Geopolitics

Executive Summary Iran Reaches Nuclear Breakout Biden And Putin Court The Middle East Biden And Putin Court The Middle East The next geopolitical crisis will stem from the Middle East. The US, Russia, and China are striving for greater influence there and Iran’s nuclear quest is reaching a critical juncture. The risk of US-Israeli attacks against Iran remains 40% over the medium term and will rise sharply if Iran attempts to construct a deliverable nuclear device. Saudi Arabia may increase oil production but only if global demand holds up, which OPEC will assess at its August 3 meeting. Global growth risks will prevail in the short term and reduce its urgency. Russia will continue to squeeze supplies of energy and food for the outside world. The restart of Nord Stream 1 and the Turkey-brokered grain export proposal are unreliable signals. Russia’s aim is victory in Ukraine and any leverage will be used. The US may be done with the Middle East but the Middle East may not be done with the US. Structurally we remain bullish on gold and European defense stocks but we are booking 17% and 18% gains on our current trades. The deterioration in global growth and likely pullback in inflation will temporarily undercut these trades. Tactical Recommendation Inception Date Return LONG GOLD (CLOSED) 2019-06-12 17.1% LONG EUROPEAN AEROSPACE & DEFENSE / EUROPEAN TECH EQUITIES (CLOSED) 2022-03-18 17.9% Bottom Line: Global demand is weakening, which will weigh on bond yields and commodities. Yet underlying oil supply constraints persist – and US-Iran conflict will exacerbate global stagflation. Feature Chart 1Equity Volatility And Oil Price Volatility Equity Volatility And Oil Price Volatility Equity Volatility And Oil Price Volatility US President Joe Biden visited Saudi Arabia last week in a belated attempt to make amends with OPEC, increase oil production, and reduce inflation ahead of the midterm election. Biden also visited Israel to deter Iran, which is the next geopolitical crisis that markets are underrating. Meanwhile Russian President Vladimir Putin went to Iran on his second trip outside of Russia since this year’s invasion of Ukraine. Putin sought an ally in his conflict with the West, while also negotiating with Turkish President Recep Erdogan, who sought to position himself as a regional power broker. In this report we analyze Biden’s and Putin’s trips and what they mean for the global economy and macro investors. Macroeconomics is bearish for oil in the short term but geopolitics is bullish for oil in the short-to-medium term. The result is volatility (Chart 1). OPEC May Pump More Oil But Not On Biden’s Time Frame Here are the important developments from Biden’s trip: A credible threat against Iran: The US and Israel issued a joint declaration underscoring their red line against Iranian nuclear weaponization.1 Meanwhile the Iranians claimed to have achieved “nuclear breakout,” i.e. enough highly enriched uranium to construct a nuclear device (Chart 2). A balance-of-power coalition to contain Iran: Israel and Saudi Arabia improved relations on the margin. Each took action to build on the strategic détente between Israel and various Arab states that is embodied in the 2020 Abraham Accords.2 This strategic détente has staying power because it is a self-interested attempt by the various nations to protect themselves against common rivals, particularly Iran (Chart 3). Biden also tried to set up a missile defense network with Israel and the Arabs, although it was not finalized.3 Chart 2Iran Reaches Nuclear Breakout Biden And Putin Court The Middle East Biden And Putin Court The Middle East A reaffirmed US-Saudi partnership: The US and Saudi Arabia reaffirmed their partnership despite a rocky patch over the past decade. The rocky patch arises from US energy independence, China’s growth, and US attempts to normalize ties with Iran (Chart 4). These trends caused the Saudis to doubt US support and to view China as a strategic hedge. Chart 3Iran: Surrounded And Outgunned Biden And Putin Court The Middle East Biden And Putin Court The Middle East ​​​​​​ President Biden came into office aiming to redo the Iran deal and halt arms sales to Saudi Arabia. Since then he has been chastened by high energy prices, a low approval rating, and hawkish Iranian policy. On this trip he came cap in hand to the Saudis in a classic example of geopolitical constraints. If the US-Iran deal is verifiably dead, then US-Saudi ties will improve sustainably. (Though of course the Saudis will still do business with China and even start trading with China in the renminbi.) What global investors want to know is whether the Saudis and OPEC will pump more oil. The answer is maybe someday. The Saudis will increase production to save the global business cycle but not the Democrats’ election cycle. They told Biden that they will increase production only if there is sufficient global demand. Global Brent crude prices have fallen by 6% since May, when Biden booked his trip, so the kingdom is not in a great rush to pump more. Its economy is doing well this year (Chart 5). Chart 4Drivers Of Saudi Anxiety Drivers Of Saudi Anxiety Drivers Of Saudi Anxiety ​​​​​ Chart 5Saudis Won't Pump If Demand Is Weak Saudis Won't Pump If Demand Is Weak Saudis Won't Pump If Demand Is Weak ​​​​​​ At the same time, if global demand rebounds, the Saudis will not want global supply constraints to generate punitive prices that cap the rebound or kill the business cycle. After all, a global recession would deplete Saudi coffers, set back the regime’s economic reforms, exacerbate social problems, and potentially stir up political dissent (Chart 6). Related Report  Geopolitical StrategyThird Quarter Geopolitical Outlook: Thunder And Lightning Hence the Saudis will not increase production substantially until they have assessed the global economy and discussed the outlook with the other members of the OPEC cartel in August and September, when the July 2021 agreement to increase production expires. We expect global demand to weaken as Europe and China continue to struggle. Our Commodity & Energy Strategist Bob Ryan argues that further escalation in the energy war between the EU and Russia could push prices above $220 per barrel by Q4 2023, whereas an economic collapse could push Brent down to $60 per barrel. His base case Brent price forecast remains $110 per barrel on average in 2022 and $117 per barrel in 2023 (Chart 7). Chart 6Saudis Will Pump To Prevent Recession Saudis Will Pump To Prevent Recession Saudis Will Pump To Prevent Recession ​​​​​​ Chart 7BCA's July 2022 Oil Price Forecast BCA's July 2022 Oil Price Forecast BCA's July 2022 Oil Price Forecast ​​​​​​ The geopolitical view suggests upside oil risks over the short-to-medium time frame but the macroeconomic view suggests that downside risks will be priced first. Bottom Line: Saudi Arabia may increase production but not at any US president’s beck and call. The Saudis are not focused on US elections, they benefit from the current level of prices, and they do not suffer if Republicans take Congress in November. The downside risk in oil prices stems from demand disappointments in global growth (especially China) rather than any immediate shifts in Saudi production discipline. Volatility will remain high. US-Iran Talks: Dying But Not Dead Yet In fact the Middle East underscores underlying and structural oil supply constraints despite falling global demand. While Iran is a perennial geopolitical risk, the world is reaching a critical juncture over the next couple of years. Investors should not assume that Iran can quietly achieve nuclear arms like North Korea. Since August 2021 we have argued that the US and Iran would fail to put back together the 2015 nuclear deal (the Joint Comprehensive Plan of Action or JCPA). This failure would in turn lead to renewed instability across the Middle East and sporadic supply disruptions as the different nations trade military threats and potentially engage in direct warfare. This forecast is on track after Biden’s and Putin’s trip – but we cannot yet say that it is fully confirmed. Biden’s joint declaration with Israeli Prime Minister Yair Lapid closed any daylight that existed between the US and Israel. Given that there was some doubt about the intentions of Biden and the Democrats, it is now crystal clear that the US is determined to prevent Iran from getting nuclear weapons even if it requires military action. The US specifically said that it will use “all instruments of national power” to prevent that outcome. Chart 8Iran Not Forced To Capitulate Iran Not Forced To Capitulate Iran Not Forced To Capitulate Judging by the tone of the statement, the Israelis wrote the document and Biden signed it.4 Biden’s foreign policy emphasizes shoring up US alliances and partnerships, which means letting allies and partners set the line. Israel’s Begin Doctrine – which says that Israel is willing to attack unilaterally and preemptively to prevent a hostile neighbor from obtaining nuclear weapons – has been reinforced. The US is making a final effort to intimidate Iran into rejoining the deal. By clearly and unequivocally reiterating its stance on nuclear weapons, and removing doubts about its stance on Israel, there is still a chance that the Iranian calculus could change. This is possible notwithstanding Ayatollah Khamenei’s friendliness with Putin and criticisms of western deception.5 After all, why would the Iranians want to be attacked by the US and Israeli militaries? Iran will need to think very carefully about what it does next. Khamenei just turned 83 years old and is trying to secure the Islamic Republic’s power transition and survival after his death. Here are the risks: Iran’s economy, buoyed by the commodity cycle, is not so weak as to force Khamenei to capitulate. Back in 2015 oil prices had collapsed and his country was diplomatically isolated. Today the economy has somewhat weathered the storm of the US’s maximum pressure sanctions (Chart 8). Iran is in bad shape but it has not been brought to its knees. Another risk is that Khamenei believes the American public lacks the appetite for war. Americans say they are weary of Middle Eastern wars and do not feel particularly threatened by Iran. However, this would be a miscalculation. US war-weariness is nearing the end of its course. The US engages in a major military expedition roughly every decade. Americans are restless and divided – and the political elite fear populism – so a new foreign distraction is not as unlikely as the consensus holds. Moreover a nuclear Iran is not an idle threat but would trigger a regional nuclear arms race and overturn the US grand strategy of maintaining a balance of power in the Middle East (as in other regions). In short, the US government can easily mobilize the people to accept air strikes to prevent Iran from going nuclear because there is latent animosity toward Iran in both political parties (Chart 9). Chart 9Risk: Iran Overrates US War-Weariness Biden And Putin Court The Middle East Biden And Putin Court The Middle East Another risk is that Iran forges ahead believing that the US and Israel are unwilling or unable to attack and destroy its nuclear program. The western powers might opt for containment like they did with North Korea or they might attack and fail to eliminate the program. This is hard to believe but Iran clearly cannot accept US security guarantees as an alternative to a nuclear deterrent when it seeks regime survival. At the same time Russia is courting Iran, encouraging it to join forces against the American empire. Iran is planning to sell drones to Russia for use in Ukraine, while Russia is maintaining nuclear and defense cooperation with Iran. Putin’s trip highlighted a growing strategic partnership despite a low base of economic ties  (Chart 10).6 Chart 10Russo-Iranian Ties Russo-Iranian Ties Russo-Iranian Ties ​​​​​​ Chart 11West Vulnerable To Middle East War Biden And Putin Court The Middle East Biden And Putin Court The Middle East While Russia does not have an interest in a nuclear-armed Iran, it is not afraid of Iran alone, and it would benefit enormously if the US and Israel got bogged down in a new war that destabilized the Middle East. Oil prices would rise, the US would be distracted, and Europe would be even more vulnerable (Chart 11). Chart 12China's Slowdown And Dependency On Middle East China's Slowdown And Dependency On Middle East China's Slowdown And Dependency On Middle East China’s interest is different. It would prefer for Iran to undermine the West by means of a subtle and long-term game of economic engagement rather than a destabilizing war in the region that would upset China’s already weak economy. However, Beijing will not join with the US against Iran, especially if Iran and Russia are aligned. Ultimately China needs to access Iranian energy reserves via overland routes so that it gains greater supply security vis-à-vis the American navy (Chart 12). Since June 2019, we have maintained 40% odds of a military conflict with Iran. The logic is outlined in Diagram 1, which we have not changed. Conflict can take various forms since the western powers prefer sabotage or cyber-attacks to outright assault. But in the end preventing nuclear weapons may require air strikes – and victory is not at all guaranteed. We are very close to moving to the next branch in Diagram 1, which would imply odds of military conflict rise from 40% to 80%. We are not making that call yet but we are getting nervous. Diagram 1Iran Nuclear Crisis: Decision Tree Biden And Putin Court The Middle East Biden And Putin Court The Middle East Moreover it is the saber rattling around this process – including an extensive Iranian campaign to deter attack – that will disrupt oil distribution and transport sooner rather than later. Bottom Line: The US and Iran could still find diplomatic accommodation to avoid the next step in our decision tree. Therefore we are keeping the odds of war at a subjective 40%. But we have reached a critical juncture. The next step in the process entails a major increase in the odds of air strikes. Putin’s Supply Squeeze Will Continue As we go to press, financial markets are reacting to President Putin’s marginal easing of Russian political pressure on food and energy supplies. First, Putin took steps toward a deal, proposed by Turkish President Erdogan, to allow Ukrainian grain exports to resume from the Black Sea. Second, Putin allowed a partial restart of the Nord Stream 1 natural gas pipeline, after a total cutoff occurred during the regular, annual maintenance period. However, these moves should be kept into perspective. Nord Stream 1 is still operating at only 40% of capacity. Russia reduced the flow by 60% after the EU agreed to impose a near-total ban on Russian oil exports by the end of the year. Russia is imposing pain on the European economy in pursuit of its strategic objectives and will continue to throttle Europe’s natural gas supply. Russia’s aims are as follows: (1) break up European consensus on Russia and prevent a natural gas embargo from being implemented in future (2) pressure Europe into negotiating a ceasefire in Ukraine that legitimizes Russia’s conquests (3) underscore Russia’s new red line against NATO military deployments in Finland and Sweden. Europe, for its part, will continue to diversify its natural gas sources as rapidly as possible to reduce Russia’s leverage. The European Commission is asking countries to decrease their natural gas consumption by 15% from August to March. This will require rationing regardless of Russia’s supply squeeze. The collapse in trust incentivizes Russia to use its leverage while it still has it and Europe to try to take that leverage away. The economic costs are frontloaded, particularly this winter. The same goes for the Turkish proposal to resume grain exports. Russia will continue to blockade Ukraine until it achieves its military objectives. The blockade will be tightened or loosened as necessary to achieve diplomatic goals. Part of the reason Russia invaded in the first place was to seize control of Ukraine’s coast and hold the country’s ports, trade, and economy hostage. Bottom Line: Russia’s relaxation of food and energy flows is not reliable. Flows will wax and wane depending on the status of strategic negotiations with the West. Europe’s economy will continue to suffer from a Russia-induced supply squeeze until Russia achieves a ceasefire in Ukraine. So will emerging markets that depend on grain imports, such as Turkey, Egypt, and Pakistan. Investment Takeaways The critical juncture has arrived for our Iran view. If Iran does not start returning to nuclear compliance soon, then a fateful path of conflict will be embarked upon. The Saudis will not give Biden more oil barrels just yet. But they may end up doing that if global demand holds up and the US reassures them that their regional security needs will be met. First, the path for oil over the next year will depend on the path of global demand. Our view is negative, with Europe heading toward recession, China struggling to stimulate its economy effectively, and the Fed unlikely to achieve a soft landing. Second, the path of conflict with Iran will lead to a higher frequency of oil supply disruptions across the Middle East that will start happening very quickly after the US-Iran talks are pronounced dead. In other words, oil prices will be volatile in a stagflationary environment. In addition, while inflation might roll over for various reasons, it is not likely to occur because of any special large actions by Saudi Arabia. The Saudis are waiting on global cues. Of these, China is the most important. We are booking a 17% gain on our long gold trade as real rates rise and China’s economy deteriorates (Chart 13). This is in line with our Commodity & Energy Strategy, which is also stepping aside on gold for now. Longer term we remain constructive as we see a secular rise in geopolitical risk and persistent inflation problems. Chart 13Book Gains On Gold ... For Now Book Gains On Gold ... For Now Book Gains On Gold ... For Now We are booking an 18% gain on our long European defense / short European tech trade. Falling bond yields will benefit European tech (Chart 14). We remain bullish on European and global defense stocks. Chart 14Book Gains On EU Defense Vs Tech ... For Now Book Gains On EU Defense Vs Tech ... For Now Book Gains On EU Defense Vs Tech ... For Now ​​​​​​ Chart 15Markets Underrate Middle East Geopolitical Risk Biden And Putin Court The Middle East Biden And Putin Court The Middle East ​​​​​ Stay long US equities relative to UAE equities. Middle Eastern geopolitical risk is underrated (Chart 15). Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1      The White House, “The Jerusalem U.S.-Israel Strategic Partnership Joint Declaration,” July 14, 2022, whitehouse.gov. 2     Israel and the US will remove international peacekeepers from the formerly Egyptian Red Sea islands of Tiran and Sanafir, which clears the way for Saudi Arabia to turn them into tourist destinations. Saudi Arabia also removed its tight airspace restrictions on Israel, enabling civilian Israeli airlines to fly through Saudi airspace on normal basis. Of course, Saudi allowance for Israeli military flights to pass through Saudi airspace would be an important question in any future military operation against Iran. 3     The US has long wanted regional missile defense integration. The Biden administration is proposing “integrated air defense cooperation” that would include Israel as well as the Gulf Cooperation Council (GCC). A regional “air and missile defense architecture” would counter drones and missiles from rival states and non-state actors such as Iran and its militant proxies. Simultaneously the Israelis are putting forward the proposed Middle East Air Defense Alliance (MEAD) in meetings with the same GCC nations. Going forward, Iran’s nuclear ambitions will give more impetus to these attempts to cooperate on air defense. 4     This is apparent from the hard line on Iran and the relatively soft line on Russia in the document. Israel is wary of taking too hard of a line against Russia because of its security concerns in Syria where Russian forces are present. See footnote 1 above. 5     Khamenei called for long-term cooperation between Russia and Iran; he justified Russia’s invasion of Ukraine as a defense against NATO encroachment; he called for the removal of the US dollar as the global reserve currency. See “Khamenei: Tehran, Moscow must stay vigilant against Western deception,” Israel Hayom, July 20, 2022, israelhayom.com. 6     Russia’s natural gas champion Gazprom signed an ostensible $40 billion memorandum of understanding with Iran’s National Oil Company to develop gas fields and pipelines. See Nadeen Ebrahim, “Iran and Russia’s friendship is more complicated than it seems,” CNN, July 20, 2022, cnn.com. However, while there are longstanding obstacles to Russo-Iranian cooperation, the West’s tough new sanctions on Russia and EU diversification will make Moscow more willing to invest in Iran. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

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

Executive Summary China's Unemployment Questions From The Road Questions From The Road Over the past week we have been visiting clients along the US west coast. In this report we hit some of the highlights from the most important and frequently asked questions. Xi Jinping is seizing absolute power just as the country’s decades-long property boom turns to bust. He will stimulate the economy but Chinese stimulus is less effective than it used to be. The US and Israel are underscoring their red line against Iranian nuclear weaponization. If Iran does not freeze its nuclear program, the Middle East will begin to unravel again. The UK’s domestic instability is returning, with Scotland threatening to leave the union. Brexit, the pandemic, and inflation make a Scottish referendum a more serious risk than in the past. Shinzo Abe’s assassination makes him a martyr for a vision of Japan as a “normal country” – i.e. one that is not pacifist but capable of defending itself. Japan’s rearmament, like Germany’s, points to the decline of the WWII peace settlement and the return of great power competition. Bottom Line: Investors need a new global balance to be achieved through US diplomacy with Russia, China, and Iran. That is not forthcoming, as the chief nations face instability at home and a stagflationary global economy. Feature The world is becoming less stable as stagflation combines with great power competition. Global uncertainty is through the roof. From a macroeconomic perspective, investors need to know whether central banks can whip inflation without triggering a recession. From a geopolitical perspective, investors need to know whether Russia’s conflict with the West will expand, whether US-China and US-Iran tensions will escalate in a damaging way, and whether domestic political rotations in the US and China this fall will lead to more stable and productive economies. China: What Will Happen At The Communist Party Reshuffle? General Secretary Xi Jinping will cement another five-to-10 years in power while promoting members of his faction into key positions on the Politburo and Politburo Standing Committee. By December Xi will roll out a pro-growth strategy for 2023 and the government will signal that it will start relaxing Covid-19 restrictions. But China’s structural problems ensure that this good news for global growth will only have a fleeting effect. China’s governance is shifting from single-party rule to single-person rule. It is also shifting from commercially focused decentralization to national security focused centralization. Xi has concentrated power in himself, in the party, and in Beijing at the expense of political opponents, the private economy, and outlying regions like Hong Kong, the South China Sea, and Xinjiang. The subordination of Taiwan is the next major project, ensuring that China will ally with Russia and that the US and China cannot repair or deepen their economic partnership. Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Xi and the Communist Party began centralizing political power and economic control shortly after the Great Recession. At that time it became clear that a painful transition away from export manufacturing and close relations with the United States was necessary. The transition would jeopardize China’s long-term economic, social, political, and geopolitical stability. The Communist Party believed it needed to revive strongman leadership (autocracy) rather than pursuing greater liberalization that would ultimately increase the odds of political revolution (democratization). The Xi administration has struggled to manage the country’s vast debt bubble, given that total debt standing has surged to 287% of GDP. The global pandemic forced the government to launch another large stimulus package, which it then attempted to contain. Corporate and household deleveraging ensued. The property and infrastructure boom of the past three decades has stalled, as the regime has imposed liquidity and capital requirements on banks and property developers to try to avoid a financial crisis. Regulatory tightening occurred in other sectors to try to steer investment into government-approved sectors and reduce the odds of technological advancement fanning social dissent. China’s draconian “zero Covid” policy sought to limit the disease’s toll, improve China’s economic self-reliance, and eliminate the threat of social protest during the year of the twentieth party congress. But it also slammed the brakes on growth. China is highly vulnerable to social instability for both structural and cyclical reasons. Chinese social unrest was our number one “Black Swan” for this year and it is now starting to take shape in the form of angry mortgage owners across the country refusing to make mortgage payments on houses that were pre-purchased but not yet built and delivered (Chart 1). Chart 1China: Mortgage Payment Boycott Questions From The Road Questions From The Road The mortgage payment boycott is important because it is stemming from the outstanding economic and financial imbalance – the property sector – and because it is a form of cross-regional social organization, which the Communist Party will disapprove. There are other social protests emerging, including low-level bank runs, which must be monitored very closely. Local authorities will act quickly to stop the spread of the mortgage boycott. But unhappy homeowners will be a persistent problem due to the decline of the property sector and industry. China’s property sector looks uncomfortably like the American property sector ahead of the 2006-08 bust. Prices for existing homes are falling while new house prices are on the verge of falling (Chart 2). While mortgages only make up 15% of bank assets, and household debt is only 62% of GDP, households are no longer taking on new debt (Chart 3). Chart 2China's Falling Property Prices China's Falling Property Prices China's Falling Property Prices ​​​​​​ Chart 3China's Property Crisis China's Property Crisis China's Property Crisis ​​​​​​ Chart 4China's Unemployment China's Unemployment China's Unemployment Most likely China’s property sector is entering the bust phase that we have long expected – if not, then the reason will be a rapid and aggressive move by authorities to expand monetary and fiscal stimulus and loosen economic restrictions. That process of broad-based easing – “letting 100 flowers bloom” – will not fully get under way until after the party congress, say in December. Unemployment is rising across China as the economy slows, another point of comparison with the United States ahead of the 2008 property collapse (Chart 4). Unemployment is a manipulated statistic so real conditions are likely worse. There is no more important indicator. China’s government will be forced to ease policy, creating a positive impact on global growth in 2023, but the impact will be fleeting. Bottom Line: The underlying debt-deflationary context will prevail before long in China, weighing on global growth and inflation expectations on a cyclical basis. Middle East: Why Did Biden Go And What Will He Get? President Biden traveled to Israel and now Saudi Arabia because he wants Saudi Arabia and the Gulf Arab members of OPEC to increase oil production to reduce gasoline prices at the pump for Americans ahead of the midterm elections (Chart 5). Chart 5Biden Goes To Israel And Saudi Arabia Biden Goes To Israel And Saudi Arabia Biden Goes To Israel And Saudi Arabia True, fears of recession are already weighing on prices, but Biden embarked on this mission before the growth slowdown was fully appreciated and he is not going to lightly abandon the anti-inflation fight before the midterm election. Biden also went because one of his top foreign policy priorities – the renegotiation of the 2015 nuclear deal with Iran – is falling apart. The Iranians do not want to freeze their nuclear program because they want regime survival and security. While Biden is offering a return to the 2015 deal, the conditions that produced the deal are no longer applicable: Russia and China are not cooperating with the US and EU to isolate Iran. Russia is courting Iran, oil prices are high and sanction enforcement is weak (unlike 2015). The Iranians now know, after the Trump administration, that they cannot trust the Americans to give credible security guarantees that will last across parties and administrations. The war in Ukraine also underscores the weakness of diplomatic security guarantees as opposed to a nuclear deterrent. Hence the joint US and Israeli declaration that Iran will never be allowed to obtain nuclear weapons. The good news is that this kind of joint statement is precisely what needed to occur – the underscoring of the red line – to try to change Ayatollah Ali Khamenei’s calculus regarding his drive to achieve nuclear breakout. In 2015 Khamenei gave diplomacy a chance to try to improve the economy, stave off social unrest, prepare the way for his eventual leadership succession process, and secure the Islamic Republic. The bad news is that Khamenei probably cannot make the same decision this time, as the hawkish faction now runs his government, the Americans are unreliable, and Russia and China are offering an alternative strategic orientation. The Saudis will pump more oil if necessary to save the global business cycle but not at the beck and call of a US president. The drop in oil prices reduces their urgency. The Americans can reassure the Saudis and Israel as long as the deal with Iran is not going forward. That looks to be the case. But then the US and Israel will have to undertake joint actions to underline their threat to Iran – and Iran will have to threaten to stage attacks across the region so as to deter any attack. Bottom Line: If a US-Iran deal does not materialize at the last minute, Middle Eastern instability will revive and a new source of oil supply constraint will plague the global economy. We continue to believe a US-Iran deal is unlikely, with only 40% odds of happening. Europe: Will Russia Turn Back On The Natural Gas? Russia’s objective in cutting off European natural gas is to inflict a recession on Europe. It wants a better bargaining position on strategic matters. Therefore we assume Russia will continue to squeeze supplies from now through the winter, when European demand rises and Russian leverage will peak. If Russia allows some flow to return, then it will be part of the negotiating process and will not preclude another cutoff before winter. It is possible that Russia is merely giving Europe a warning and will revert back to supplying natural gas. The problem is that Russia’s purpose is to achieve a strategic victory in Ukraine and in negotiations over NATO’s role in the Nordic countries. Russia has not achieved these goals, so natural gas cutoff will likely continue. Russia also hopes that by utilizing its energy leverage – while it still has it – it will bring forward the economic pain of Europe’s transition away from reliance on Russian energy. In that case European countries will experience recession and households will begin to change their view of the situation. European governments will be more likely to change their policies, to become more pragmatic and less confrontational toward Russia. Or European governments will be voted out of power and do the same thing. Other states could join Hungary in saying that Europe should never impose a full natural gas embargo on Russia. Russia would be able to salvage some of its energy trade with Europe over the long run, despite the war in Ukraine and the inevitable European energy diversification. In recent months we highlighted Italy as the weakest link in the European chain and the country most likely to see such a shift in policy occur. Italy’s national unity coalition had lost its reason for being, while the combination of rising bond yields and natural gas prices weighed on the economy. The Italian bond spread over German bunds has long served as our indicator of European political stress – and it is spiking now, forcing the European Central Bank to rush to plan an anti-fragmentation strategy that would theoretically enable it to tighten monetary policy while preventing an Italian debt crisis (Chart 6). The European Union remains unlikely to break up – Russian aggression was always one of our chief arguments for why the EU would stick together. But Italy will undergo a recession and an election (due by June 2023 but that could easily happen this fall), likely producing a new government that is more pragmatic with regard to Russia so as to reduce the energy strain. Chart 6Italy's Crisis Points To EU Divisions On Russia Italy's Crisis Points To EU Divisions On Russia Italy's Crisis Points To EU Divisions On Russia Italy’s political turmoil shows that European states are feeling the energy crisis and will begin to shift policies to reduce the burden on households. Households will lose their appetite for conflict with Russia on behalf of Ukrainians, especially if Russia begins offering a ceasefire after completing its conquest of the Donetsk area. If Russia expands its invasion, then Europe will expand sanctions and the risk of further strategic instability will go up. But most likely Russia will seek to quit while it is ahead and twist Europe’s arm into foisting a ceasefire onto Ukraine. Bottom Line: A change of government in Italy will increase the odds that the EU will engage in diplomacy with Russia in the coming year, if Russia offers, so as to reach a new understanding, restore natural gas flows, and salvage the economy. This would leave NATO enlargement unresolved but a shift in favor of a ceasefire in Ukraine in 2023 would be less negative for European assets and the euro. UK: Who Will Replace Boris Johnson? Last week UK Prime Minister Boris Johnson fell from power and now the Conservative Party is engaging in a leadership competition to replace him. We gave up on Johnson after he survived his no-confidence vote and yet it became clear that he could not recover in popular opinion. The inflation outburst destroyed his premiership and wiped away whatever support he had gained from executing Brexit. In fact it reinforced the faction that believed Brexit was the wrong decision. Going forward the UK will be consumed with domestic political turmoil as the cost of stagflation mounts, and geopolitical turmoil as Scotland attempts to hold a second independence referendum, possibly by October 2023. Global investors should focus primarily on Scotland’s attempt to secede, since the breakup of the United Kingdom would be a momentous historical event and a huge negative shock for pound sterling. While only 44.7% of Scots voted for independence in 2014, now they have witnessed Brexit, Covid-19, and stagflation, producing tailwinds for the Scots nationalist vote (Chart 7). Chart 7Forget Bojo's Exit, Watch Scotland Questions From The Road Questions From The Road There are still major limitations on Scotland exiting, since its national capabilities are limited, it would need to join the European Union, and Spain and possibly others will threaten to veto its membership in the European Union for fear of feeding their own secessionist movements. But any new referendum – including one done without the approval of Westminster – should be taken very seriously by investors. Bottom Line: Johnson’s removal will only marginally improve the Tories’ ability to manage the rebellion brewing in the north. A snap election that brings the Labour Party back into power would have a greater chance of keeping Scotland in the union, although it is not clear that such a snap election will happen in time to affect any Scottish decision. The UK faces economic and political turmoil between now and any referendum and investors should steer clear of the pound. (Though we still favor GBP over eastern European currencies). Britain will remain aggressive toward Russia but its ability to affect the Russian dynamic will fall, leaving the US and EU to decide the fate of Russian relations. Japan: What Is The Significance Of Shinzo Abe’s Assassination? Former Japanese Prime Minister Shinzo Abe was assassinated by a lone fanatic with a handmade gun. The significance of the incident is that Abe will become a martyr for a certain vision of Japan – his vision of Japan, which is that Japan can become a “normal country” that moves beyond the shackles of the guilt of its imperial aggression in World War II. A normal country is one that is economically stable and militarily capable of defending itself – not a pacifist country mired in debt-deflation. Abe stood for domestic reflation and a proactive foreign policy, along with the normalization of the Japanese Self-Defense Forces (JSDF). True, economic policy can become less dovish if necessary to deal with inflation. Some changes at the Bank of Japan may usher in a less dovish shift in monetary policy in particular. But monetary policy cannot become outright hawkish like it was before Abe. And Abe’s fiscal policy was never as loose as it was made out to be, given that he executed several hikes to the consumption tax. Japan’s structural demographic decline and large debt burden will continue to weigh on economic activity whenever real rates and the yen rise. The government will be forced to reflate using monetary and fiscal policy whenever deflation threatens to return. Debt monetization will remain an option for future Japanese governments, even if it is restrained during times of high inflation. Chart 8Shinzo Abe's Legacy Questions From The Road Questions From The Road ​​​​​​​ This is not only because Japanese households will become depressed if deflation is left unchecked but also because economic growth must be maintained in order to sustain the nation’s new and growing national defense budgets. Japan’s growing need for self defense stems from China’s strategic rise, Russia’s aggression, and North Korea’s nuclearization, plus uncertainty about the future of American foreign policy. These trends will not change anytime soon. Indeed the Liberal Democratic Party’s popularity has increased under Abe’s successor, Prime Minister Fumio Kishida, who will largely sustain Abe’s vision. The Diet still has a supermajority in favor of constitutional revision so as to enshrine the self-defense forces (Chart 8). And the de facto policy of rearmament continues even without formal revision. Bottom Line: Any Japanese leader who attempts to promote a hawkish BoJ, and a dovish JSDF, will fail sooner rather than later. The revolving door of prime ministers will accelerate. As Japan’s longest-serving prime minister, Shinzo Abe opened up the reliable pathway, which is that of a dovish BoJ and a hawkish foreign policy. This is important for the world, as well as Japan, because a more hawkish Japan will increase China’s fears of strategic containment. The frozen conflicts in Asia will continue to thaw, perpetuating the secular rise in geopolitical risk. We remain long JPY-KRW, since the BoJ may adjust in the short term and Chinese stimulus is still compromised, but that trade is on downgrade watch. Investment Takeaways Russia’s energy cutoff is aimed at pushing Europe into recession so as to force policy changes or government changes in Europe that will improve Russia’s position at the negotiating table over Ukraine, NATO, and other strategic disputes. Hence Russia is unlikely to increase the natural gas flow until it believes it has achieved its strategic aims and multiple veto players in the EU will prevent the EU from ever implementing a full-blown natural gas embargo. Chinese stimulus cannot be fully effective until it relaxes Covid-19 restrictions, likely beginning in December or next year when Xi Jinping uses his renewed political capital to try to stabilize the economy. However, China’s government powers alone are insufficient to prevent the debt-deflationary tendency of the property bust. The Middle East faces rising geopolitical tensions that will take markets by surprise with additional energy supply constraints. The implication is continued oil volatility given that global growth is faltering. Once global demand stabilizes, the Middle East’s turmoil will add to existing oil supply constraints to create new price pressures. The odds are not very high of the Federal Reserve achieving a “soft landing” in the context of a global energy shock and a stagflationary Europe and China.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com ​​​​​​​ Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades () Section II: Special (EDIT this Header) Section III: Geopolitical Calendar

Executive Summary Further GDP Weakness Would Push Brent Lower Further GDP Weakness Would Push Brent Lower Further GDP Weakness Would Push Brent Lower Markets remain alert for indications of what Russia will do next. Last week, President Vladimir Putin threatened “catastrophic consequences” if G7 states are able to impose a price cap on Russian oil sales. A sharp drop in output – more than 3mm b/d – would send prices sharply higher, and could not be replaced in 2H22. KSA and the UAE are signaling their limited ability to significantly increase oil output ahead of US President Joseph Biden’s visit to the region later this week. Our simulation of demand losses of ~500k b/d in 2H22 and ~1.0mm b/d in 2023 suggests Brent could fall $7/bbl to $108/bb in 2H22 and $8/bbl to $109/bbl in 2023, all else equal. A Russian court decision last week briefly halted flows on the Caspian Pipeline Consortium’s (CPC) 1.3mm b/d line moving Kazakh oil to the Black Sea through Russia, adding a new variable into supply-side modeling. A trivial fine was levied, but a larger message was delivered. Sporadic force majeure declarations and output losses in Libya, where Russian mercenaries actively support Khalifa Haftar’s Libyan National Army (LNA), continue to make supply assessments difficult. Bottom Line: Tight supply fundamentals will keep oil markets volatile and biased to the upside, despite recurrent recession fears overwhelming demand expectations.  While a deep recession cannot be discounted, we remain focused on the objective fact of physically tight markets, and Russia's political-economy considerations affecting the evolution of prices. Feature Anyone who has spent time in trading markets will appreciate the implications of a $65-at-$380/bbl bid-ask spread on Brent. This two-way quote represents worst cases scenarios on the demand and supply sides of the market. And huge uncertainty. The bid comes from Citi’s recession-driven view, while the offer is courtesy of JP Morgan’s worst-case supply-shock assessment – i.e., Russia pulling 5mm b/d off the market if G7 states impose a price cap on its exports.1 Related Report  Commodity & Energy StrategyCopper Prices Decouple From Fundamentals Of late, demand-side concerns are driving markets, along with other technical factors we discussed in last week’s report on copper: low liquidity in trading markets; elevated global policy uncertainty, as seen by the two-way quote above; worries Fed tightening will overshoot the mark as it attempts to control hotter inflation, and an expansion of Russia’s economic war that now engulfs Ukraine.2 The latter point touches on events that cross commodity markets globally: Russia is threatening “catastrophic consequences” if G7 states impose a price cap on its oil sales. This goes directly to the supply side, as it most likely entails a dramatic gesture to reduce crude oil output sharply – i.e., more than 3mm b/d – which would send prices soaring. Russia’s coffers are in excellent shape at present, given the high prices its oil, gas and coal producers have been able to fetch since it invaded Ukraine.3 In our modeling, if Russia were to cut the 2.3mm b/d of crude and condensate it sent to Europe last year, Brent prices would move above $140/bbl.4 Higher volumes taken off the market would result in higher prices. These factors all interact with each other producing feedback loops – e.g., higher uncertainty causes lower liquidity in hedging markets and wider bid-ask spreads on smaller volumes – affecting decisions on everything from capex levels to headcounts. Demand Concerns Consume Markets Last month, we lowered our Brent forecast for this year and next to $110/bbl and $117/bbl, respectively, on the back of a sharp downgrade in global growth expectations from the World Bank. The Bank’s forecast prompted us to reduce our 2022 oil demand growth forecast to 2.0mm b/d this year vs 4.8mm b/d in our January forecast, and, for next year, to 1.8mm b/d. Given the obvious concern in markets, we simulated another hit to demand of 500k b/d in 2H22 and 1.0mm b/d next year, due to a further markdown in real GDP growth. This scenario brings our demand growth expectation down to 1.5mm b/d this year and 800k b/d next year. In this simulation, the lower GDP growth takes our average price expectation for 2H22 to $108/bbl and $109/bbl next year, or $7/bbl and $8/bbl lower, respectively (Chart 1). The lower demand we model here is offset to some degree by our maintained hypothesis that OPEC 2.0 – particularly its core producers Saudi Arabia and the UAE – will temper production somewhat (Chart 2), so as not to produce very large unintended inventory accumulations (Chart 3). Chart 1Further GDP Weakness Would Push Brent Lower Further GDP Weakness Would Push Brent Lower Further GDP Weakness Would Push Brent Lower This concern is particularly acute if these producers receive new information that demand is slowing more than they expected. We are certain this will come up when US President Biden is in Riyadh later this week to meet Saudi Crown Prince Mohammed bin Salman Al Saud (MBS), to again discuss, among other things, the Kingdom’s ability and willingness to increase supply. Chart 2Core OPEC 2.0 Will Temper Production Increases... Core OPEC 2.0 Will Temper Production Increases... Core OPEC 2.0 Will Temper Production Increases... Chart 3...To Avoid Unintended Inventory Accumulations ...To Avoid Unintended Inventory Accumulations ...To Avoid Unintended Inventory Accumulations Russia Exerts Supply-Side Influence Russia is at war with Ukraine and the West – i.e., the G7 and NATO states arming and actively seeking to limit its access to revenues from the sale of hydrocarbons. Russia is treating this as a war, and it is operating on multiple fronts, in addition to its kinetic engagement with Ukrainian forces. In a market as finely balanced and uncertain as the current one, small, unexpected shifts in supply or demand can have outsized effects. Last week, for example, a decision by a Russian court briefly halted flows on the Caspian Pipeline Consortium’s (CPC) 1.3mm b/d line moving Kazakh oil to the Black Sea. This boosted prices more than 5% over the ensuing couple of days. Flows were allowed to resume after trivial fine was paid and prices fell. But a larger message was delivered. This remains a powerful lever Moscow can use at a moment’s notice to tighten supplies. Opportunities elsewhere in oil-producing provinces also are continuously cultivated by Russian operatives to influence supplies. Sporadic public demonstrations and force majeure declarations have led to output losses in Libya, where Russian mercenaries actively support Khalifa Haftar’s Libyan National Army (LNA). This continues to make supply assessments difficult. Libya currently produces ~ 650k b/d, according to the US EIA, down from ~ 1.12mm b/d in 4Q21. As in many things, Russia’s playing a game of chess with its opponents and forcing them to react to its threats and decisions. And this strategy is not limited to Ukraine, the EU or oil. For example, the seizure of Shell’s ownership in the Sakhalin-2 LNG facilities by Russia’s state-owned Gazprom was described by The Journal of Petroleum Technology (JPT) as a “backdoor” nationalization of Shell’s interest. This will have long-term consequences far removed from the Ukraine War, and could affect LNG deliveries to Japan and South Korea, which will become critical in a super-tight LNG market going into winter. This couldn’t be more timely, as Japan and South Korean – in a first-ever event – attended the end-June NATO meeting.5 Investment Implications Russia’s war against Ukraine has multiple dimensions, all of which can impact oil and gas prices going forward. Despite the obvious concerns over a deep recession reducing global oil demand – and commodity demand generally – we continue to focus on the objective fact of physically tight markets, and Russia's political-economy considerations affecting the evolution of prices. This informs our view that prices will remain volatile with a significant bias to the upside. Small, unexpected shocks in a fundamentally tight market on the supply side support our view prices will move higher.   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 Whether the EU can avoid rationing – and fill its natural-gas storage – ahead of winter will depend on what Russia does with its exports of the gas exported on Nord Stream 1 (NS1) and other pipes (Chart 4). We believe Russia will cut off most of its exports to the EU before winter sets in. It likely will use use the current 10-day maintenance on NS1, which began Monday, as a pretext to cut supplies, in retaliation for the EU cutting off crude oil and refined products imports. President Putin of Russia most likely will offer to keep the gas flowing so inventories can be refilled, in return for the EU lifting sanctions it imposed following Russia's invasion of Ukraine. Precious Metals: Bullish June headline US CPI was reported at 9.1% yoy, continuing the streak of rising prices. The Fed will need to aggressively hike rates to bring price levels lower, raising the risk of plunging the US into a recession. Recession fears will reduce long-term bond yields and should support gold prices. While high inflation is good for gold, the yellow metal saw investment outflows during May and June, as investors opt for the USD as a safe-haven asset. Ags/Softs: Neutral Food prices fell for the third straight month in June, but still are near historic highs following Russia’s invasion of Ukraine.6 Wheat prices fell by 5.7% in June but was still higher by 48.5% compared to 2021 (Chart 5).7 This might be down to recession fears, or, more likely, due to better crop conditions, seasonal availability from new harvests in the northern hemisphere, and more exports from Russia. The UN’s FAO warned factors that drove global prices higher still persist. Russia is expected to harvest one of its largest wheat crops since the fall of the Soviet Union.8 According to the 2022/23 USDA outlook, there will be less supplies and consumption, higher exports and stocks.9 Chart 4 Russia Pulls Oil, Gas Supply Strings Russia Pulls Oil, Gas Supply Strings Chart 5 Wheat Price Level Going Down Wheat Price Level Going Down   Footnotes 1     Please see Citigroup says oil prices could tumble to $65 by the end of the year if a recession whacks demand, published by businessinsider.com on July 5, 2022, and Oil could hit $380 if Russia slashes output over price cap, J.P.Morgan says, published by reuters.com on July 4, 2022. 2     Please see Copper Prices Decouple From Fundamentals published on July 7, 2022. 3    Please see Russia sees extra $4.5 billion in July budget revenue on higher oil prices published by reuters.com on July 5, 2022. 4    Please see Oil, Natgas Prices Set To Surge, which we published on May 19, 2022.  It is available at ces.bcaresearch.com. 5    Please see Japan and South Korea's Attendance at the Upcoming NATO Summit Could Worsen Global Tensions, published by time.com on June 16, 2022. 6    Please see Global food prices may be falling, but economist warns Asia’s food costs could still soar published by CNBC on July 11, 2022. 7     Please see Wheat, Corn Prices Tempered- Easing Global Food Cost Concerns published by University of Illinois on July 1, 2022 . 8    Please see Dollar rises to 20-year highs, sends grains lower published by FarmProgress on July 12, 2022. 9    Please see Grain: World Market and Trade published by USDA on July 12, 2022.   Investment Views and Themes Strategic Recommendations Tactical Trades Trades Closed in 2022

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 Unhappy Households Make Unhappy Voters Unhappy Households Make Unhappy Voters Unhappy Households Make Unhappy Voters US polarization while down is still near historic peaks. Negative sentiments are forming among households and businesses due to inflation and high gas price, which makes fiscal expansion unlikely in the near future. President Biden is running out of options to shore the Democrats’ political capital ahead of the midterm. Biden will resort to using executive orders and move on to foreign affairs as the legislative route is blocked. More actions in the international realm will inject geopolitical risks in an already volatile year. Asset Initiation Date Return Long US Health Care Vs. S&P 500 2021-06-30 13.5% Bottom Line: Higher political risk in the near term warrants a defensive posture. Feature Dear Client, This week’s report is brought to you by Jesse Kuri, Associate Editor of our US Political Strategy. Jesse provides an update of our US Political Capital Index, which enables us to quantify the Biden administration’s ability to get things done. Jesse measures precisely how far Biden’s political capital has fallen since his election in November 2020 and highlights the key indicators investors should monitor to assess whether the administration can regain effectiveness after the midterm election.  Jesse also updates our US Equity Sector Political Risk Matrix, which combines insights from our US Equity Strategist Irene Tunkel with our own assessments of whether politics will add upside or downside risk to each sector. Health care stocks are notable for facing policy risks skewed to the upside. All very best, Matt Gertken, Chief US Political Strategist Last week, the Supreme Court delivered two political shocks to the system. On June 23rd, the Supreme Court ruled that New York’s state limit on carrying guns in public violates the Second Amendment. Furthermore, on June 24th, the court delivered what was well known for almost a month: A ban on abortion by the state of Mississippi is constitutional, overturning a 49-year-old precedent set up by Roe v. Wade. Both rulings are set to aggravate the already elevated political tensions in the US. Related Report  US Political StrategyThe Supreme Court And Midterm Elections The high court rulings overshadowed a momentous bipartisan move in Congress – the passage of the first gun control bill in almost 30 years on June 24th. 15 Republican Senators and 14 Republican House Members joined their Democratic colleagues to pass the Bipartisan Safer Communities Act. This bill includes more stringent background checks for gun buyers younger than 21 years of age, more funding for mental health care programs, federal funding to encourage states to implement red flag laws to take guns away from questionable owners, and the closing of the boyfriend loophole. So, how should investors reconcile the seemingly contradictory moves in US politics: Extreme polarization and unrest punctuated by moments of bipartisanship? Investors should ignore the US gun law — and instead focus on women’s support of Biden in coming months. If women start becoming more active in voting and start approving Democrats much more than expected, then that will help Democrats marginally. But it will not likely change the outcome of the midterm, which favors Republicans heavily in the House at least. Is President Biden’s political capital too low to save his party from a political reckoning this year? Most likely the answer is yes. Biden’s Political Capital Roundup Political Polarization Chart 1Polarization: Declining But Near Peak Polarization: Declining But Near Peak Polarization: Declining But Near Peak It would be easier to push for a policy in a less divided country, as there is a consensus on what constitutes good policy among the stakeholders. But a country that is depolarizing in times of economic stress is a negative for the political capital of the government of the day, as there is a consensus that times are tough, and the acting government will be blamed for this. In June, our polarization proxy, constructed by differencing Democrats’ and Republicans’ approval of President Biden, increased. The polarization proxy increased as Democrats’ approval of Biden rose while Republicans’ approvals remained flat, relative to their respective levels in May. Also in May, our economic sentiment polarization indicator, which is the difference between the economic sentiment of Democrats and Republicans, increased from its level in April, as Republicans’ sentiment declined by 25%, while Democrats’ sentiment only fell by 7%. On the other hand, the Philadelphia Fed Partisan Conflict Index, another indicator that the US Political Strategy team tracks, declined in May. This is not surprising considering that this indicator is constructed by the Philly Fed from news headlines which had either been dominated by the war in Ukraine or by the skyrocketing inflation. The only other time that this indicator declined was during the pandemic because everyone was in agreement that the pandemic is a negative event, just like the war in Ukraine and inflation. All three indicators are below their respective levels of November 2020. While polarization declined, it is still close to its peak in 2019-2020 (Chart 1). Household Sentiment Chart 2Biden's Approval Plumbing New Lows Biden's Approval Plumbing New Lows Biden's Approval Plumbing New Lows A government with a high approval rating among households can afford to pass policies and painful reforms, as it is less likely to be punished at the ballot box if voters are happy. Unfortunately for President Biden, his approval rating is plumbing new lows; the American Rescue Plan, loose monetary policy, and external geopolitical shocks have all resulted in US inflation reading that were last seen 40 years ago. As a result, Biden was never rewarded by voters for the passage of the American Rescue Plan and the Infrastructure Investment and Jobs Act. To shore up his and the Democrats’ political capital, Biden is now attempting to strike deals with partners and adversaries in Europe, the Middle East, and China, but they are not likely to lend him or the Democrats a helping hand; and, even if deals could be reached, the damage to the Democrats’ midterm prospect has already been done, which goes beyond the pattern where the President’s party tends to suffer in the first midterm. In another sign of the souring mood among voters, the Conference Board Consumer Confidence Index declined by 2% in May on a month-over-month basis and 11% on a year-over-year basis. While the consumer confidence index is higher now than it was in November 2020, it is 17% below its peak in the summer of 2021. What would have been a comeback year for US consumer spending is going to be dampened by high energy prices and general price inflation due to external shocks (Chart 2). Business Sentiment Governments also need the support of the business community to implement policies: Negative sentiment in the business community would subdue capital spending and job growth, which would affect household sentiment and subsequently, the ability of the government to pass its agenda. In May, high-frequency business indicators pointed to business sentiment turning negative. The capex intention survey declined by 20% from April and 37% compared to May of last year. Every activity indicator from the ISM, apart from the manufacturing employment index, is below their respective levels in November 2020, when the pandemic was raging, and vaccines had not yet been rolled out (Chart 3). The small business surveys conducted by the NFIB is indicative of the underlying reasons behind negative business sentiment: Despite lower concern about regulation and taxes, business concerns over inflation and labor costs are up by 1300% and 100%, respectively, since November of 2020. Concerns over taxes and regulation have largely been allayed as the Democrats have failed to use their second chance at reconciliation, with moderate senators objecting to higher taxes. But this decline in worries over taxes and regulation have given way to concerns about inflation and labor costs, and President Biden and the Democrats are struggling to address these concerns (Chart 4). Chart 3Businesses Are Downbeat... Businesses Are Downbeat... Businesses Are Downbeat... ​​​​​​ Chart 4... Due to Inflation and Labor Costs ... Due to Inflation and Labor Costs ... Due to Inflation and Labor Costs ​​​​​​ Government Sector Chart 5The Purse String Will Be Tightened The Purse String Will Be Tightened The Purse String Will Be Tightened The government can use fiscal policy to shore up its diminishing political capital. In Q1 2022, the fiscal thrust for the federal government was -14.3% of GDP, a 27 percentage-point swing from Q1 of last year when the Biden administration passed the American Rescue Plan (Chart 5). It is unlikely that fiscal thrust would recover anytime soon considering that fiscal stimulus early in Biden’s term had contributed to the inflation that the economy is experiencing now. While the Democrats have one last chance at using reconciliation, at best they would pass a deficit neutral budget, as there is no appetite for another extravagant budget in this inflationary environment; at worst, they could be pushed by moderate Democrats towards increasing revenue through tax hikes. Hence, Biden’s political capital through the use of fiscal policy is unlikely to recover. Economic Conditions The economy is the one bright spot underpinning Biden’s political capital (Chart 6). The unemployment rate was unchanged at 3.6% in May, close to an all-time low and 3.1 percentage points below November 2020. For the first time in his term, the stock market-to-wage ratio fell in April to below the level of November 2020 – mainly due to the sell-off in the stock market. While this is positive for reducing inequality, the Fed’s attempt to cool down the economy will also affect wage growth and household wealth via the stock market. In May, policy uncertainty was still lower than what it was in November 2020, but on a month-on-month basis, uncertainty in the US increased by 12%. Personal bankruptcies in Q1 barely increased from Q4 2021, while business bankruptcies declined by 3% during the same period. Consumer loan delinquencies also remained flat at 1.6%. Financial distress levels are still significantly below their pre-pandemic level (Chart 7). Chart 6Recovery Is Going Well... Recovery Is Going Well... Recovery Is Going Well... ​​​​​ Chart 7... And Household And Business Finances Are Improving... ... And Household And Business Finances Are Improving... ... And Household And Business Finances Are Improving... ​​​​​​ Chart 8... But Inflation And Gas Price Overshadow the Recovery ... But Inflation And Gas Price Overshadow the Recovery ... But Inflation And Gas Price Overshadow the Recovery If voters weigh these indicators equally, Biden will have strong political capital underpinned by the strong economy (78% of these indicators are sending positive signals), but there are two indicators with outsized impacts on household and business sentiment: inflation and gas prices (Chart 8). Inflation is close to an all-time high, and the high inflation will force the Federal Reserve to act to raise rates which will, in turn, cool down economic activity. The latest readings of gas prices pin them at 5 dollars per gallon, a 138% increase from November 2020. The oil/energy shock is happening at a time when Americans are experiencing their first summer without restrictions since 2019. High gas prices, high inflation, and the potential for a recession may threaten the much-awaited pent-up demand. Asset Market Chart 9Stock Market Woes Add To The Negative Sentiment Stock Market Woes Add To The Negative Sentiment Stock Market Woes Add To The Negative Sentiment The equity market is also a component of political capital – while a booming stock market is not guaranteed to be a tailwind for the President as seen from the case of President Trump during the midterm of 2018, a bear market will compound the negativity that is abound in the economy. The S&P 500 is down 18% from December 2021 and the 2-year Treasury yield is up by 231 bps. The S&P 500 is only 8% above its November 2020 level and if one takes into consideration inflation since then, the S&P 500 is below its level of November 2020 (Chart 9). Our colleagues at the Emerging Markets Strategy service have estimated that the recent selloff has wiped out roughly US$12 trillion from the US equity market and US$3.5 trillion from the US bond market. Political/Constitutional Strength An immutable component of political capital is the constitutional strength of the President – majorities in the Electoral College and popular votes, and control of Congress and the Supreme Court. President Biden, unlike Presidents Bush and Trump, had majorities in both the electoral college and national popular votes. But his control of Congress was significantly weaker; in 2017 Republicans had a seat majority in the Senate and a 23-seat advantage in the House, while the Democrats a one seat advantage in the Senate, via the Vice President, and a 4-seat majority in the House at Biden’s inauguration. Furthermore, Trump started his term with an evenly split Supreme Court, which later was expanded to 5-4 once Justice Gorsuch was confirmed, while Democrats have a 3-6 disadvantage due to the passing of Justice Ginsburg in 2020. Biden’s constitutional strength is weaker than Trump’s and Obama’s. Bottom Line: Biden’s political capital had been greatly diminished and he will unlikely be able to push for his agenda through legislative means. He is also unlikely to be able to replenish his political capital anytime soon due to skyrocketing inflation, which makes fiscal policy unpalatable to the public. As the midterm closes in, Biden will be desperate to shore up his and the Democrats political capital, and as the legislative route will be unavailable, he will resort to regulatory, executive, and foreign policy actions. Investment Conclusions As a foreign energy shock is mainly responsible for high gasoline prices in the US, Biden will attempt to have a reset with oil producers in the Middle East; but this will come at the cost of diplomacy with Iran, while attempting to restart nuclear negotiations with Iran will come at the cost of further alienating oil producers and allies in the Middle East. The Democrats domestic approach which was to disparage oil producers for alleged price gouging will also inject downside risk to the energy sector. Europe and Japan will be weighed down by the global energy shock as they are both net importers of energy, unlike the US. This will affect the sales of US industrial products abroad and by extension, the US industrial sector. Geopolitical risks will depress capex spending in Europe. The consumer discretionary sector could trade sideways as inflation bites and the stock market declines, yet strong household finances – as seen by low delinquency rates and massive pent-up demand from 2 years of lockdowns – will be tailwinds for the sector. The tech and communication services sectors will benefit from near-peak polarization, yet there are regulatory challenges at home and abroad which could weigh these sectors down. Financial regulations will pick up from low levels at end-2021 due to changes at the Fed. Plus, the Democrats and regulatory agencies will not look too kindly on banks aiding companies in merging and consolidating in a market where inflation is sky-high. The increases in rents could spur action from local governments to act on housing market which may include anti-market policies such as rent control and stabilization, which will negatively impact the real estate sector. Health care is the only sector with political risks to the upside – Biden had punted on radical changes to the health care system and even if he seeks to make changes, he lacks the political capital to do so. His actions abroad will also put a floor under global geopolitical risks, ensuring the USD remains well bid, and health care tends to do well when the dollar is in a bull market.     Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Executive Summary Russia Squeezes EU Natural Gas Russia Squeezes EU Natural Gas Russia Squeezes EU Natural Gas Major geopolitical shocks tend to coincide with bear markets, so the market is getting closer to pricing this year’s bad news. But investors are not out of the woods yet. Russia is cutting off Europe’s natural gas supply ahead of this winter in retaliation to Europe’s oil embargo. Europe is sliding toward recession. China is reverting to autocratic rule and suffering a cyclical and structural downshift in growth rates. Only after Xi Jinping consolidates power will the ruling party focus exclusively on economic stabilization. The US can afford to take risks with Russia, opening up the possibility of a direct confrontation between the two giants before the US midterm election. A new strategic equilibrium is not yet at hand. Tactical Recommendation Inception Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 18.3% Bottom Line: Maintain a defensive posture in the third quarter but look for opportunities to buy oversold assets with long-term macro and policy tailwinds. Feature 2022 is a year of geopolitics and supply shocks. Global investors should remain defensive at least until the Chinese national party congress and US midterm election have passed. More fundamentally, an equilibrium must be established between Russia and NATO and between the US and Iran. Until then supply shocks will destroy demand. Checking Up On Our Three Key Views For 2022 Our three key views for the year are broadly on track: 1.  China’s Reversion To Autocracy: For ten years now, the fall in Chinese potential economic growth has coincided with a rise in neo-Maoist autocracy and foreign policy assertiveness, leading to capital flight, international tensions, and depressed animal spirits (Chart 1). Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Rising incomes provided legitimacy for the Communist Party over the past four decades. Less rapidly rising incomes – and extreme disparities in standards of living – undermine the party and force it to find other sources of public support. Fighting pollution and expanding the social safety net are positives for political stability and potentially for economic productivity. But converting the political system from single-party rule to single-person rule is negative for productivity. Mercantilist trade policy and nationalist security policy are also negative. China’s political crackdown, struggle with Covid-19, waning exports, and deflating property market have led to an abrupt slowdown this year. The government is responding by easing monetary, fiscal, and regulatory policy, though so far with limited effect (Chart 2). Economic policy will not be decisive in the third quarter unless a crash forces the administration to stimulate aggressively. Chart 1China's Slowdown Leads To Maoism, Nationalism China's Slowdown Leads To Maoism, Nationalism China's Slowdown Leads To Maoism, Nationalism ​​​​​​ Chart 2Chinese Policy Easing: Limited Effect So Far Chinese Policy Easing: Limited Effect So Far Chinese Policy Easing: Limited Effect So Far ​​​​​ Chart 3Nascent Rally In Chinese Shares Will Be Dashed Nascent Rally In Chinese Shares Will Be Dashed Nascent Rally In Chinese Shares Will Be Dashed Once General Secretary Xi Jinping secures another five-to-ten years in power at the twentieth national party congress this fall, he will be able to “let 100 flowers bloom,” i.e. ease policy further and focus exclusively on securing the economic recovery in 2023. But policy uncertainty will remain high until then. The party may have to crack down anew to ensure Xi’s power consolidation goes according to plan. China is highly vulnerable to social unrest for both structural and cyclical reasons. The US would jump to slap sanctions on China for human rights abuses. Hence the nascent recovery in Chinese domestic and offshore equities can easily be interrupted until the political reshuffle is over (Chart 3). If China’s economy stabilizes and a recession is avoided, investors will pile into the rally, but over the long run they will still be vulnerable to stranded capital due to Chinese autocracy and US-China cold war. If the Politburo and Politburo Standing Committee are stacked with members of Xi’s faction, as one should expect, then the reduction in policy uncertainty will only be temporary. Autocracy will lead to unpredictable and draconian policy measures – and it cannot solve the problem of a shrinking and overly indebted population. If the Communist Party changes course and stacks the Politburo with Xi’s factional rivals, to prevent China from going down the Maoist, Stalinist, and Putinist route, then global financial markets will cheer. But that outcome is unlikely. Hawkish foreign policy means that China will continue to increase its military threats against Taiwan, while not yet invading outright. Beijing has tightened its grip over Tibet, Xinjiang, and Hong Kong since 2008; Taiwan and the South China Sea are the only critical buffer areas that remain to be subjugated. Taiwan’s midterm elections, US midterms, and China’s party congress will keep uncertainty elevated. Taiwan has underperformed global and emerging market equities as the semiconductor boom and shortage has declined (Chart 4). Hong Kong is vulnerable to another outbreak of social unrest and government repression. Quality of life has deteriorated for the native population. Democracy activists are disaffected and prone to radicalization. Singapore will continue to benefit at Hong Kong’s expense (Chart 5). Chart 4Taiwan Equity Relative Performance Peaked Taiwan Equity Relative Performance Peaked Taiwan Equity Relative Performance Peaked ​​​​​​ Chart 5Hong Kong Faces More Troubles Hong Kong Faces More Troubles Hong Kong Faces More Troubles ​​​​​​ Chart 6Japan Undercuts China Japan Undercuts China Japan Undercuts China China and Japan are likely to engage in clashes in the East China Sea. Beijing’s military modernization, nuclear weapons expansion, and technological development pose a threat to Japanese security. The gradual encirclement of Taiwan jeopardizes Japan’s vital sea lines of communication. Prime Minister Fumio Kishida is well positioned to lead the Liberal Democratic Party into the upper house election on July 10 – he does not need to trigger a diplomatic showdown but he would not suffer from it. Meanwhile China is hungry for foreign distractions and unhappy that Japan is reviving its military and depreciating its currency (Chart 6). A Sino-Japanese crisis cannot be ruled out, especially if the Biden administration looks as if it will lose its nerve in containing China. Financial markets would react negatively, depending on the magnitude of the crisis. North Korea is going back to testing ballistic missiles and likely nuclear weapons. It is expanding its doctrine for the use of such weapons. It could take advantage of China’s and America’s domestic politics to stage aggressive provocations. South Korea, which has a hawkish new president who lacks parliamentary support, is strengthening its deterrence with the United States. These efforts could provoke a negative response from the North. Financial markets will only temporarily react to North Korean provocations unless they are serious enough to elicit military threats from Japan or the United States. China would be happy to offer negotiations to distract the Biden administration from Xi’s power grab. South Korean equities will benefit on a relative basis as China adds more stimulus. 2.  America’s Policy Insularity: President Biden’s net approval rating, at -15%, is now worse than President Trump’s in 2018, when the Republicans suffered a beating in midterm elections (Chart 7). Biden is now fighting inflation to try to salvage the elections for his party. That means US foreign policy will be domestically focused and erratic in the third quarter. Aside from “letting” the Federal Reserve hike rates, Biden’s executive options are limited. Pausing the federal gasoline tax requires congressional approval, and yet if he unilaterally orders tax collectors to stand down, the result will be a $10 billion tax cut – a drop in the bucket. Biden is considering waiving some of former President Trump’s tariffs on China, which he can do on his own. But doing so will hurt his standing in Rust Belt swing states without reducing inflation enough to get a payoff at the voting booth – after all, import prices are growing slower from China than elsewhere (Chart 8). He would also give Xi Jinping a last-minute victory over America that would silence Xi’s critics and cement his dictatorship at the critical hour. Chart 7Democrats Face Shellacking In Midterm Elections Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning ​​​​​​ Chart 8Paring Trump Tariffs Won't Reduce Inflation Much Paring Trump Tariffs Won't Reduce Inflation Much Paring Trump Tariffs Won't Reduce Inflation Much ​​​​​​ Chart 9Only OPEC Can Help Biden - And Help May Come Late Only OPEC Can Help Biden - And Help May Come Late Only OPEC Can Help Biden - And Help May Come Late Biden is offering to lift sanctions on Iran, which would free up 1.3 million barrels of oil per day. But Iran is not being forced to freeze its nuclear program by weak oil prices or Russian and Chinese pressure – quite the opposite. If Biden eases sanctions anyway, prices at the pump may not fall enough to win votes. Hence Biden is traveling to Saudi Arabia to make amends with Crown Prince Mohammed bin Salman. OPEC’s interest lies in producing enough oil to prevent a global recession, not in flooding the market on Biden’s whims to rescue the Democratic Party. Saudi and Emirati production may come but it may not come early in the third quarter. Lifting sanctions on Venezuela is a joke and Libya recently collapsed again (Chart 9). Even in dealing with Russia the Biden administration will exhibit an insular perspective. The US is not immediately threatened, like Europe, so it can afford to take risks, such as selling Ukraine advanced and long-range weapons and providing intelligence used to sink Russian ships. If Russia reacts negatively, a direct US-Russia confrontation will generate a rally around the flag that would help the Democrats, as it did under President John F. Kennedy in 1962 – one of the rare years in which the ruling party minimized its midterm election losses (Chart 10). The Cuban Missile Crisis counted more with voters than the earlier stock market slide. 3.  Petro-States’ Geopolitical Leverage: Oil-producing states have immense geopolitical leverage this year thanks to the commodity cycle. Russia will not be forced to conclude its assault on Ukraine until global energy prices collapse, as occurred in 2014. In fact Russia’s leverage over Europe will be greatly reduced in the coming years since Europe is diversifying away from Russian energy exports. Hence Moscow is cutting natural gas flows to Europe today while it still can (Chart 11). Chart 10Biden Can Afford To Take Risks With Russia Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning ​​​​​​ Chart 11Russia Squeezes EU's Natural Gas Russia Squeezes EU's Natural Gas Russia Squeezes EU's Natural Gas ​​​​​​ Chart 12EU/China Slowdown Will Weigh On World Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning Russia’s objective is to inflict a recession and cause changes in either policy or government in Europe. This will make it easier to conclude a favorable ceasefire in Ukraine. More importantly it will increase the odds that the EU’s 27 members, having suffered the cost of their coal and oil embargo, will fail to agree to a natural gas embargo by 2027 as they intend. Italy, for example, faces an election by June 2023, which could come earlier. The national unity coalition was formed to distribute the EU’s pandemic recovery funds. Now those funds are drying up, the economy is sliding toward recession, and the coalition is cracking. The most popular party is an anti-establishment right-wing party, the Brothers of Italy, which is waiting in the wings and can ally with the populist League, which has some sympathies with Russia. A recession could very easily produce a change in government and a more pragmatic approach to Moscow. The Italian economy is getting squeezed by energy prices and rising interest rates at the same time and cannot withstand the combination very long. A European recession or near-recession will cause further downgrades to global growth, especially when considering the knock-on effects in China, where the slowdown is more pronounced than is likely reported. The US economy is more robust but it will have to be very robust indeed to withstand a recession in Europe and growth recession in China (Chart 12). Russia does not have to retaliate against Finland and Sweden joining NATO until Turkey clears the path for them to join, which may not be until just before the Turkish general election due in June 2023. But imposing a recession on Europe is already retaliation – maybe a government change will produce a new veto against NATO enlargement. Russian retaliation against Lithuania for blocking 50% of its shipments to the Kaliningrad exclave is also forthcoming – unless Lithuania effectively stops enforcing the EU’s sanctions on Russian resources. Russia cannot wage a full-scale attack on the Baltic states without triggering direct hostilities with NATO since they are members of NATO. But it can retaliate in other ways. In a negative scenario Moscow could stage a small “accidental” attack against Lithuania to test NATO. But that would force Biden to uphold his pledge to defend “every inch” of NATO territory. Biden would probably do so by staging a proportionate military response or coordinating with an ally to do it. The target would be the Russian origin of attack or comparable assets in the Baltic Sea, the Black Sea, Ukraine, Belarus, or elsewhere. The result would be a dangerous escalation. Russia could also opt for cyber-attacks or economic warfare – such as squeezing Europe’s natural gas supply further. Ultimately Russia can afford to take greater risks than the US over Kaliningrad, other territories, and its periphery more broadly. That is the difference between Kennedy and Biden – the confrontation is not over Cuba. Russia is also likely to take a page out of Josef Stalin’s playbook and open a new front – not so much in Nicaragua as in the Middle East and North Africa. The US betrayal of the 2015 nuclear deal with Iran opens the opportunity for Russia to strengthen cooperation with Iran, stir up the Iranians’ courage, sell them weapons, and generate a security crisis in the Middle East. The US military would be distracted keeping peace in the Persian Gulf while the Europeans would lose their long-term energy alternative to Russia – and energy prices would rise. The Iranians – who also have leverage during a time of high oil prices – are not inclined to freeze their nuclear program. That would be to trade their long-term regime survival for economic benefits that the next American president can revoke unilaterally. Bottom Line: Xi Jinping is converting China back into an autocracy, the Biden administration lacks options and is willing to have a showdown with Russia, and the Putin administration is trying to inflict a European recession and political upheaval. Stay defensive. Checking Up On Our Strategic Themes For The 2020s As for our long-term themes, the following points are relevant after what we have learned in the second quarter: 1.  Great Power Rivalry: The war in Ukraine has reminded investors of the primacy of national security. In an anarchic international system, if a single great nation pursues power to the neglect of its neighbors’ interests, then its neighbors need to pursue power to defend themselves. Before long every nation is out for itself. At least until a new equilibrium is established. For example, Russia’s decision to neutralize Ukraine by force is driving Germany to abandon its formerly liberal policy of energy cooperation in order to reduce Russia’s energy revenues and avoid feeding its military ambitions. Russia in turn is reducing natural gas exports to weaken Europe’s economy this winter. Germany will re-arm, Finland and Sweden will eventually join NATO, and Russia will underscore its red line against NATO bases or forces in Finland and Sweden. If this red line is violated then a larger war could ensue. Chart 13China Will Shift To Russian Energy China Will Shift To Russian Energy China Will Shift To Russian Energy Until Russia and NATO come to a new understanding, neither Europe nor Russia can be secure. Meanwhile China cannot reject Russia’s turn to the east. China believes it may need to use force to prevent Taiwan independence at some point, so it must prepare for the US and its allies to treat it the same way that they have treated Russia. It must secure energy supply from Russia, Central Asia, and the Middle East via land routes that the US navy cannot blockade (Chart 13). Beijing must also diversify away from the US dollar, lest the Treasury Department freeze its foreign exchange reserves like it did Russia’s. Global investors will see diversification as a sign of China’s exit from the international order and preparation for conflict, which is negative for its economic future. However, the Russo-Chinese alliance presents a historic threat to the US’s security, coming close to the geopolitical nightmare of a unified Eurasia. The US is bound to oppose this development, whether coherently or not, and whether alone or in concert with its allies. After all, the US cannot offer credible security guarantees to negotiate a détente with China or Iran because its domestic divisions are so extreme that its foreign policy can change overnight. Other powers cannot be sure that the US will not suffer a radical domestic policy change or revolution that leads to belligerent foreign policy. Insecurity will drive the US and China apart rather than bringing them together. For example, Russia’s difficulties in Ukraine will encourage Chinese strategists to go back to the drawing board to adjust their plans for military contingencies in Taiwan. But the American lesson from Ukraine is to increase deterrence in Taiwan. That will provoke China and encourage the belief that China cannot wait forever to resolve the Taiwan problem. Until there is a strategic understanding between Russia and NATO, and the US and China, the world will remain in a painful and dangerous transitional phase – a multipolar disequilibrium. Chart 14Hypo-Globalization: Globalizing Less Than Potential Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning 2.  Hypo-Globalization: If national security rises to the fore, then economics becomes a tool of state power. Mercantilism becomes the basis of globalization rather than free market liberalism. Hypo-globalization is the result. The term is fitting because the trade intensity of global growth is not yet in a total free fall (i.e. de-globalization) but merely dropping off from its peaks during the phase of “hyper-globalization” in the 1990s and early 2000s (Chart 14). Hypo-globalization is probably a structural rather than cyclical phenomenon. The EU cannot re-engage with Russia and ease sanctions without rehabilitating Russia’s economy and hence its military capacity – which could enable Russia to attack Europe again. The US and China can try to re-engage but they will fail. Russo-Chinese alliance ensures that the US would be enriching not one but both of its greatest strategic rivals if it reopened its doors to Chinese technology acquisition and intellectual property theft. Iran will see its security in alliance with Russia and China. China has an incentive to develop Iran’s economy so as not to depend solely on Russia and Central Asia. Russia has an incentive to develop Iran’s military capacity so as to deprive Europe of an energy alternative. Both Russia and China wish to deprive the US of strategic hegemony in the Middle East. By contrast the US and EU cannot offer ironclad security guarantees to Iran because of its nuclear ambitions and America’s occasional belligerence. Thus the world can see expanding Russian and Chinese economic integration with Eurasia, and expanding American and European integration with various regions, but it cannot see further European integration with Russia or American integration with China. And ultimately Europe and China will be forced to sever links (Chart 15). Globalization will not cease – it is a multi-millennial trend – but it will slow down. It will be subordinated to national security and mercantilist economic theory. 3.  Populism/Nationalism: In theory, domestic instability can cause introversion or extroversion. But in practice we are seeing extroversion, which is dangerous for global stability (Chart 16). Chart 15Global Economic Disintegration Global Economic Disintegration Global Economic Disintegration ​​​​​​ Chart 16Internal Sources Of Nationalism Internal Sources Of Nationalism Internal Sources Of Nationalism ​​​​​​ Russia’s invasion of Ukraine derived from domestic Russian instability – and instability across the former Soviet space, including Belarus, which the Kremlin feared could suffer a color revolution after the rigged election and mass protests of 2020-21. The reason the northern European countries are rapidly revising their national defense and foreign policies to counter Russia is because they perceive that the threat to their security is driven by factors within the former Soviet sphere that they cannot easily remove. These factors will get worse as a result of the Ukraine war. Russian aggression still poses the risk of spilling out of Ukraine’s borders. China’s Maoist nostalgia and return to autocratic government is also about nationalism. The end of the rapid growth phase of industrialization is giving way to the Asian scourge: debt-deflation. The Communist Party is trying to orchestrate a great leap forward into the next phase of development. But in case that leap fails like the last one, Beijing is promoting “the great rejuvenation of the Chinese nation” and blaming the rest of the world for excluding and containing China. Taiwan, unfortunately, is the last relic of China’s past humiliation at the hands of western imperialists. China will also seek to control the strategic approach to Taiwan, i.e. the South China Sea. China’s claim that the Taiwan Strait is sovereign sea, not international waters, will force the American navy to assert freedom of passage. American efforts to upgrade Taiwan relations and increase deterrence will be perceived as neo-imperialism. The United States, for its part, could also see nationalism convert into international aggression. The US is veering on the brink of a miniature civil war as nationalist forces in the interior of the country struggle with the political establishment in the coastal states. Polarization has abated since 2020, as stagflation has discredited the Democrats. But it is now likely to rebound, making congressional gridlock all but inevitable. A Republican-controlled House will find a reason to impeach President Biden in 2023-24, in hopes of undermining his party and reclaiming the presidency. Another hotly contested election is possible, or worse, a full-blown constitutional crisis. American institutions proved impervious to the attempt of former President Trump and his followers to disrupt the certification of the Electoral College vote. However, security forces will be much more aggressive against rebellions of whatever stripe in future, which could lead to episodes in which social unrest is aggravated by police repression. If the GOP retakes the White House – especially if it is a second-term Trump presidency with a vendetta against political enemies and nothing to lose – then the US will return to aggressive foreign policy, whether directed at China or Iran or both. In short, polarization has contaminated foreign policy such that the most powerful country in the world cannot lead with a steady hand. Over the long run polarization will decline in the face of common foreign enemies but for now the trend vitiates global stability. Chart 17Germany And Japan Rearming Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning It goes without saying that nationalism is also an active force in Iran, where 83-year-old Supreme Leader Ayatollah Khamenei is attempting to ensure the survival of his regime in the face of youthful social unrest and an unclear succession process. If Khamenei takes advantage of the commodity cycle, and American and Israeli disarray, he can make a mad dash for the bomb and try to achieve regime security. But if he does so then nationalism will betray him, since Israel and/or the US are willing to conduct air strikes to uphold the red line against nuclear weaponization. If any more proof of global nationalism is needed, look no further than Germany and Japan, the principal aggressors of World War II. Their pacifist foreign policies have served as the linchpins of the post-war international order. Now they are both pursuing rearmament and a more proactive foreign policy (Chart 17). Nationalism may be very nascent in Germany but it has clearly made a comeback in Japan, which exacerbates China’s fears of containment. The rise of nationalism in India is widely known and reinforces the trend. Bottom Line: Great power rivalry is intensifying because of Russia’s conflict with the West and China’s inability to reject Russia. Hypo-globalization is the result since EU-Russia and US-China economic integration cannot easily be mended in the context of great power struggle. Domestic instability in Russia, China, and the US is leading to nationalism and aggressive foreign policy, as leaders find themselves unwilling or unable to stabilize domestic politics through productive economic pursuits. Investment Takeaways BCA has shifted its House View to a neutral asset allocation stance on equities relative to bonds (Chart 18). Chart 18BCA House View: Neutral Stocks Versus Bonds BCA House View: Neutral Stocks Versus Bonds BCA House View: Neutral Stocks Versus Bonds Geopolitical Strategy remains defensively positioned, favoring defensive markets and sectors, albeit with some exceptions that reflect our long-term views. Tactically stay long US 10-year Treasuries, large caps versus small caps, and defensives versus cyclicals. Stay long Mexico and short the UAE (Chart 19). Strategically stay long gold, US equities relative to global, and aerospace/defense sectors (Chart 20). Among currencies favor the USD, EUR, JPY, and GBP. Chart 19Stay Defensive In Q3 2022 Stay Defensive In Q3 2022 Stay Defensive In Q3 2022 ​​​​​​ Chart 20Stick To Long-Term Geopolitical Trades Stick To Long-Term Geopolitical Trades Stick To Long-Term Geopolitical Trades ​​​​​​ Chart 21Favor Semiconductors But Not Taiwan Favor Semiconductors But Not Taiwan Favor Semiconductors But Not Taiwan ​​​​​ Chart 22Indian Tech Will Rebound Amid China's Geopolitical Risks Indian Tech Will Rebound Amid China's Geopolitical Risks Indian Tech Will Rebound Amid China's Geopolitical Risks ​​​​​ Chart 23Overweight ASEAN Overweight ASEAN Overweight ASEAN Go long US semiconductors and semi equipment versus Taiwan broad market (Chart 21). While we correctly called the peak in Taiwanese stocks relative to global and EM equities, our long Korea / short Taiwan trade was the wrong way to articulate this view and remains deeply in the red. Similarly our attempt to double down on Indian tech versus Chinese tech was ill-timed. China eased tech regulations sooner than we expected. However, the long-term profile of the trade is still attractive and Chinese tech will still suffer from excessive government and foreign interference (Chart 22). Go long Singapore over Hong Kong, as Asian financial leadership continues to rotate (see Chart 5 above). Stay long ASEAN among emerging markets. We will also put Malaysia on upgrade watch, given recent Malaysian equity outperformance on the back of Chinese stimulus and growing western interest in alternatives to China (Chart 23).     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary Biden Can Take Risks With Russia Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort President Biden will make a last-ditch effort to mitigate Democratic losses in the midterm elections and the effect will be still-high policy uncertainty and erratic US behavior. Biden can take several executive actions against inflation but we do not expect them to resolve the global supply shock or to save the Democrats from a Republican takeover of Congress this fall. There is substantial risk of a direct US-Russia crisis ahead of the election that would sustain bearish sentiment. US policy remains a headwind for equities in 2022 but possibly a tailwind in 2023. A rally after the midterm is fairly likely.   Recommendation (Tactical) Initiation Date  Return Long DXY (Dollar Index) 23-FEB-22 8.8% Bottom Line: Maintain a defensive posture in the third quarter but look for opportunities to buy oversold assets with long-term macro and policy tailwinds. Feature President Biden and the Democratic Party will make a last-ditch effort in the third quarter to mitigate their large expected losses in the midterm elections. The president will concentrate on fighting inflation, which is weighing on wages, incomes, and consumer and business sentiment (Chart 1). Related Report  US Political StrategyBiden Opens The Border Biden’s frantic efforts will induce additional market volatility. The president has a few limited tools to address global energy and supply shocks that probably will not work. Inflation will remain problematic even if it slows down over the next three months as our bond strategists expect. The odds of recession have risen sharply. Our Chief Global Strategist Peter Berezin suggests that the odds are 40% – a point underscored by inversion of some parts of the yield curve and a falling leading economic indicator (Chart 2). President Biden recently met with outside economic adviser Larry Summers and concluded that a recession is “not inevitable.” Not very comforting. Chart 1Inflation's Toll Inflation's Toll Inflation's Toll Chart 2Odds Of Recession Rising Odds Of Recession Rising Odds Of Recession Rising Summers, who warned Biden and the Democrats not to add $1.9 trillion in spending at the beginning of 2021, has put forward research showing recession odds at 60%-70% over the next 12-24 months.1 However, BCA’s own recession checklist is still ambivalent (Table 1). BCA’s House View is now neutral on equities. Table 1BCA Recession Checklist Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort What could change the US policy outlook? Not much. Avoiding recession, reducing inflation, mobilizing women voters, and clashing directly with Russia could mitigate some of the Democrats’ expected losses this fall, but the outcome would probably be the same. Betting markets give a 72%probability to Democrats losing control of both the House of Representatives and the Senate. Our own election models show Democrats losing 22 seats in the House and two seats in the Senate (see Appendix), reinforcing our February forecast. The implication is congressional gridlock in 2023-24. Gridlock is marginally positive for the broad US equity market beginning in Q4 2022 … but marginally negative before then. Checking Up On Our Three Key Views For 2022 Our three key views for 2022 remain intact at the halfway point of the year. : 1.   From Single-Party Rule To Gridlock: The Democrats are highly likely to lose control of the House of Representatives this fall, meaning that unified government will end with the lame duck legislative session in November and December. The Democrats’ fiscal 2022 budget reconciliation bill is less likely to pass now that midterm campaigning has begun. A fiscally expansive bill would add to inflation. A deficit-reducing bill – i.e. one with substantial tax hikes – would increase the odds of recession. Biden no longer has an interest in pushing the bill until he is reasonably sure a recession can be avoided. It is very hard to garner 218 votes in the House and 51 votes in the Senate now that Biden’s and Democrats’ popular support is melting down. Democrats are polling comparably to Republicans who lost 41 House seats in the 2018 midterms (Chart 3). Thus while it is still possible for Democrats to pass an energy security and climate change bill under Biden’s presidency, we have no conviction that they can do it before the midterm. More likely it would have to pass during the lame-duck session in the fourth quarter – or as a compromise law with a Republican Congress in 2023-24. Until 2025, at earliest, US government will be divided, which means that the post-election drop in policy uncertainty will be short-lived, as fears will emerge of breaching the debt ceiling in early 2023. Chart 3Democratic Party Troubles Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort 2.   From Legislative To Executive Power: With the legislature stymied, Biden will resort to executive power to keep his presidency afloat. So what will he do? Fight inflation. Biden’s anti-inflation plan consists of three prongs. The first is “letting” the Fed raise interest rates, which is well under way. The Fed hiked rates by 75 basis points on June 15 and plans to raise the Fed funds rate to 3.25% or 3.5% by end of year. The second prong is passing his Build Back Better plan and the third is consolidating the fiscal deficit. But these two options are bogged down in Congress – no new belt-tightening will occur until 2023 at earliest. So Biden’s remaining options consist of administrative maneuvers and executive orders. Biden could stop collecting the federal gas tax, although the tax has not risen since 1993 and its removal will have a marginal impact (Chart 4). He has already tapped the strategic petroleum reserve, to an unprecedented degree, without preventing the surge in prices at the pump (Chart 5). Chart 4Biden To Defer Federal Gas Tax Biden To Defer Federal Gas Tax Biden To Defer Federal Gas Tax Chart 5Strategic Petroleum Reserve Already Tapped Strategic Petroleum Reserve Already Tapped Strategic Petroleum Reserve Already Tapped   3.   From Domestic To Foreign Policy: Part of Biden’s turn toward executive power will be a turn toward foreign policy orientation. However, before the midterm, Biden’s foreign policy will be defensive or reactive. That is, with the exception of Russia, he will attempt to placate foreign threats and mitigate the energy shock. On China, Biden is considering pulling back on some of President Trump’s extraordinary tariffs, though probably not the Section 301 tariffs related to technology theft. He has the authority to do so unilaterally just as Trump had the authority to put them on. The problem is that easing the China tariffs will have little effect on inflation, and only after the midterm, while it would weaken Biden’s political standing in the Rust Belt and undermine the US’s strategic competition with China. Tariff relief would only temporarily benefit the renminbi, if at all, given China’s need for a weak currency amid its economic slowdown (Chart 6). Hence Biden may reduce some tariffs but it will be underwhelming. Not a reliable way to bring down inflation. Chart 6Biden Can Ease China Tariffs (But Don't Bet On It) Biden Can Ease China Tariffs (But Don't Bet On It) Biden Can Ease China Tariffs (But Don't Bet On It) Second, Biden has proposed to ease sanctions on Iran if it will freeze its nuclear program and come back into compliance with the 2015 nuclear deal that the Trump administration rejected. But the Iranians can export oil anyway at today’s prices, they have customers in China and India, and they have immense military leverage over Iraqi production, which means they are not forced to capitulate (Chart 7). Not a reliable way to bring down inflation. Third, Biden is courting the Gulf Arab states and tinkering with easing sanctions on Venezuela and others. OPEC support is a better option than Iran/Venezuela. However, OPEC will decide when and how much support to give. The Arab states will act to prolong the global business cycle but will not base their strategy on helping Democrats win an election. Hence they may not come to the rescue as early as the third quarter (Chart 8). Chart 7Biden Can Ease Iran Sanctions (But Don't Bet On It) Biden Can Ease Iran Sanctions (But Don't Bet On It) Biden Can Ease Iran Sanctions (But Don't Bet On It) Chart 8Biden Casting About For Oil Providers Biden Casting About For Oil Providers Biden Casting About For Oil Providers Moreover if the Biden administration makes amends with Saudi Arabia, then Iran’s nuclear progress will steam ahead and ignite tensions in the Middle East within the year. That would vitiate the impact of increased OPEC production. Not a reliable way to bring down inflation. Biden has even sought to exempt Russia from some sanctions for the sake of reducing inflation, such as with grain exports. However, these arrangements may not last. Given Biden’s weak domestic support and given the way that the Cuban Missile Crisis helped President Kennedy to mitigate his party’s losses in 1962, Biden can afford to be confrontational and even provocative toward Russia (Chart 9). After all, Russia is already pulling levers to add to inflation. The problem is that a direct US-Russia showdown would increase inflation while heightening global risk aversion. Bottom Line: Gridlock is coming, which is marginally negative for US equities in Q3 2022 but marginally positive as early as Q4 2022 and in 2023. It is not good for equities in 2022 because of elevated uncertainty – uncertainty not so much about the election results as about the volatile and unpredictable impacts of the president’s last-ditch efforts to fight inflation. Chart 9Biden Can Take Risks With Russia Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort Checking Up On Our Strategic Themes For The 2020s Looking beyond the short term, this year’s inflation outbreak and geopolitical events will largely reinforce our three long-term US political themes, in the following ways: 1.   Millennials/GenZ Rising: In the coming 12 months, a fall in job openings due to the economic slowdown, combined with a recovering labor participation rate, could reduce wage pressures and inflation, in accordance with the Federal Reserve’s plan for a “soft landing” (Chart 10). Of course, that is not happening yet. And conversely labor participation will fall again if recession risks materialize. So there will be a lot of noise in the short run. Over the long run, a rising dependency ratio, in the context of a growing population, has inflationary implications. It decreases the pool of savings, increases the need for public investment, and increases the cost of each prime-age worker. Today the headline labor participation rate has mostly recovered but workers over the age of 55 are failing to return to pre-pandemic levels of participation, as are young people, which will keep wage pressures up (Chart 11). Chart 10The Fed's Idea Of A Soft Landing The Fed's Idea Of A Soft Landing The Fed's Idea Of A Soft Landing Chart 11Generational Shift In Labor Market Generational Shift In Labor Market Generational Shift In Labor Market Thus generational change will be marginally inflationary and will have powerful political effects. An increasingly multi-ethnic and educated population will hold different opinions from previous generations. Political parties will evolve to capture these voters. Underlying the shift will be the fact that government support will be necessary for the rising share of dependents, yet fiscal discipline will be necessary to restrict inflation. The current quarrel between older and younger generations will intensify before it subsides. The Silent Generation, along with the conservative Baby Boomers, will remain the decisive voting bloc in the 2022 midterm and will seek to freeze fiscal policy. That brings us to our next theme … 2.   Peak Polarization: Political polarization has declined since the 2020 election, as we predicted. All voters dislike high inflation (Chart 12). However, polarization will remain at historically high levels at least over the short and medium term. Chart 12Everyone Loathes Inflation Everyone Loathes Inflation Everyone Loathes Inflation Chart 13Women’s Turnout Will Matter Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort Polarization will remain high in part because of the generational divide, which is still very wide and underpins stark ideological divides. For example, a short-term driver of polarization will be abortion. The Supreme Court is likely, though not certain, to overturn the 1972 Roe v. Wade decision that guarantees nationwide access to abortion. If it does, protests and civil unrest will occur. Women turned out in droves against President Trump’s Republicans in the 2018 midterms and will do so again in 2022 (Chart 13), helping Democrats to mitigate some of their losses. Polarization will also remain high due to the electoral system and intra-party dynamics. While Democrats ensconce themselves in formal institutions, Republicans continue to transform into a populist party. So far in the Republican primary elections, candidates endorsed by former President Trump are winning the nomination at a 94% rate. Table 2 shows the outcomes in the GOP primary elections for the House of Representatives so far. A GOP House majority is likely to impeach President Biden for one or another reason, even though they will not be able to remove him from office. Table 2Polarization Will Stay Near Historic Peaks Over 2022-24 Cycle Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort Today’s extreme polarization entails that congressional gridlock will return and that the US remains at high risk of social unrest, political violence, and domestic terrorism (Chart 14). A terrorist attack that affects critical infrastructure, high-level personnel, or the electoral system would lead to greater sociopolitical instability. Especially if violence tips the narrow political balance of one of the branches of government and has a concrete impact on national policy.2 Social unrest alone will hardly move markets but unrest that fundamentally damages US political stability is possible and would engender risk-aversion. Over the long run, however, the US will avoid a second civil war since Washington possesses the world’s most powerful military and intelligence apparatus, which is highly unlikely to be coopted or defeated by an extremist movement. The military swears allegiance to the constitution. For example, neither the military nor the political institutions (as opposed to individuals) showed any serious sign of breaking down during the January 6, 2021 insurrection. The vast majority of voters will recoil from any major incidents of terrorism or militancy. While opinion polls show non-negligible support for political violence, such polls need to be interpreted carefully (Chart 15). A recent study shows that these polls overstate public support for violence.3 Chart 14Major Risk Of Domestic Terrorism, Political Violence Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort Chart 15Opinion Growing More Militant … Until Militancy Happens Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort The emerging Russo-Chinese strategic challenge, combined with generational change, will force political elites to cooperate to prevent domestic insurrections, regime fracture, and foreign humiliation. Polarization will give way to a new American consensus which is largely directed at domestic stabilization and fighting the Second Cold War. 3.   Limited Big Government: The inflation outbreak has dealt a blow to arguments in favor of unlimited government, including Modern Monetary Theory. While the US rediscovered the need for “Big Government” during the deflationary 2010s, it is already starting to rediscover the need for limited government via the inflationary 2020s (Chart 16). The next Congress will reimpose some fiscal discipline – and future governments will face some checks and balances on spending due to their fear of an inflationary surge and negative consequences at the voting booth. Unless Democrats somehow retain control of Congress this fall, they will reinforce the precedent set by the Carter administration that high inflation is politically undesirable. Chart 16Inflation Outbreak Will Limit Big Government Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort Fiscal policy will be more expansive in the coming decade than in recent decades due to structural factors. But it will still face limitations from democratic politics, i.e. gridlock. As long as polarization does not spiral out of control, the US government will not become authoritarian or autocratic and fiscal policy will not result in Big Government Socialism or No Government Anarchism. A new compromise will be found which will be Limited Big Government. Bottom Line: Generational tensions will rise and then fall – and so will political polarization. The US faces a high risk of sociopolitical instability in the short term. The 2022 midterm will become a source of uncertainty, volatility, and a still-elevated equity risk premium. After the midterm, uncertainty and risk premiums will dissipate temporarily. But avoiding a recession will become the critical factor in maintaining policy continuity and national stability through the 2024 election cycle. Investment Takeaways BCA has shifted its House View to a neutral asset allocation stance on equities relative to bonds, as noted. US Political Strategy remains defensively positioned, as midterm elections typically provide a tailwind to defensive sectors for the first three quarters of the election year. This is also true when unified governments shift to divided governments – and in that case bond yields tend to be higher than usual (Chart 17). While the inflation outbreak makes this year different from many recent midterm years, these trends have persisted. For this reason, and our Geopolitical Strategy views, we will maintain our defensive bias in the third quarter. Chart 17Stocks Flat, Bond Yields High, Until After Midterm Elections Stocks Flat, Bond Yields High, Until After Midterm Elections Stocks Flat, Bond Yields High, Until After Midterm Elections We remain overweigh health care relative to the broad market and overweight nominal Treasuries relative to inflation-protected securities. Having said that, we are putting our long US dollar (DXY) trade on downgrade watch. We do not doubt that the dollar can go higher this year but our bearish views have come to fruition both within the US and in the geopolitical space and they are now largely priced. It may soon be time to step back and reassess, especially because interest rate differentials are turning against the dollar (Chart 18). In addition China’s government will take a pro-growth turn to try to secure the economic recovery over the next 12 months. In the energy space, we expect volatility. The Biden administration is focused on fighting inflation and could pull various levers to affect the oil market, outlined above. If Biden succeeds against expectations, then the oil price would suffer a substantial setback. Moreover OPEC has an independent interest in prolonging the business cycle now that global prices have become punitive. Hence we are neutral on oil prices and booked gains on our long energy trades for the time (Chart 19). Chart 18Put US Dollar On Downgrade Watch Put US Dollar On Downgrade Watch Put US Dollar On Downgrade Watch If inflation subsides and bond yields moderate, then growth stocks should rebound against value stocks. However, we implemented this idea prematurely earlier this year and suffered for it. Therefore we remain neutral on the question of portfolio styles for now. Our cyclical plays remain the same: long cyber security stocks, defense stocks, and infrastructure stocks. We also remain long renewable energy, although for now we only recommend it as a tactical trade (Chart 20). Chart 19Energy Prices Will Be Volatile Energy Prices Will Be Volatile Energy Prices Will Be Volatile Chart 20Stick With Cyber Security, Defense, And Renewables Stick With Cyber Security, Defense, And Renewables Stick With Cyber Security, Defense, And Renewables     Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com     Footnotes 1     See Lawrence H. Summers and Alex Domash, “History Suggests a High Chance of Recession over the Next 24 Months,” Harvard Kennedy School, March 15, 2022, www.hks.harvard.edu. 2     Consider the January 6 insurrection, the recent plot against Supreme Court Justice Brett Kavanaugh’s life, the gun attack on Republican Senators in 2017, and the risk of assassinations or other extremist incidents. 3    See Sean J. Westwood et al, “Current research overstates American support for political violence,” Proceedings of the National Academy of Sciences, 119:12 (2022), pnas.org. Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort Table A3US Political Capital Index Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort Chart A1Presidential Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort Chart A2Senate Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort  Table A4House Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort Table A5APolitical Capital: White House And Congress Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort Table A5BPolitical Capital: Household And Business Sentiment Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort Table A5CPolitical Capital: The Economy And Markets Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort