAE); lower output from the rest of the coalition; falling Russian supply due to sanctions and an EU embargo on Russian oil imports; and continued capital discipline by shale producers. These factors will offset weaker global oil demand resulting from slower GDP growth in the EU and China. Chart 4Supply Will Barely Rise Despite High Margins Higher Gasoline, Diesel Prices Ahead Higher Gasoline, Diesel Prices Ahead Volatile supply-demand dynamics will keep crude oil prices elevated this year and next (Chart 5).4 The EU’s embargo on Russian oil, in particular, will raise oil-price volatility, and leave prices upwardly biased. Lastly, we do not expect the US and Iran to renew the Joint Comprehensive Plan of Action (JCPOA), which would allow ~ 1mm b/d of Iranian exports to return to the market. Chart 5Crude Oil Prices Will Remain High Crude Oil Prices Will Remain High Crude Oil Prices Will Remain High Tighter Product Markets Will Persist Refined-product stocks in the US and the rest of the world were low prior to Russia’s invasion of Ukraine, owing to strong demand growth and weak crude-oil supply growth last year, along with lower global refining capacity. US refinery utilization rates last year and earlier this year fell as refiners undertook heavier-than-usual maintenance, which was deferred during the pandemic (Chart 6). Refiners also closed ~ 1mm b/d in 2020 during the COVID-19 pandemic, which resulted in ~ 5% of US refining capacity being shut-in at the start of 2021.5 Global refining capacity has fallen by more than 2mm b/d since the COVID-19 pandemic.6 As midterm elections approach, the Biden administration has been urging refiners to restart idle capacity to little or no avail, and has threatened to re-introduce export restrictions on crude oil in an attempt to hold down gasoline and diesel prices. Chart 6US Refiners Were Shut-In For Maintenance Higher Gasoline, Diesel Prices Ahead Higher Gasoline, Diesel Prices Ahead Gasoline markets are going into their first summer without COVID-19 restrictions since 2020. While US data for the first 3 months of 2022 suggest Americans’ gasoline consumption was more price-inelastic than in the past (Chart 7), a series of record-breaking gasoline prices recently may have been enough to start curbing US gasoline demand (Chart 8). All the same, US consumers appear to be willing to pay up for holiday breaks and get-aways, which will keep pressure on inventories during the summer driving season. Chart 7US Gasoline Demand Price Inelastic In Q1… Higher Gasoline, Diesel Prices Ahead Higher Gasoline, Diesel Prices Ahead Chart 8…But Record Breaking Prices May Change That Higher Gasoline, Diesel Prices Ahead Higher Gasoline, Diesel Prices Ahead Jet, Diesel Remain Tight, Especially In Europe The approval of an embargo on Russian oil imports into the EU earlier this week means member states on the continent that rely heavily on Russian distillate exports will remain exposed to higher refined-product prices (Chart 9).7 This will keep European diesel prices and crack spreads elevated this year and next (Chart 10). Chart 9EU Dependent On Russia For Diesel Higher Gasoline, Diesel Prices Ahead Higher Gasoline, Diesel Prices Ahead Chart 10Europe Refining Margins Will Remain Elevated Higher Gasoline, Diesel Prices Ahead Higher Gasoline, Diesel Prices Ahead Shipping markets also will continue to feel the pressure of higher prices, particularly for marine diesel fuel. Russia’s invasion of Ukraine forced insurance rates higher, which propelled shipping-rates higher in Europe and Russia (Chart 11). The EU is now slapping sanctions on insurers. In addition, the Ukraine war forced a re-routing of ships and port congestion, which led to massive supply-chain disruptions due to closures and blockades.8 High refined-product prices partly is the result of European refineries either permanently shutting in production or switching to renewable energy production when faced with low Covid-19-induced demand in 2020. In the first half of 2021, as product demand started to rise, the parabolic increase in prices of natgas – used as a fuel by refiners – was an additional headwind to refining margins. Chart 11Cost Of Shipping Crude, Products Surges Higher Gasoline, Diesel Prices Ahead Higher Gasoline, Diesel Prices Ahead As of last December, more than 800 kb/d – or 5% of the continent’s refining capacity – was permanently taken offline during the pandemic.9 As a result, OECD Europe’s refining capacity for 2022 will be 11.4 mmb/d, ~ 0.8 mmb/d below pre-pandemic levels.10 Europe will need to look elsewhere for distillates. Attempting to substitute refined products in such tight energy markets will not be cheap. Sourcing imports from other states will tighten exporters’ domestic refined product markets and dislocate distillate supply to their traditional importers, which will tighten those states’ domestic markets as well. This could lead to something similar to what we are currently witnessing in LNG markets between Europe and Asia. The US, despite having its own tight refined products market, likely will step up as an alternate supplier to fill the Russian distillate supply void for states reliant on Russian diesel, jet and marine fuels. This can be seen in the 32-month high in Gulf Coast diesel exports from the US, which are the result of stronger imports by Europe and LatAm.11 Investment Implications The EU embargo on Russian oil imports will tighten global refined-product markets. If Russia retaliates by pre-emptively cutting crude oil production by 20-30%, prices would significantly exceed our forecast of $113/bbl this year and $122/bbl next year – reaching or surpassing $140/bbl. Refined-product markets will remain well bid, with prices of gasoline, jet and diesel fuel close to or above record levels. We remain long oil producers and refiners via the XOP and CRAK ETFs, along with the S&P GSCI and COMT ETF, to retain exposure to higher commodity prices and backwardation.   Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Commodities Round-Up Energy: Bullish We continue to expect Russia to cut off natural gas exports to the EU in retaliation for the embargo on EU oil imports from Russia agreed this week. The timing of this cut-off is uncertain, however. As our colleague Matt Gertken notes in this week’s Geopolitical Strategy, Russia and the EU both would benefit if exports were maintained as long as possible and phased down slowly. This would provide Russia with revenues to wage war in Ukraine, while allowing Europe to avoid recession as it phases out Russian gas. This is not an equilibrium, however, as it leaves both sides exposed to a sudden reversal of the tacit understanding. In equilibrium – i.e., the strategies that guarantee the EU and Russia lose the least – both states reduce their energy trade immediately. Russia needs to show strength in the face of the EU’s embargo, and Europe needs to cut the revenues fueling Russia’s war in Ukraine, which also will deter similar aggression against member states in the future. As soon as the EU weans itself off Russian natgas, Russia’s leverage disappears. If Europe does not diversify immediately, Russia can punish it severely by cutting off energy before it is prepared. (Chart 12). In the meantime, the EU is moving heaven and earth to fill its natgas storage as quickly as possible (Chart 13). According to the GIE AGSI, the percent-full level was 46.68%  as of May 30, 2022. Precious Metals: Bullish Gold prices pared losses last Wednesday after the Federal Open Market Committee’s (FOMC) minutes of the May meeting indicated the Fed will not raise rates by more than the half percentage points markets had priced in for June and July. Recent weakness in gold prices despite heightened geopolitical uncertainty can be attributed to the Fed’s tightening cycle. Rate hikes will increase real interest rates, the opportunity cost of holding non-yielding bullion and strengthen the USD, which competes directly with gold for safe-haven demand, and will also raise the price of gold in local currencies. Base Metals: Bullish Chile’s National Institute of Statistics reported the country’s Mining Production Index fell 10.6% year-over-year (y-o-y) in April, dragging the country’s overall Industrial Production Index lower by 3.6% y-o-y. The drop in mining was due to a 9.8% fall in copper production y-o-y. The contraction in mined copper output this month follows y-o-y contractions of 15%, 7% and 7.2% in January, February and March respectively this year. Chart 12 Higher Gasoline, Diesel Prices Ahead Higher Gasoline, Diesel Prices Ahead Chart 13 Higher Gasoline, Diesel Prices Ahead Higher Gasoline, Diesel Prices Ahead     Footnotes 1     The “crack spread” (or “cracks”) is an industry term for gross margins. It derives its name from the literal cracking of the bonds holding the hydrocarbon molecules of crude oil together under intense heat and pressure, and reforming them into refined products like gasoline and diesel fuel and other liquids and gases. The crack spread is the difference between the price of a refined product and crude oil in USD/bbl. 2     In this report, we focus on diesel fuel and gasoline. Low stocks, high prices and high crack spreads are a feature of jet-fuel markets as well. 3    Please see the US EIA’s May 2022 Gasoline and Fuel Update. 4    Please see Oil, Natgas Prices Set To Surge published on May 19, 2022 for our latest balances and price forecasts. 5    Please see the U.S. EIA’s 30 June, 2021 edition of This Week In Petroleum. 6    Please see White House Eyes Restarting Idle Refineries, published by ttnews.com on May 26, 2022. 7     Please see Breakingviews: Oil embargo will hurt Putin more than EU, published by reuters.com on May 31, 2022. 8    For more on this, please refer to High Food Prices Drive EM Inflation, which we published on May 12, 2022. 9    Please see Viewpoint: European refiners cautious on cusp of 2022, published by Argus Media on December 30, 2021. 10   Please see the IEA’s January 2022 Oil Market Report. 11    Please see to PADD 3 diesel exports reach 32 month high as the competition for the non-Russian molecule begins, published by Vortexa on May 4, 2022.   Investment Views and Themes Strategic Recommendations Tactical Trades Trades Closed in 2022

Executive Summary EU Embargoes Russian Oil Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) The EU imposed an embargo on 90% of Russian oil imports, which will provoke retaliation. Russia will squeeze Europe’s economy ahead of critical negotiations over the coming 6-12 months. Russian gains on the battlefield in Ukraine point to a ceasefire later, but not yet – and Russia will need to retaliate against NATO enlargement. The Middle East and North Africa face instability and oil disruptions due to US-Iran tensions and Russian interference. China’s autocratic shift is occurring amid an economic slowdown and pandemic. Social unrest and internal tensions will flare. China will export uncertainty and stagflation.  Inflation is causing disparate effects in South Asia – instability in Pakistan and Sri Lanka, and fiscal populism in India.   Asset Initiation Date Return Long Brazilian Financials / Indian Equities (Closed) Feb 10/22 22.5%  Bottom Line: Markets still face three geopolitical hurdles: Russian retaliation; Middle Eastern instability; Chinese uncertainty. Feature Global equities bounced back 6.1% from their trough on May 12 as investors cheered hints of weakening inflation and questioned the bearish consensus. BCA’s Global Investment Strategy correctly called the equity bounce. However, as BCA’s Geopolitical Strategy service, we see several sources of additional bad news. Throughout the Ukraine conflict we have highlighted two fundamental factors to ascertain regarding the ongoing macroeconomic impact: Will the war cut off the Russia-EU energy trade? Will the war broaden beyond Ukraine? Chart 1Russian-Exposed Assets Will Suffer More Russian-Exposed Assets Will Suffer More Russian-Exposed Assets Will Suffer More In this report we update our views on these two critical questions. The takeaway is that the geopolitical outlook is still flashing red. The US dollar will remain strong and currencies exposed to Russia and geopolitical risk will remain weak (Chart 1). In addition, China’s politics will continue to produce uncertainty and negative surprises this year. Taken together, investors should remain defensive for now but be ready to turn positive when the market clears the hurdles we identify. The fate of the business cycle hangs in the balance.  Energy Ties Eroding … Russia Will Retaliate Over Oil Embargo Chart 2AEU Embargoes Russian Oil Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) Europe is diversifying from Russian oil and natural gas. The European Union adopted a partial oil embargo on Russia that will cut oil imports by 90% by the end of 2022. It also removed Sberbank from the SWIFT banking communications network and slapped sanctions on companies that insure shipments of Russian crude. The sanctions will cut off all of Europe’s seaborne oil imports from Russia as well as major pipeline imports, except the Southern Druzhba pipeline. The EU made an exception for landlocked eastern European countries heavily dependent on Russian pipeline imports – namely Hungary, Slovakia, the Czech Republic, and Bulgaria (Chart 2A).  Focus on the big picture. Germany changed its national policy to reduce Russian energy dependency for the sake of national security. From Chancellors Willy Brandt to Angela Merkel, Germany pursued energy cooperation and economic engagement as a means of lowering the risk of war with Russia. Ostpolitik worked in the Cold War, so when Russia seized Crimea in 2014, Merkel built the Nord Stream 2 pipeline. But Merkel’s policy failed to persuade Russia that economic cooperation is better than military confrontation – rather it emboldened President Putin, who viewed Europe as divided and corruptible. Chart 2BRussia Squeezes EU’s Natural Gas Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) Russia’s regime is insecure and feels threatened by the US and NATO. Russia believed that if it invaded Ukraine, the Europeans would maintain energy relations for the sake of preserving overall strategic stability. Instead Germany and other European states began to view Russia as irrational and aggressive and hence a threat to their long-term security. They imposed a coal ban, now an oil ban the end of this year, and a natural gas ban by the end of 2027, all formalized under the recently announced RePowerEU program. Russia retaliated by declaring it would reduce natural gas exports to the Netherlands and probably Denmark, after having already cut off Finland, Poland, and Bulgaria (Chart 2B). As a pretext Russia points to its arbitrary March demand that states pay for gas in rubles rather than in currencies written in contracts. This ruble payment scheme is being enforced on a country-by-country basis against those Russia deems “unfriendly,” i.e. those that join NATO, adopt new sanctions, provide massive assistance to Ukraine, or are otherwise adverse. Chart 3Russia Actively Cutting Gas Flows Russia Actively Cutting Gas Flows Russia Actively Cutting Gas Flows Russia and Ukraine are already reducing natural gas exports through the Ukraine and Turkstream pipelines while the Yamal pipeline has been empty since May – and it is only a matter of time before flows begin to fall in the Nord Stream 1 pipeline to Germany (Chart 3). German government and industry are preparing to ration natural gas (to prioritize household needs) and revive 15 coal plants if necessary. Europe is attempting to rebuild stockpiles for the coming winter, when Russian willingness and capability to squeeze natural gas flows will reach a peak. The big picture is demonstrated by game theory in Diagram 1. The optimal situation for both Russia and the EU is to maintain energy exports for as long as possible, so that Russia has revenues to wage its war and Europe avoids a recession while transitioning away from Russian supplies (bottom right quadrant, each side receives four points). The problem is that this solution is not an equilibrium because either side can suffer a sudden shock if the other side betrays the tacit agreement and stops buying or selling (bottom left and top right quadrants). Diagram 1EU-Russia Standoff: What Does Game Theory Say? Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) The equilibrium – the decision sets in which both Russia and the EU are guaranteed to lose the least – is a situation in which both states reduce energy trade immediately. Europe needs to cut off the revenues that fuel the Russian war machine while Russia needs to punish and deter Europe now while it still has massive energy leverage (top left quadrant, circled). Once Europe diversifies away, Russia loses its leverage. If Europe does not diversify immediately, Russia can punish it severely by cutting off energy before it is prepared.   Russian energy weaponization is especially useful ahead of any ceasefire talks in Ukraine. Russia aims for Ukrainian military neutrality and a permanently weakened Ukrainian state. To that end it is seizing territory for the Luhansk and Donetsk People’s Republics, seizing the southern coastline and strategic buffer around Crimea, and controlling the mouth of the Dnieper river so that Ukraine is forever hobbled (Map 1). Once it achieves these aims it will want to settle a ceasefire that legitimizes its conquests. But Ukraine will wish to continue the fight. Map 1Russian Invasion Of Ukraine, 2022 Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) Russia will need leverage over Europe to convince the EU to lean on Ukraine to agree to a ceasefire. Something similar occurred in 2014-15 when Russia collaborated with Germany and France to foist the Minsk Protocols onto Ukraine. If Russia keeps energy flowing to EU, the EU not only gets a smooth energy transition away from Russia but also gets to keep assisting Ukraine’s military effort. Whereas if Russia imposes pain on the EU ahead of ceasefire talks, the EU has greater interest in settling a ceasefire. Finally, given Russia’s difficulties on the battlefield, its loss of European patronage, and potential NATO enlargement on its borders, Moscow is highly likely to open a “new front” in its conflict with the West. Josef Stalin, for example, encouraged Kim Il Sung to invade South Korea in 1950. Today Russia’s options lie in the Middle East and North Africa – the regions where Europe turns for energy alternatives. Not only Libya and Algeria – which are both inherently fertile ground for Russia to sow instability –  but also Iran and the broader Middle East, where a tenuous geopolitical balance is already eroding due to a lack of strategic understanding between the US and Iran. Russia’s capabilities are limited but it likely retains enough influence to ignite existing powder kegs in these areas.   Bottom Line: Investors still face a few hurdles from the Ukraine war. First, the EU’s expanding energy embargo and Russian retaliation. Second, instability in the Middle East and North Africa. Hence energy price pressures will remain elevated in the short term and kill more demand, thus pushing the EU and the rest of the world toward stagflation or even recession. War Contained To Ukraine So Far … But Russia To Retaliate Over NATO Enlargement At present Russia is waging a full-scale assault on eastern and southern Ukraine, where about half of Donetsk awaits a decision (Map 2). If Russia emerges victorious over Donetsk in the summer or fall then it can declare victory and start negotiating a ceasefire. This timeline assumes that its economic circumstances are sufficiently straitened to prevent a campaign to the Moldovan border.1   Map 2Russia May Declare Victory If It Conquers The Rest Of Donetsk Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) There are still ways for the Ukraine war to spill over into neighboring areas. For example, the Black Sea is effectively a Russian lake at the moment, which prevents Ukrainian grain from reaching global markets where food prices are soaring. Eventually the western maritime powers will need to attempt to restore freedom of navigation. However, Russia is imposing a blockade on Ukraine, has more at stake there than other powers, and can take greater risks. The US and its allies will continue to provide Ukraine with targeting information against Russian ships but this assistance could eventually provoke a larger naval conflict. Separately, the US has agreed to provide Ukraine with the M142 High Mobility Artillery Rocket System (HIMARS), which could lead to attacks on Russian territory that would prompt a ferocious Russian reaction. Even assuming that the Ukraine war remains contained, Russia’s strategic conflict with the US and the West will remain unresolved and Moscow will be eager to save face. Russian retaliation will occur not only on account of European energy diversification but also on account of NATO enlargement. Finland and Sweden are attempting to join NATO and as such the West is directly repudiating the Putin regime’s chief strategic demand for 22 years. Finland shares an 830 mile border with Russia, adding insult to injury. The result will be another round of larger military tensions that go beyond Ukraine and prolong this year’s geopolitical risk and uncertainty. Russia’s initial response to Finland’s and Sweden’s joint application to NATO was to dismiss the threat they pose while drawing a new red line. Rather than forbidding NATO enlargement, Russia now demands that no NATO forces be deployed to these two states. This demand, which Putin and other officials expressed, may or may not amount to a genuine Russian policy change. Russia’s initial responses should be taken with a grain of salt because Turkey is temporarily blocking Finland’s and Sweden’s applications, so Russia has no need to respond to NATO enlargement yet. But the true test will come when and if the West satisfies Turkey’s grievances and Turkey moves to admit the new members. If enlargement becomes inevitable, Russia will respond. Russia will feel that its national security is fundamentally jeopardized by Sweden overturning two centuries of neutrality and Finland reversing the policy of “Finlandization” that went so far in preventing conflict during the Cold War. Chart 4Military Balances Stacking Up Against Russia Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) Russia’s military options are limited. Russia has little ability to expand the war and fight on multiple fronts judging by the army’s recent performance in Ukraine and the Red Army’s performance in the Winter War of 1939. This point can be illustrated by taking the military balance of Russia and its most immediate adversaries, which add up to about half of Russian military strength even apart from NATO (Chart 4). Russian armed forces already demonstrated some pragmatism in April by withdrawing from Kyiv and focusing on more achievable war aims. Unless President Putin turns utterly reckless and the Russian state fails to restrain him, Russia will opt for defensive measures and strategic deterrence rather than a military offensive in the Baltics. Hence Russia’s military response will come in the form of threats rather than outright belligerence. However, these threats will probably include military and nuclear actions that will raise alarm bells across Europe and the United States. President Dmitri Medvedev has already warned of the permanent deployment of nuclear missiles in the Kaliningrad exclave.2 This statement points to only the most symbolic option of a range of options that will increase deterrence and elevate the fear of war. Otherwise Russia’s retaliation will consist of squeezing global energy supply, as discussed above, including by opening a new front in the Middle East and North Africa. Instability should be expected as a way of constraining Europe and distracting America. Higher energy prices may or may not convince the EU to negotiate better terms with Russia but they will sow divisions within and among the allies. Ultimately Russia is highly unlikely to sacrifice its credibility by failing to retaliate for the combination of energy embargo and NATO enlargement on its borders. Since its military options are becoming constrained (at least its rational ones), its economic and asymmetrical options will grow in importance. The result will be additional energy supply constraints. Bottom Line: Even assuming that the war does not spread beyond Ukraine – likely but not certain – global financial markets face at least one more period of military escalation with Russia. This will likely include significant energy cutoffs and saber-rattling – even nuclear threats – over NATO enlargement.   China’s Political Situation Has Not Normalized China continues to suffer from a historic confluence of internal and external political risk that will cause negative surprises for investors. Temporary improvements in government policy or investor sentiment – centered on a relaxation of “Zero Covid” lockdowns in major cities and a more dovish regulatory tone against the tech giants – will likely be frustrated, at least until after a more dovish government stance can be confirmed in the wake of the twentieth national party congress in October or November this year. At that event, Chinese President Xi Jinping is likely to clinch another ten years in power and complete the transformation of China’s governance from single-party rule to single-person rule. This reversion to autocracy will generate additional market-negative developments this year. It has already embedded a permanently higher risk premium in Chinese financial assets because it increases the odds of policy mistakes, international aggression, and ultimately succession crisis. The most successful Asian states chose to democratize and expand free markets and capitalism when they reached a similar point of economic development and faced the associated sociopolitical challenges. But China is choosing the opposite path for the sake of national security. Investors have seen the decay of Russia’s economy under Putin’s autocracy and would be remiss not to upgrade the odds of similarly negative outcomes in China over the long run as a result of Xi’s autocracy, despite the many differences between the two countries. China’s situation is more difficult than that of the democratic Asian states because of its reviving strategic rivalry with the United States. US Secretary of State Antony Blinken recently unveiled President Biden’s comprehensive China policy. He affirmed that the administration views China as the US’s top strategic competitor over the long run, despite the heightened confrontation with Russia.3 The Biden administration has not eased the Trump administration’s tariffs or punitive measures on China. It is unlikely to do so during a midterm election year when protectionist dynamics prevail – especially given that the Xi administration will be in the process of reestablishing autocracy, and possibly repressing social unrest, at the very moment Americans go to the polls. Re-engagement with China is also prohibited because China is strengthening its strategic bonds with Russia. President Biden has repeatedly implied that the US would defend Taiwan in any conflict with China. These statements are presented as gaffes or mistakes but they are in fact in keeping with historical US military actions threatening counter-attack during the three historic Taiwan Strait crises. The White House quickly walks back these comments to reassure China that the US does not support Taiwanese independence or intend to trigger a war with China. The result is that the US is using Biden’s gaffe-prone personality to reemphasize the hard edge (rather than the soft edge) of the US’s policy of “strategic ambiguity” on Taiwan. US policy is still ambiguous but ambiguity includes the possibility that a president might order military action to defend Taiwan. US attempts to increase deterrence and avoid a Ukraine scenario are threatening for China, which will view the US as altering the status quo and penalizing China for Russia’s actions. Beijing resumed overflights of Taiwan’s air defense identification zone in the wake of Biden’s remarks as well as the decision of the US to send Senator Tammy Duckworth to Taiwan to discuss deeper economic and defense ties. Consider the positioning of US aircraft carrier strike groups as an indicator of the high level of strategic tensions. On January 18, 2022, as Russia amassed military forces on the Ukrainian border – and the US and NATO rejected its strategic demands – the US had only one publicly acknowledged  aircraft carrier in the Mediterranean (the USS Harry Truman) whereas it had at least five US carriers in East Asia. On February 24, the day of Russia’s invasion of Ukraine, the US had at least four of these carriers in Asia. Even today the US has at least four carriers in the Pacific compared to at least two in Europe – one of which, notably, is in the Baltics to deter Russia from attacking Finland and Sweden (Map 3). The US is warning China not to take advantage of the Ukraine war by staging a surprise attack on Taiwan. Map 3Amid Ukraine War, US Deters China From Attacking Taiwan Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) Of course, strategic tensions are perennial, whereas what investors are most concerned about is whether China can secure its economic recovery. The latest data are still disappointing. Credit growth continues to falter as the private sector struggles with a deteriorating demographic and macroeconomic outlook (Chart 5). The credit impulse has entered positive territory, when local government bonds are included, reflecting government stimulus efforts. But it is still negative when excluding local governments. And even the positive measure is unimpressive, having ticked back down in April (Chart 6). Chart 5Credit Growth Falters Amid Economic Transition Credit Growth Falters Amid Economic Transition Credit Growth Falters Amid Economic Transition Chart 6Silver Lining: Credit Impulse Less Negative Silver Lining: Credit Impulse Less Negative Silver Lining: Credit Impulse Less Negative Bottom Line: Further monetary and fiscal easing will come in China, a source of good news for global investors next year if coupled with a broader policy shift in favor of business, but the effects will be mixed this year due to Covid policy and domestic politics. Taken together with a European energy crunch and Middle Eastern oil supply disruptions, China’s stimulus is not a catalyst for a sustainable global equity market rally this year. South Asia: Inflation Hammers Sri Lanka And Pakistan Since 2020 we have argued that the global pandemic would result in a new wave of supply pressures and global social unrest. High inflation is blazing a trail of destruction in emerging markets, notably in South Asia, where per capita incomes are low and political institutions often fragile. Chart 7South Asia: Surging Inflation Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) Sri Lanka has been worst affected (Chart 7). Inflation surged to an eye-watering 34% in April  and is expected to rise further. Surging inflation has affected Sri Lanka disproportionately because its macroeconomic and political fundamentals were weak to begin with. The tourism-dependent Sri Lankan economy suffered a body blow from terrorist attacks in 2019 and the pandemic in 2020-21. Then 2022 saw a power struggle between Sri Lanka’s President Gotabaya Rajapaksa and members of the national assembly including Prime Minister (PM) Mahinda Rajapaksa. The crisis hit a crescendo when the country defaulted on external debt obligations last month. These events weigh on Sri Lanka’s ability to transition from a long civil war (1983-2009) to a path of sustained economic development. While the political crisis has seemingly stabilized following the appointment of new Prime Minister Ranil Wickremesinghe, we remain bearish on a strategic time horizon. This is mainly because the new PM is unlikely to bring about structural solutions for Sri Lanka’s broken economy. Moreover, Sri Lanka holds more than $50 billion of foreign debt, or 62% of GDP. Another country that has been dealing with political instability alongside high inflation in South Asia is Pakistan, where inflation hit a three-year high in April (see Chart 7 above). The latest twist in Pakistan’s never-ending cycle of political uncertainty comes from the ousted Prime Minister Imran Khan. The former PM, who commands an unusual popular support group due to his fame as a cricketer prior to entering politics, is demanding fresh elections and otherwise threatening to hold mass protests. Pakistan’s new coalition government and Prime Minister Shehbaz Sharif, who came to power amid parliamentary intrigues, are refusing elections and ultimatums. From a structural perspective Pakistan is characterized by a weak economy and an unusually influential military. Now it faces high inflation and rising food prices – indeed it is one of the countries that is most dangerously exposed to the Russia-Ukraine war as it depends on these two for over 70% of its grain imports. Bottom Line: MSCI Sri Lanka has underperformed the MSCI EM index by 58.3% this year to date. Pakistan has underperformed the same index by 41.6% over the same period. Against this backdrop, we remain strategic sellers of both bourses. Instability in these countries is also one  of the factors behind our strategic assessment of India as a country with a growing domestic policy consensus. South Asia: India’s Fiscal Populism And Geopolitics Inflation is less rampant in India, although still troublesome. Consumer prices nearly jumped to an 8-year high in April (see Chart 7). With a loaded state election calendar due over the next 12-18 months, the jump in inflation naturally triggered a series of mitigating policy responses. Ban On Wheat Exports: India produces 14% of the world’s wheat and 11% of grains, and exports 5% and 7%, respectively. India’s exports could make a large profit in the context of global shortages. But Prime Minister Narendra Modi is entering into the political end of the business cycle, with key state elections due that will have an impact on the ruling party’s political standing two years before the next federal election. He fears political vulnerability if exports continue amid price pressures at home. The emphasis on food security is typical but also bespeaks a lack of commitment to economic reform. Chart 8India's Real Interest Rates Fall India's Real Interest Rates Fall India's Real Interest Rates Fall Surprise Rate Hikes: The Reserve Bank of India (RBI) increased the policy repo rate by 40 basis points at an unscheduled meeting on May 4, thereby implementing its first rate hike since August 2018. With real rates in India lower than those in China or Brazil (Chart 8), the RBI will be forced to expedite its planned rate hikes through 2022. Tax Cuts On Fuel: India’s central government also announced steep cuts in excise duty on fuel. This is another populist measure that reduces political pressures but fails to encourage the private sector to adjust.  These measures will help rein in inflation but the rate hikes will weigh on economic growth while the tax cuts will add to India’s fiscal deficit. Indeed, India is resorting to fiscal populism with key state elections looming. Geopolitical risk is less of a concern for India – indeed the Ukraine war has strengthened its bargaining position. In the short run, India benefits from the ability to buy arms and especially cheap oil from Russia while the EU imposes an embargo. But over the long run its economy and security can be strengthened by greater interest from the US and its allies, recently highlighted by the fourth meeting of the Quadrilateral Security Dialogue (Quad) and the launch of the US’s Indo-Pacific Economic Framework (IPEF). These initiatives are modest but they highlight the US’s need to replace China with India and ASEAN over time, a trend that no US administration can reverse now because of the emerging Russo-Chinese strategic alliance. At the same time, the Quad underscores India’s maritime interests and hence the security benefits India can gain from aligning its economy and navy with the other democracies. Bottom Line: Fiscal populism in the context of high commodity prices is negative for Indian equities. However, our views on Russia, the Middle East, and China all point to a sharper short-term spike in commodity prices that ultimately drives the world economy deeper into stagflation or recession. Therefore we are booking a 22.5% profit on our tactical decision to go long Brazilian financials relative to Indian equities.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Chart 9Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Chart 10Other Measures Of Russian Geopolitical Risk Other Measures Of Russian Geopolitical Risk Other Measures Of Russian Geopolitical Risk Chart 11China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator Chart 12United Kingdom: GeoRisk Indicator United Kingdom: GeoRisk Indicator United Kingdom: GeoRisk Indicator Chart 13Germany: GeoRisk Indicator Germany: GeoRisk Indicator Germany: GeoRisk Indicator Chart 14France: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator Chart 15Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Chart 16Canada: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator Chart 17Spain: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator Chart 18Australia: GeoRisk Indicator Australia: GeoRisk Indicator Australia: GeoRisk Indicator Chart 19Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Chart 20Korea: GeoRisk Indicator Korea: GeoRisk Indicator Korea: GeoRisk Indicator Chart 21Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Chart 22South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Chart 23Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator   Footnotes 1     Recent diplomatic flaps between core European leaders and Ukrainian President Volodymyr Zelensky reflect Ukraine’s fear that Europe will negotiate a “separate peace” with Russia, i.e. accept Russian territorial conquests in exchange for economic relief. 2     Dmitri Medvedev explicitly states ‘there can be no more talk of any nuclear-free status for the Baltic - the balance must be restored’ in warning Finland and Sweden joining NATO. Medvedev is suggesting that nuclear weapons will be placed in this area where Russia has its Kaliningrad exclave sandwiched between Poland and Lithuania. Guy Faulconbridge, ‘Russia warns of nuclear, hypersonic deployment if Sweden and Finland join NATO’, April 14, 2022, Reuters. 3    See Antony J Blinken, Secretary of State, ‘The Administration’s Approach to the People’s Republic of China’, The George Washington University, Washington D.C., May 26, 2022, state.gov. Additionally, see President Joe Biden’s remarks on China and getting involved military to defend Taiwan in a joint press conference with Japan’s Prime Minister Kishida Fumio. ‘Remarks by President Biden and Prime Minister Kishida Fumio of Japan in Joint Press Conference’, Akasaka Palace, Tokyo, Japan, May 23, 2022, whitehouse.gov.   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Section III: Geopolitical Calendar

Executive Summary Inflationary Pressures To Fade Inflationary Pressures To Fade Inflationary Pressures To Fade The biggest problem for the European economy is surging inflation. Inflation has eroded household real disposable income and is hurting consumption. Inflation is set to roll over this summer, which should allow European economies to begin recovering in the fourth quarter of 2022. The ECB is likely to pause after exiting negative interest rates in Q3. European credit is becoming more attractive, but the risks to our view of European growth could still cause major problems for this asset class. Swiss stocks are vulnerable to a pullback relative to German ones. In France, President Emmanuel Macron is likely to get a legislative majority in June.     Bottom Line: European growth should recover after inflation rolls over this summer. The peak in inflation will allow the ECB to pause after its deposit rate gets to zero. Despite this positive view, the large risks hanging over Europe suggest prudence is still warranted.   European assets are rebounding in conjunction with the decline in risk aversion visible around global markets. The euro is catching a welcome bid too. However, as we wrote last week, while the conditions are falling in place to see a rally in Europe, too many risks continue to lurk in the background.  Therefore, we maintain our conservative approach to European markets, and we still recommend a defensive portfolio. Related Report  European Investment StrategyDon’t Be A Hero To shift to a less defensive stance, we want first to observe a peak in European inflation. Inflation represents the greatest problem for the European economy. If inflation continues to surge, the purchasing power of households will deteriorate further and the ECB will ratchet up its hawkish rhetoric, which will cause considerable mayhem in the European economy.   A Reprieve For Europe? Only when the income suppressing impact of inflation recedes will European growth strengthen. Chart 1Paying More For The Same Paying More For The Same Paying More For The Same Higher prices continue to hurt European consumption. As witnessed in the US, European retail sales are rising in nominal terms (Chart 1). However, households are not consuming more; they are spending more to purchase the same amount of goods, which is illustrated by the stagnation in retail sales volumes over the past twelve months. Households are not increasing the size of their consumption baskets, because their incomes are not keeping up with inflation. Unlike in the US, Eurozone households never saw their real disposable income spike during the pandemic because European governments focused on preserving jobs rather than distributing large handouts to households. As a result, European real disposable income began to lag its pre-pandemic trend (Chart 2). As the economy recovered, disposable income did not converge back to trend. Now that food and energy prices have spiked, the gap between real disposable income and its trend is only widening. Wages are not coming to the rescue either. The European labor market has been incapable of generating the same kind of wage growth that the US labor market has enjoyed. Even the recent uptick in negotiated wages is not as strong as it seems. German workers benefited from a one-off payment that caused wages to spike by 6.7%, elevating the Euro Area average to 2.8% from 1.6%. However, without that adjustment, German underlying wage growth fell from 3.9% to 1.6% (Chart 3), which means that the underlying European wage only rose by 2%. Chart 2Inflation Destroys Purchasing Power Inflation Destroys Purchasing Power Inflation Destroys Purchasing Power Chart 3Not As Strong As It Seems Not As Strong As It Seems Not As Strong As It Seems The distinction between one-off payments and underlying wages matters. As per Milton Friedman’s permanent income hypothesis, households are unlikely to shift their consumption pattern based on a temporary boost to income. They will save it, or in today’s case, use their one-off payment to cover their food and energy price increases. If today’s wage boost is not repeated, but inflation remains elevated, consumption will suffer. Europe’s tourism industry would be another major beneficiary from the peak in inflation. Prior to the pandemic, tourism contributed to 13%, 14% and 9% of the Italian, Spanish, and French economies, respectively. This sector was decimated during the pandemic after travel came to a halt. We are seeing positive signs emerge on this front. In the spring of 2021, nights spent at hotels were 80% below their spring 2019 levels for the Euro Area (Chart 4). As of March 2022, this variable is now between 15% and 30% below their March 2019 levels in Italy and France, respectively. Moreover, Google Mobility indices for the retail and recreation sectors have almost fully recovered (Chart 5). Thus, we can expect these trends to gather steam once inflation slows, because it will free up household disposable income. Europe’s periphery is particularly well placed to benefit from this eventual positive development. Chart 4Improving Tourism Sector Improving Tourism Sector Improving Tourism Sector Chart 5Mobility Pick-Up Mobility Pick-Up Mobility Pick-Up Positively, European inflation will peak soon. Commodity prices remain elevated, but commodity inflation has decelerated significantly. Hence, the commodity impulse is consistent with an imminent decline in Euro Area HICP (Chart 6). A simulation using BCA’s Commodity & Energy forecast for Brent, which also assumes that European natural gas prices will continue to hover around EUR100/MWh and that EUR/USD will hit 1.1 by year-end, confirms that energy inflation will swoon (Chart 7). Even if we assume a sudden surge in energy prices due to a Russian natural gas cutoff, energy inflation will recede in the second half of 2022 after spiking this summer. Chart 6Peak Inflation? Peak Inflation? Peak Inflation? Chart 7Beware The Russia Cutoff Risk Beware The Russia Cutoff Risk Beware The Russia Cutoff Risk Chart 8Less Pressure From The Consumer Of Last Resort Less Pressure From The Consumer Of Last Resort Less Pressure From The Consumer Of Last Resort Beyond the energy market, global forces also point toward a peak in European inflation in the coming months. The surge in US goods consumption over the past 24 months was felt globally and generated inflationary pressures in Europe as well. However, US durable goods consumption is declining (Chart 8). As a result, this important driver of European inflation will recede. Bottom Line: European consumption will not recover until inflation peaks. Without a deceleration in inflation, household disposable income will remain weak and consumers will remain careful. The good news is that European inflation is still on track to begin its descent this summer, which will boost the prospect for consumer spending and tourism. ECB Update: A Fall Pause? In a blog post last Monday, ECB president Christine Lagarde confirmed that the central bank will lift interest rates in July and will push the deposit rate to zero by September. Chart 9Too Much Priced In Too Much Priced In Too Much Priced In The economy is likely able to handle those two rate hikes. Our ECB monitor highlights the need to remove monetary accommodation in the Eurozone (Chart 9). Moreover, the German 2-/10-year yield curve has steepened this year, despite the hawkish shift in the ECB’s rhetoric, which confirms that monetary conditions are extremely accommodative. We expect the ECB to pause its rate hike campaign after exiting negative rates this fall to reassess economic conditions. Constraints on the ECB remain potent. If the central bank ignores these limiting factors, a policy mistake will ensue. Inflation is likely to decelerate by the end of the summer, which will undercut the hawks driving the consensus at the Governing Council today. Inflation is the factor pushing the ECB Monitor higher right now, not growth conditions (Chart 9, second panel). Thus, the case for lifting rates will weaken considerably when inflation slows. Growth is unlikely to have recovered enough by September to justify additional rate hikes after inflation slows. The expected improvement in consumption and household finances discussed earlier will be embryonic by the end of the summer and will not offer a clear case to lift rates further. Instead, the ECB will still have to juggle the tightening in financial conditions created by wider bond spreads in the European periphery and the impact of China’s slowdown on European exports. Meanwhile, capex is unlikely to strengthen meaningfully as long as global trade softens. As a result, we stay long the June 2023 Euribor futures. An extended pause after the September meeting will prevent the ECB from hiking rates as much as money markets expect over the coming twelve months (Chart 9, bottom panel). If the ECB goes ahead and continues to lift rates in the fall and early winter, the European economy will weaken considerably more and the previous rate hikes will have to be undone. Both scenarios are bullish for the June 2023 Euribor contract. Bottom Line: The ECB is likely to pause after pushing its deposit rate to zero in the third quarter in order to reassess economic conditions. Inflation is the main factor behind higher rates, and it will peak this summer. Meanwhile, the economy is still not strong enough to justify significantly higher interest rates. The market’s pricing in the ESTR curve is much too aggressive considering this context. Stay long June 2023 Euribor futures. Credit Update: Don’t Be A Hero Chart 10Cautious In Absolute Terms, Positive On Relative Performance Cautious In Absolute Terms, Positive On Relative Performance Cautious In Absolute Terms, Positive On Relative Performance Credit markets are experiencing a second episode of spread widening this year. The first episode was triggered by the invasion of Ukraine by Russia. The current one reflects strong inflation, weaker growth prospects, and the ECB’s policy shift. Year-to-date, European investment grade and high-yield corporate bond option-adjusted spreads have widened by 74bps and 188bps, respectively (Chart 10, top panel). As we wrote last week, if the global economic situation were to stabilize, then European assets would be a buy at current levels. This is especially true for European credit. Beyond attractive valuations, corporate bond issuers’ balance sheets are in good shape and the default risk is low.   However, the same risks that prevent us from being buyers of the euro and European stocks today also hang over the credit market. Specifically, a further deterioration of the energy flows between Russia and the EU and/or a policy mistake, whereby the ECB delivers the seven rate hikes priced in the overnight index swap market, would cause spreads to widen meaningfully from their current elevated levels. Therefore, we recommend investors remain on the sidelines and wait for a safer entry point over the coming weeks. Once inflation has peaked and stagflation/recession fears recede, then credit spreads will have ample room to narrow, especially if the ECB decides to pause after lifting the deposit rate to 0% (Chart 10, second panel). In the meantime, expected policy rate differentials are still supportive of an overweight on European credit relative to US credit (Chart 10, bottom panel). Bottom Line: European spreads are most likely peaking. However, the same risks that hang over EUR/USD and European equities prevent us from buying this asset class just yet. Swiss Stocks Are Getting Expensive Chart 11Swiss Stocks Getting Ahead Of Earnings Swiss Stocks Getting Ahead Of Earnings Swiss Stocks Getting Ahead Of Earnings The defensive Swiss market has greatly outperformed its Euro Area counterpart this year. However, the recent bout of Swiss outperformance has been completely dissociated from the trend in Swiss EPS relative to those of the Euro Area (Chart 11). Now, Swiss equities are particularly expensive and sport multiples 45% greater than the P/E ratio of the Eurozone MSCI benchmark. This bifurcation between the relative performance of Swiss stocks and their relative earnings represents a trading opportunity. Specifically, Swiss shares look vulnerable against German ones, which have been seriously beaten down in recent years. Chart 12Priced For The Apocalypse Priced For The Apocalypse Priced For The Apocalypse Swiss stocks have been re-rated on the back of many forces. First, the valuations of Swiss stocks relative to German ones have risen in tandem with the Eurozone’s headline and core inflation (Chart 12, top and second panel). Swiss relative valuations have also benefited from the significant tailwind created by higher 2-year rates in the Eurozone (Chart 12, third panel) and from the weakness in the euro (Chart 12, fourth panel). Finally, Swiss relative valuations seem to have already priced in a significant deterioration in European manufacturing activity, which would have lifted their appeal as a defensive play (Chart 12, bottom panel). We recommend selling Swiss stocks against German ones. We anticipate European inflation to peak this summer. Our ECB view is consistent with a decline in Germany’s 2-year bond yields. We also expect the euro to bottom and, even though we have written about a deterioration in European manufacturing activity, the recent explosion of Swiss multiples relative to German ones looks overdone. This trade may be seen as our first attempt to dip our toe into cyclical assets, even if we generally favor capital preservation over risk taking at this juncture. Bottom Line: The outperformance of Swiss equities is overextended and is already pricing in a dire outcome for European economies. Selling Swiss shares relative to German stocks is an attractive way to add tentatively some risk to a European portfolio. France Update: Likely Legislative Majority For Macron Chart 13French Polls Suggest Macron Will Get His Legislative Majority Looking Beyond Europe’s Inflation Peak Looking Beyond Europe’s Inflation Peak President Emmanuel Macron’s political party, Renaissance (previously En Marche!), may surprise to the upside in this year’s legislative election. An aggregate of recent polls (Chart 13) suggests that the presidential coalition (which includes Renaissance and its allies) will obtain between 295 and 340 seats in the Assemblée Nationale, more than the 289 seats needed to achieve a majority. The odds of seeing an historically low voter turnout should also play in the French president’s favor. Chart 14Favor French Small-Caps & Avoid Consumer Stocks Favor French Small-Caps & Avoid Consumer Stocks Favor French Small-Caps & Avoid Consumer Stocks Macron will not have to compromise to build a coalition in favor of his reform agenda, which bodes well for French productivity and trend growth. This election should not have an impact on French assets beyond that. We continue to recommend investors favor French small-caps, as they will benefit from an improvement in domestic consumer confidence and an eventual strengthening in the euro (Chart 14). Meanwhile, we still see more downside for French consumer stocks (Chart 14, bottom panel).   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Jeremie Peloso, Editor/Strategist JeremieP@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Listen to a short summary of this report.         Executive Summary US Financial Conditions Have Tightened Significantly This Year US Financial Conditions Have Tightened Significantly This Year US Financial Conditions Have Tightened Significantly This Year US financial conditions have tightened by enough that the Fed no longer needs to talk up interest rate expectations. If inflation decelerates faster than anticipated over the coming months, as we expect will be the case, the Fed’s messaging will soften further. Bond yields in the US and abroad are likely to fall over the next 6-to-12 months, even if they do rise over a longer-term horizon. Stay overweight stocks, favoring non-US equities over their US peers. We are closing our short 10-year Gilts trade, initiated at a yield of 0.85%, for a gain of 7.5%. We are also opening a new trade going long Canadian short-term interest rate futures versus their US counterparts. Investors expect Canadian rates to exceed US rates in 2024, which seems unlikely to us given that the Canadian housing market is much more sensitive to higher rates than the US market. Bottom Line: After having tightened significantly over the past seven months, financial conditions should loosen modestly during the remainder of the year. This should benefit risk assets. Fed Focused on Financial Conditions Chart 1Tighter Financial Conditions Will Hurt Growth Tighter Financial Conditions Will Hurt Growth Tighter Financial Conditions Will Hurt Growth Like many central banks, the Fed sees financial conditions as a key driver of the real economy. While there are many financial conditions indices (FCIs), most include bond yields, credit spreads, equity prices, and the exchange rate as inputs. Higher bond yields, wider credit spreads, lower equity prices, and a strong currency all lead to tighter financial conditions and a weaker economy, and vice versa. Goldman’s US FCI is especially popular among market participants. It is calibrated so that 100 bps in tightening corresponds, all things equal, to a 100 basis-point decline in US real GDP growth over the subsequent four quarters. The Goldman FCI has tightened by 212 bps since the start of the year and by 225 points from its loosest level in November 2021. If the historic relationship between the FCI and the economy holds, the tightening in financial conditions would be enough to push US growth to a below-trend pace by the second quarter of 2023. In fact, the tightening in the Goldman FCI over the past 12 months already suggests that the manufacturing ISM will fall below 50 (Chart 1).  Along the same lines, the Chicago Fed’s Adjusted National FCI, which measures financial conditions relative to current economic conditions, has moved slightly into restrictive territory. Aside from a brief period at the outset of the pandemic, the index has been consistently in expansionary territory since early 2013 (Chart 2). Chart 2The Chicago Fed Financial Conditions Index Has Moved Into Slightly Restrictive Territory Are Financial Conditions Tight Enough? Are Financial Conditions Tight Enough? Other data are consistent with the message from the FCIs. Most notably, growth estimates for the US and for other major economies have come down over the past few months (Chart 3). Economic surprise indices have also fallen, especially in the US.   Chart 3AGrowth Forecasts Have Softened As Economic Data Have Surprised To The Downside (I) Growth Forecasts Have Softened As Economic Data Have Surprised To The Downside (I) Growth Forecasts Have Softened As Economic Data Have Surprised To The Downside (I) Chart 3BGrowth Forecasts Have Softened As Economic Data Have Surprised To The Downside (II) Growth Forecasts Have Softened As Economic Data Have Surprised To The Downside (II) Growth Forecasts Have Softened As Economic Data Have Surprised To The Downside (II) Mission Accomplished? Chart 4The Fed Expects To Lift Rates Above Its Estimate Of Neutral The Fed Expects To Lift Rates Above Its Estimate Of Neutral The Fed Expects To Lift Rates Above Its Estimate Of Neutral Given the recent tightening in financial conditions and weaker growth expectations, the Fed is likely to soften its tone. Already this week, Atlanta Fed President Raphael Bostic suggested that the Fed could pause raising rates in September in order to assess the impact of the Fed’s tightening campaign. The Fed minutes also conveyed a sense of flexibility and data-dependence about the timing and magnitude of future hikes once rates reach 2%. It’s worth stressing that the Fed expects rates to rise in 2023 to about 40 bps above its estimate of the terminal rate (Chart 4). Jawboning rate expectations higher would potentially undermine the Fed’s goal of achieving a soft landing for the economy. Inflation Will Dictate How Much Easing Lies Ahead There is a big difference between not wanting financial conditions to tighten further and wanting them to loosen. The Fed would only want to see an easing in financial conditions if inflation were to fall faster than expected. Chart 5 shows how the year-over-year change in the core PCE deflator would evolve over the remainder of the year depending on different assumptions about the month-over-month change in the deflator. The Fed would be able to reach its expectation of year-over-year core PCE inflation of 4.1% for end-2022 if the month-over-month change averages 0.33%. Monthly core PCE inflation averaged 0.3% in February and March and is expected to clock in at around the same level for April once the data is released tomorrow. Chart 5AUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.3% (I) US Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.3% (I) US Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.3% (I) Chart 5BUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.3% (II) US Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.3% (II) US Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.3% (II) Regardless of tomorrow’s data print, as we discussed last week, we expect the monthly inflation rate to average less than 0.3 in the back half of the year. If that happens, inflation will surprise to the downside relative to the Fed’s expectations. Consistent with the observation above, market-based inflation expectations have already declined. The 5-year TIPS inflation breakeven has fallen from 3.64% in March to 2.98% at present. The widely watched 5-year/5-year forward breakeven rate is back down to 2.29%, at the bottom of the Fed’s comfort zone of 2.3%-to-2.5% (Chart 6).1 The Citi US Inflation Surprise Index has also rolled over (Chart 7). Chart 6Market-Based Inflation Expectations Have Come Down Of Late Market-Based Inflation Expectations Have Come Down Of Late Market-Based Inflation Expectations Have Come Down Of Late Chart 7The US Inflation Surprise Index Has Rolled Over The US Inflation Surprise Index Has Rolled Over The US Inflation Surprise Index Has Rolled Over Financial Conditions  Abroad Financial conditions indices in the other major developed economies have tightened somewhat less than in the US because equities represent a smaller share of household net worth abroad and also because most currencies have weakened against the US dollar (Chart 8). Nevertheless, with growth momentum having already deteriorated sharply, central banks are signaling a more balanced approach towards policy normalization. Chart 8Financial Conditions Have Tightened More In The US Than Elsewhere This Year Are Financial Conditions Tight Enough? Are Financial Conditions Tight Enough? ECB: Wait and See? In a blog post published on Monday, Christine Lagarde observed that inflation expectations have risen from pre-pandemic levels, implying that real policy rates are currently lower than they were two years ago. In her mind, this warrants ending net purchases under the Asset Purchase Programme early in the third quarter. It also warrants raising the deposit rate by 25 bps at both the July and September meetings, bringing it back to zero from -0.5% at present. Beyond then, Lagarde was circumspect about what should be done, stressing the need for “gradualism, optionality and flexibility.” She noted that “The euro area is clearly not facing a typical situation of excess aggregate demand or economic overheating … Both consumption and investment remain below their pre-crisis levels, and even further below their pre-crisis trends.” She then added: “The outlook is now being clouded by the negative supply shocks hitting the economy … households’ expectations of their future financial situation dropped to their second-lowest level on record in March and remained close to that level in April.” The market expects the ECB to raise rates by 170 bps over the next 12 months, bringing the deposit rate to 1.2% by mid-2023 (Chart 9). BCA’s Global Fixed Income team, led by Rob Robis, foresees only 50 bps of tightening over the next 12 months. Chart 9Markets Expect Rates To Rise The Most In The Anglo-Saxon World Are Financial Conditions Tight Enough? Are Financial Conditions Tight Enough? The UK, Canada, and Australia: Frothy Housing Markets Will Limit Rate Hikes The Bank of England (BoE) hiked rates by 90 bps over the past 12 months. The UK OIS curve is priced for another 140 bps of rate hikes over the next year. According to the BoE’s forecasting models, this would raise the unemployment rate by two percentage points while lowering inflation to below 2% within the next two-to-three years. In our opinion, that is more tightening than the BoE would like to see. BCA’s strategists expect the BoE to deliver only another 75 bps of hikes over the next year. Chart 10Buildup In Leverage And Frothy Housing Markets Pose A Challenge To Monetary Policy In Some Developed Market Countries Buildup In Leverage And Frothy Housing Markets Pose A Challenge To Monetary Policy In Some Developed Market Countries Buildup In Leverage And Frothy Housing Markets Pose A Challenge To Monetary Policy In Some Developed Market Countries The Canadian economy has been quite strong, with the unemployment rate falling to 5.2% in April, the lowest since 1974. The Canadian OIS curve is discounting 195 bps of interest rate hikes over the next 12 months, substantially more than the 150 bps of tightening our fixed income team foresees. By mid-2024, investors expect Canadian policy rates to be about 25 bps above US rates. This seems unreasonable to us, and as of this week, we are expressing this view by going long the June 2024 3-month Canadian Bankers’ Acceptance (BAX) futures contract (BAM4) versus the corresponding 3-month US SOFR futures contract (SFRM4). A more liquid option is to simply go long the 10-year Canadian government bond versus the 10-year US Treasury note. At present, Canadian 10-year government bonds are yielding  5 bps more than their US counterparts. Unlike in the US, where household debt has fallen over the past 14 years, debt in Canada has risen, fueled by a massive housing boom (Chart 10). High indebtedness and the prevalence of variable rate/short-term fixed-rate mortgages will limit the ability of the BoC to raise rates. The Australian OIS curve is currently discounting 262 bps of rate hikes over the next year which, if realized, would take the cash rate to 3.3% – a level last seen in 2013 when the neutral rate in Australia was much higher by the RBA’s own reckoning. BCA’s fixed income strategists expect only 150 bps of tightening over the next 12 months. Japan: Yield Curve Control Will Continue Chart 11Japan: Long-Term Inflation Expectations Are Far Lower Than In The Rest Of The World Japan: Long-Term Inflation Expectations Are Far Lower Than In The Rest Of The World Japan: Long-Term Inflation Expectations Are Far Lower Than In The Rest Of The World The Bank of Japan expects inflation excluding fresh food prices to remain at about 2% in the second half of 2022, but then to slow to 1.1% in the fiscal year starting April 2023. The Japan OIS curve is discounting almost no tightening over the next 12 months. Long-term inflation expectations are far lower in Japan than in any other major economy, which makes ultra-low rates a necessity for the foreseeable future (Chart 11). China: Outright Easing Chart 12Covid Restrictions Have Eased Only Modestly In China Are Financial Conditions Tight Enough? Are Financial Conditions Tight Enough? China faces a trifecta of problems: A weakening housing market; slowing external demand for manufactured goods; and the ongoing threat of Covid-related lockdowns. Despite a steep drop in the number of new Covid cases over the past month, China’s lockdown index has only eased modestly, as the authorities continue to fret about the next outbreak (Chart 12). The leadership in Beijing has responded with policy easing. The PBoC lowered the 5-year loan prime rate by 15 bps last week, the largest such cut since 2019. This followed a cut in the floor rate for first-home mortgages that was announced on May 15. BCA’s China strategists believe these measures will arrest the deep contraction in the property market but will not spark a full-blown recovery due to the ongoing commitment of the government to the “three red lines” policy.2  In normal times, a Chinese real estate slump would be a cause of grave concern for global investors. These are not normal times, however. Public enemy number one these days is inflation. A weaker Chinese property market would curb commodity demand, thus helping to cool inflation. That would be a welcome development for global investors. Investment Conclusions Global financial conditions have tightened to the point that betting on ever-higher rates, at least for the next 12 months, no longer makes sense. If global inflation decelerates faster than anticipated during the remainder of the year, as we expect will be the case, central banks will dial back the hawkish rhetoric.  We took partial profits on our short 10-year Treasury trade earlier this month (initiated at a yield of 1.45%). As of this week, consistent with the earlier decision of BCA’s fixed income strategists to upgrade UK Gilts, we are closing our short 10-year Gilt position (initiated at a yield of 0.85%) for a gain of 7.5%. The coming Goldilocks environment of falling inflation and supply-side led growth will buttress equities. We expect global stocks to rise 15%-to-20% over the next 12 months, with non-US markets outperforming the US. Looking further out, the fate of Goldilocks will rest on where the neutral rate of interest resides. If the neutral rate in the US turns out to be substantially lower than 2.5%, then any growth recovery will falter as the lagged effects of restrictive monetary policy work their way through the economy. Conversely, if the neutral rate turns out to be substantially higher than 2.5%, then inflation will reaccelerate as the economy overheats. Given the choice, we would wager on the latter outcome. Thus, while we expect global bond yields to decline over a 12-month horizon, we foresee them rising over a 2-to-5-year time frame. Similarly, while stocks will strengthen over the next 12 months, they are likely to encounter another bout of turbulence starting late next year or in 2024 as central banks initiate a second round of rate hikes.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on           LinkedIn Twitter     Footnotes 1     The Federal Reserve targets an average inflation rate of 2% for the Personal Consumption Expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of 2.3%-to-2.5%. 2      The People’s Bank of China and the housing ministry issued a deleveraging framework for property developers in August 2020, consisting of a 70% ceiling on liabilities-to-assets, a net debt-to-equity ratio capped at 100%, and a limit on short-term borrowing that cannot exceed cash reserves. Developers breaching these “red lines” run the risk of being cut off from access to new loans from banks, while those who respect them can only increase their interest-bearing borrowing by 15% at most. Global Investment Strategy View Matrix Are Financial Conditions Tight Enough? Are Financial Conditions Tight Enough? Special Trade Recommendations Current MacroQuant Model Scores Are Financial Conditions Tight Enough? Are Financial Conditions Tight Enough?

Executive Summary EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply The EU's failed foreign policy – premised on ever-deeper engagement with the Soviet Union and, after it collapsed, Russia – will drive its hot mess of an energy policy for years. In the short term, the EU's REPowerEU scheme proposed last week to fund the decoupling from Russia will lift its green-house gas (GHG) emissions, if the sale of €20 billion of EU Emission Trading System (ETS) allowances goes forward. Markets traded lower over the week, to make room for the higher ETS pollution-permit supply. This could increase the volume of allowances sales needed to reach the €20 billion target. Another €10 billion investment in natgas pipelines also will be funded. Longer-term, the acceleration of the EU's renewable-power build-out via so-called Projects of Common Interest (PCI) will get an €800 billion boost, with another round of funding to be proposed for early next year. EU funding will lift base metals and steel prices – raising the cost of the renewables build-out – and keep fossil-fuels well bid.   Bottom Line: The REPowerEU scheme will increase volatility in the EU's ETS market, and add significant new demand to base metals and fossil-fuel markets. The propensity of EU policymakers to interfere in its ETS market makes it unattractive. We remain long the S&P GSCI index, and the COMT, XOP, XME and PICK ETFs expecting higher base metals, oil and gas prices. Tactically, we are getting long 4Q22 Brent calls struck at $120/bbl, anticipating an EU embargo of Russian oil imports. Feature Over the past three decades, foreign policy for the EU largely was set by Germany, the organization's most powerful economy. Successive generations of German politicians championed the idea that the West could bring the former Soviet Union – and later Russia – into the modern world of global trade through Ostpolitik, which had, at its core, a belief in the power of trade to effect political and economic change.1 This change-through-trade policy survived the Cold War, the collapse of the Soviet Union and rise of Russia from its ashes. It also survived Russia's first invasion of Ukraine in 2014. Indeed, following that invasion, Russia marked the completion of its Nord Stream 2 (NS2) natural gas pipeline – running parallel to NS1 – in September of last year. If NS2 were up and running now, it would have increased Russian gas flows into the EU and its revenue flows.2 As our Geopolitical Strategists noted, Germany even got the Biden administration to agree in summer 2021 to set aside any sanctions so that Germany could operate NS2 with Russia. Related Report  Commodity & Energy StrategyDie Cast By EU: Inflation, Recession Risks Rise Yet Russia did not share the German commitment to economic engagement within a US-led liberal international order. Russia's second invasion of Ukraine in February was a bridge too far, and catalyzed the EU's response, again led by Germany, to de-couple from Russia in the energy sector. The EU's reversal of a failed foreign policy, which produced its dependence on Russian energy, leaves it with a hot mess of an energy policy that is evolving rapidly. In its wake, volatility in the EU carbon-trading market has ensued, along with the promise of an accelerated doubling-down on renewable-energy generation. Higher Emissions, Lower Emissions Prices Last week, the EU proposed its REPowerEU scheme, which is meant to enable the decoupling of the EU from Russian energy dependence by funding hundreds-of-billions-of-euros in new energy investments over coming years.3 Chart 1EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply In a history heavily laden with paradox, this new scheme will lift the EU's green-house gas (GHG) emissions – including CO2 – if the sale of €20 billion of EU Emission Trading System (ETS) allowances goes forward.4 So, in the breach, the EU is willing to significantly relax its environmental goals – the E in ESG – to begin undoing its failed foreign policy. Markets already are making room for this increased ETS pollution-permit supply, which, as allowances prices weaken, will require additional supplies to reach the €20 billion target (Chart 1). This will lead to higher coal and fossil fuel usage during Germany's hot-mess de-coupling with Russia. In addition to raising funds by selling pollution permits, the EU will invest another €10 billion in natgas pipelines. This will help counter the likely loss of Russian gas when it embargoes Russian oil imports, but will take time (a few years) to actually put in the ground.5 The additional pipe would address one of the EU's weakest energy links: the lack of pipeline capacity to transport liquified natural gas (LNG) inland once it arrives in Europe. Europe pushed hard to re-load natgas inventories ahead of the coming winter season, and appears to have made progress in this regard (Chart 2). Europe was a strong bid for LNG in the first four months of this year, according to Refinitiv reporting.6 LNG imports were up 58% over the first four months of this year, totaling 45.3mm MT. This kept European natgas prices elevated vs. Asia (Chart 3). Chart 2Europe Re-Loads Storage One Hot Mess: EU Energy Policy One Hot Mess: EU Energy Policy Chart 3Europe Outbids Asia For LNG One Hot Mess: EU Energy Policy One Hot Mess: EU Energy Policy The back-and-forth between the Asian and European markets will continue for the rest of this year, particularly going into the Northern Hemisphere's summer, when demand for natgas in Asia, in particular, will remain strong. REPowerEU Will Boost Base Metals Demand Longer term, the EU's REPowerEU proposal, if approved, will accelerate the EU's renewable-power build-out via so-called Projects of Common Interest (PCI). The proposal contains €800 billion to support new renewable-energy proposals, with another round of funding proposed for early next year.   The doubling down by the EU on renewables will lift base metals and steel prices as soon as the REPowerEU program starts funding investments in renewable technology and short-term projects like pipeline buildouts (maybe sooner as hedges are placed). Given the tightness already apparent in the base metals markets, this will raise the price of critical materials – copper, aluminum, steel – and will, in the process, keep fossil-fuels well bid: large capital projects do not get done without a lot of diesel and gasoline being consumed.7  The EU is not alone in its desire to accelerate renewables investment: The US is funding a similar build-out, as is China, which will be accelerating its infrastructure and renewables investments. The constraint on all of these programs to build out renewables is low capex in base metals (Chart 4), and oil and gas (Chart 5). This has kept the level of supply from quickly responding to increased demand, which keeps these markets in sharp backwardations. Market tightness in metals and energy will be compounded by stronger bids from the three largest economic centers in the world – the EU, US and China.Chart 4Weak Capex Holds Base Metals Supply Growth Down … One Hot Mess: EU Energy Policy One Hot Mess: EU Energy Policy Investment Implications Chart 5… And Oil + Gas Supply Growth One Hot Mess: EU Energy Policy One Hot Mess: EU Energy Policy The EU's REPowerEU scheme is not a done deal, but we give it high odds of being adopted. It will increase volatility in the EU's ETS market, and add significant new demand to base metals and fossil-fuel markets. In terms of where to take risk, now that this proposal has been floated, we would avoid getting long carbon permits traded on the EU's ETS carbon market, given the propensity of policymakers to meddle excessively, which, in and of itself, is a risk that is difficult – if not impossible – to forecast. However, we do continue to favor being long the S&P GSCI index, and the COMT, XOP, XME and PICK ETFs expecting higher base metals, oil and gas prices. On a tactical basis, we are getting long 4Q22 Brent calls struck at $120/bbl at tonight's close, anticipating an EU embargo of Russian oil imports. 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 officials involved in negotiations to restore the Iran nuclear deal appear to be signaling US interests could be served by agreeing such a deal.8 Allowing Iran back into the market as a bona fide oil exporter would return ~ 1mm b/d or more to global crude markets by year-end.  This would partly reverse the higher prices we expect in the wake of an EU to embargo Russian oil imports this week.  Presently, oil markets are rallying as the necessity for Russia to shut in oil production post-embargo is discounted (Chart 6).9 That said, a deal to allow Iran back into export markets would dampen the move we expect in the wake of an EU embargo. The market will remain tight after a US-Iran deal, but this might be attractive to the Biden administration as mid-terms approach, and to the EU, as it also would reduce the funds available for Russia to wage war on Ukraine.  On a tactical basis, we are getting long 4Q22 Brent calls struck at $120/bbl at tonight's close, anticipating the EU embargo.  We will close this position out if the US and Iran reinstate the Joint Comprehensive Plan of Action (JCPOA), which would allow Iran to resume oil exports.   Precious Metals: Bullish The World Platinum Investment Council (WPIC) projects a 2022 surplus of 627 koz, slightly lower than the previous forecast of 657k oz for this period. This year, strong automotive demand is expected to be offset by reductions in jewellery and industrial demand. Car manufacturers’ switch from Russian palladium to platinum – as they self-sanction – will bullish for platinum. Russia accounts for ~40% of global palladium mined output. The organization predicts lower mine supply caused primarily by supply-chain bottlenecks and COVID-19 restrictions. Nornickel, one of the world’s largest platinum miners is expected to reduce mined output on the back of supply-chain disruptions due to Russian sanctions.    Base Metals: Bullish Iron ore prices rose on the wider than anticipated cut in China’s benchmark interest rate for mortgages on May 20th (Chart 7). The upcoming easing of lockdowns in Shanghai will further boost iron ore prices, as markets expect Chinese economic activity to pick up. However, if China sticks to its zero-COVID policy, lockdowns will continue to occur in different cities and regions. BCA’s Emerging Markets Strategy expects these ‘rolling lockdowns’ to last at least until the end of this year. This will affect manufacturing and steel production, primary iron ore demand drivers. Iron ore’s reliance on China’s economic health means price of the industrial metal will not meaningfully rise this year, barring a supply shortfall. Chart 6 Brent Prices Going Up Brent Prices Going Up Chart 7 BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI) GOING DOWN BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI) GOING DOWN     Footnotes 1     Please see The Former Chancellor Who Became Putin’s Man in Germany, published by the New York Times 23 April 2022.  This is an excellent precis of the history of German-Russian trade vis-à-vis the career of former German chancellor Gerhard Schröder, who held the office from 1998 – 2005.  The deep energy relationship with Russia began in the late 1960s under the chancellorship of Willy Brandt.  As much as 55% of Germany's gas needs were supplied by Russia prior to its invasion of Ukraine 24 February 2022.  Now its Russian gas imports are closer to 20%; Germany and the EU are scrambling to eliminate any and all energy trade with Russia, beginning with reducing gas imports by two-thirds this year, and likely embargoing all oil imports by year-end. 2     Russia completes Nord Stream 2 construction, gas flows yet to start, published by reuters.com 10 September 2021. 3    Please see REPowerEU: A plan to rapidly reduce dependence on Russian fossil fuels and fast forward the green transition* published by the European Commission 18 May 2022.  Energy accounted for 62% of the EU's Russian imports in 2021, just under €100 billion worth of gas (40%), oil (27%) and coal (46%), according to the European Commission's tally in In focus: Reducing the EU’s dependence on imported fossil fuels published 20 April 2022.  In 2011, energy accounted for 77% of the EU's imports from Russia. 4    Please see Felix K. Chang's report Legacy of Ostpolitik: Germany's Russia Policy and Energy Security published by the Foreign Policy Research Institute in May 2014.  This includes a summary of the paradoxical nature of Germany's Ostpolitik policy following Russia's first invasion of Ukraine. 5    Please see German economy minister expects EU embargo on Russian oil 'within days' -ZDF, published by reuters.com 23 May 2022. 6    Please see LNG momentum swinging back to Asia as Europe demand eases: Russell published by reuters.com on 24 May 2022. 7     Please see Tight Commodity Markets: Persistently High Inflation, which we published 24 March 2022.  It is available at ces.bcaresearch.com. 8    Please see Analysis: Subtle shift in U.S. rhetoric suggests new Iran approach published by reuters.com 24 May 2022, and German economy minister expects EU embargo on Russian oil 'within days' -ZDF, published by reuters.com 23 May 2022. 9    Please see Oil, Natgas Prices Set To Surge, which we published last week. Investment Views and Themes Recommendations Strategic Recommendations Trades Closed in 2022 Summary of Closed Trades