Oil

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

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

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

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

Executive Summary The Good: There are compelling reasons to believe the Ukraine war will not break out into a broader NATO-Russia war, i.e. World War III. The Bad: The 1945 peace settlement is breaking down and the world is fundamentally less stable. Even if the Ukraine war is contained, other wars are likely in the coming decade. The Ugly: Russia is not a rising power but a falling power and its attempt to latch onto China will jeopardize global stability for the foreseeable future. Secular Rise In Geopolitical Risk Is Empirical The Geopolitical Consequences Of The Ukraine War The Geopolitical Consequences Of The Ukraine War Trade Recommendation Inception Date Return LONG GOLD (STRATEGIC) 2019-12-06 32.3% Bottom Line: Within international equities, favor bourses that are least exposed to secular US geopolitical conflict with Russia and China, particularly in the Americas, Western Europe, and Oceania. Feature Two weeks ago our Global Investment Strategy service wrote a report called “The Economic And Financial Consequences Of The War In Ukraine,” arguing that while the war’s impact on commodity markets and financial conditions would be significant, the global economy would continue to grow and equity prices would rise over the coming 12 months. Related Report  Geopolitical Strategy2022 Key Views: The Gathering Storm This companion special report will consider the geopolitical consequences of the Ukraine war. The primary consequence is that “Great Power Struggle” will intensify, as the return of war to Europe will force even the most pacific countries like Germany and Japan to pursue their national security with fewer illusions about the capacity for global cooperation. Globalization will continue to decay into “Hypo-Globalization” or regionalism, as the US severs ties with Russia and China and encourages its allies to do the same. Specifically, Germany will ultimately cleave to the West, China will ultimately cleave to Russia, a new shatter-belt will emerge from East Europe to the Middle East to East Asia, and US domestic politics will fall short of civil war. Given that US financial assets are already richly priced, global investors should seek to diversify into cheaper international equities that are nevertheless geopolitically secure, especially those in the Americas, western Europe, and Oceania. Global Versus Regional Wars Russia’s invasion of Ukraine is a continuation of a regional war that started in 2014. The war has been contained within Ukraine since 2014 and the latest expansion of the war is also contained so far. The war broke out because Russia views a western-allied Ukraine as an intolerable threat to its national security. Its historic grand strategy calls for buffer space against western military forces. Moscow feared that time would only deepen Ukraine’s bonds with the West, making military intervention difficult now but impossible in the future. As long as Russia fails to neutralize Ukraine in a military-strategic sense, the war will continue. President Putin cannot accept defeat or the current stalemate and will likely intensify the war until he can declare victory, at least on the goal of “de-militarization” of Ukraine. So far Ukraine’s battlefield successes and military support from NATO make a Russian victory unlikely, portending further war. If Ukraine and Russia provide each other with acceptable security guarantees, an early ceasefire is possible. But up to now  Ukraine is unwilling to accept de-militarization and the loss of Crimea and the Donbass, which are core Russian demands (Map 1). Map 1Russian Invasion Of Ukraine, 2022 The Geopolitical Consequences Of The Ukraine War The Geopolitical Consequences Of The Ukraine War Russia’s invasion of Ukraine has caused a spike in the global geopolitical risk index, which is driven by international media discourse (Chart 1). The spike confirms that geopolitical risk is on a secular upward trend. The trough occurred after the fall of the Soviet Union when the world enjoyed relative peace and prosperity. The new trend began with the September 11, 2001 terrorist attacks and the US’s preemptive invasion of Iraq. This war initiated a fateful sequence in which the US became divided and distracted, Russia and China seized the opportunity to rebuild their spheres of influence, and international stability began to decline. Chart 1Secular Rise In Geopolitical Risk Is Empirical The Geopolitical Consequences Of The Ukraine War The Geopolitical Consequences Of The Ukraine War Now Russia’s invasion of Ukraine presents an opportunity for the US and its allies to rediscover their core national interests and the importance of collective security. This implies increasing strategic pressure not only on Russia but also on China and their ragtag group of allies, including Iran, Pakistan, and North Korea. The world will become even less stable in this context. Chart 2Russian War Aims Limited The Geopolitical Consequences Of The Ukraine War The Geopolitical Consequences Of The Ukraine War Still, Russia will not expand the Ukraine war to other states unless it faces regime collapse and grows desperate. The war is manifestly a stretch for Russia’s military capabilities and a larger war would weaken rather than strengthen Russia’s national security. NATO utterly overwhelms Russia’s military capacity, even if we are exceedingly generous and assume that China offers full military support along with the rest of the Shanghai Cooperation Organization (Chart 2). As things stand Russia still has the hope of reducing Ukraine without destroying its economic foundation, i.e. commodity exports. But an expansion of the war would destroy the regime – and possibly large swathes of the world given the risk of nuclear weapons in such a scenario. If Russia’s strategic aim were to rebuild the Soviet Union, then it would know that it would eventually need to fight a war with NATO and would have attacked critical NATO military bases first. At very least it would have cut off Europe’s energy supplies to induce a recession and hinder the Europeans from mounting a rapid military defense. It would have made deeper arrangements for China to buy its energy prior to any of these actions. At present, about three-fifths of Russian oil is seaborne and can be easily repurposed, but its natural gas exports are fixed by pipelines and the pipeline infrastructure to the Far East is woefully lacking (Chart 3). The evidence does not suggest that Russia aims for world war. Rather, it is planning on a war limited to eastern and southern Ukraine. Chart 3Russia Gas Cutoff Would Mean Desperation, Disaster The Geopolitical Consequences Of The Ukraine War The Geopolitical Consequences Of The Ukraine War None of the great powers are willing or forced to wage war with Russia directly. The US and UK are the most removed and hence most aggressive in arming Ukraine but they are still avoiding direct involvement: they have repeatedly renounced any intention of committing troops or imposing a no-fly zone over Ukraine and they are still limiting the quality of their defense aid for fear of Russian reprisals. The EU is even more keen to avoid a larger war. Germany and France are still attempting to maintain basic level of economic integration with Russia. China is not likely to enter the war on Russia’s behalf – it will assist Russia as far as it can without breaking economic relations with Europe. The war’s limitations are positive for global investors but only marginally. The law that governs the history of war is the law of unintended consequences. Investors should absolutely worry about unintended consequences, even as they strive to be clear-headed about Russia’s limited means and ends. If Russia fails or grows desperate, if it makes mistakes or miscalculates, if the US is unresponsive and aggressive, or if lesser powers attempt to provoke greater American or European security guarantees, then the war could spiral out of control. This risk should keep every investor alive to the need to maintain a reasonable allocation to safe-haven assets.  If not, the end-game is likely a deliberate or de facto partition of Ukraine, with Russia succeeding in stripping Crimea and the Donbass from Ukraine, destroying most of its formal military capacity, and possibly installing a pro-Russian government in Kyiv. Western Ukraine will become the seat of a government in exile as well as the source of arms and materiel for the militant insurgency that will burn in eastern Ukraine. Over the course of this year Russia is likely to redouble its efforts to achieve its aims – a summer or fall campaign is likely to try to break Ukraine’s resistance. But if and when commodity revenues dry up or Russia’s economic burden becomes unbearable, then it will most likely opt for ceasefire and use Ukrainian military losses as proof of its success in de-militarizing the country. Why Germany Will Play Both Sides But Ultimately Cleave To The West A critical factor in limiting the war to Ukraine is Europe’s continued energy trade with Russia. If either Russia or Europe cuts off energy flows then it will cause an economic crash that will destabilize the societies and increase the risk of military miscalculation. German Chancellor Olaf Scholz once again rejected a European boycott of Russian energy on March 23, while US President Joe Biden visited and urged Europe to intensify sanctions. Scholz argued that no sanctions can be adopted that would hurt European consumers more than the Kremlin. Scholz’s comments related to oil as well as natural gas, although Europe has greater ability to boycott oil, implying that further oil supply tightening should be expected. Germany is not the only European power that will refuse an outright boycott of Russian energy. Russia’s closest neighbors are highly reliant on Russian oil and gas (Chart 4). It only takes a single member to veto EU sanctions. While several western private companies are eschewing business with Russia, other companies will pick up the slack and charge a premium to trade in Russian goods. Chart 4Germany Will Diversify Energy But Not Boycott Russia The Geopolitical Consequences Of The Ukraine War The Geopolitical Consequences Of The Ukraine War Chart 5Economically, Germany Will Cleave To The West Economically, Germany Will Cleave To The West Economically, Germany Will Cleave To The West Germany’s insistence on maintaining a basic level of economic integration with Russia stems from its national interest. During the last Cold War, Germany got dismembered. Germany’s whole history consists of a quest for unification and continental European empire. Modern Germany is as close to that goal as possible. What could shatter this achievement would be a severe recession that would divide the European Union, or a war in Europe that would put Germans on the front lines. An expansion of the US sanction regime to cover all of Russia and China would initiate a new cold war and Germany’s economic model would collapse due to restrictions on both the import and export side. Germany’s strategy has been to maintain security through its alliance with America while retaining independence and prosperity through economic engagement with Russia and China. The Russia side of that equation has been curtailed since 2014 and will now be sharply curtailed. Germany has also been increasing military spending, in a historic shift that echoes Japan’s strategic reawakening over the past decade in face of Chinese security competition. Chart 6Strategically, Germany Will Cleave To The West The Geopolitical Consequences Of The Ukraine War The Geopolitical Consequences Of The Ukraine War But Germany will be extremely wary of doing anything to accelerate the process of economic disengagement with China. China does not pose a clear and present military threat to Germany, though its attempt to move up the manufacturing value chain poses an economic threat over time. As long as China does not provide outright military support for Russia’s efforts in Ukraine, and does not adopt Russia’s belligerence against neighboring democracies like Taiwan, Germany will avoid imposing sanctions. This stance will not be a major problem with the US under the Biden administration, which is prioritizing solidarity with the allies, but it could become a major problem in a future Republican administration, which will seek to ramp up the strategic pressure on China. Ultimately, however, Germany will cleave to the West. Germany is undertaking a revolution in fiscal policy to increase domestic demand and reduce export dependency. Meanwhile its export-driven economy is primarily geared toward other developed markets, which rake up 70% of German exports (78% of which go to other EU members). China and the former Soviet Union pale in comparison, at 8% and 3% respectively (Chart 5). From a national security perspective Germany will also be forced to cleave to the United States. NATO vastly outweighs Russia in the military balance. But Russia vastly outweighs Germany (Chart 6). The poor performance of Russia’s military in Ukraine will not console the Germans given Russian instability, belligerence, and nuclear status. Germany has no choice but to rely on the US and NATO for national security. If the US conflict with China escalates to the point that the US demands Germany carry a greater economic cost, then Germany will eventually be forced to yield. But this shift will not occur if driven by American whim – it will only occur if driven by Chinese aggression and alliance with Russia. Which brings us to our next point: China will also strive to retain its economic relationship with Germany and Europe. Why China Will Play Both Sides But Ultimately Cleave To Russia Chart 7China Will Delay Any Break With Europe China Will Delay Any Break With Europe China Will Delay Any Break With Europe The US cannot defeat China in a war, so it will continue to penalize China’s economy. Washington aims to erode the foundations of China’s military and technological might so that it cannot create a regional empire and someday challenge the US globally. Chinese cooperation with other US rivals will provide more occasions for the US to punish China. For example, Presidents Biden and Xi Jinping talked on March 18 and Biden formally threatened China with punitive measures if Beijing provides Russia with military aid or helps Russia bypass US sanctions. Since China will help Russia bypass sanctions, US sanctions on China are likely this year, sooner or later. Europe thus becomes all the more important to China as a strategic partner, an export market, and a source of high-quality imports and technology. China needs to retain close relations as long as possible to avoid a catastrophic economic adjustment. Europe is three times larger of an export market for China than Russia and the former Soviet Union (Chart 7). Chart 8China Cannot Reject Russia The Geopolitical Consequences Of The Ukraine War The Geopolitical Consequences Of The Ukraine War When push comes to shove, however, China cannot afford to reject Russia. Russia’s decision to break ties with Europe reflects the Putin regime’s assessment that the country cannot preserve its national security against the West without allying with China. Ultimately Russia offers many of the strategic benefits that China needs. Most obviously, if China is ever forced into a military confrontation with the West, say over the status of Taiwan, it will need Russian assistance, just as Russia needs its assistance today. China’s single greatest vulnerability is its reliance on oil imported from the Persian Gulf, which is susceptible to American naval interdiction in the event of conflict. Russia and Central Asia form the second largest source of food, energy, and metals for China (Chart 8). Russia provides an overland route to the supply security that China craves. Chart 9Russia Offers Key To China's Eurasian Strategy Russia Offers Key To China's Eurasian Strategy Russia Offers Key To China's Eurasian Strategy Russia also wields immense influence in Central Asia and significant influence in the Middle East. These are the critical regions for China’s Eurasian strategy, symbolized in the Belt and Road Initiative. Chinese investment in the former Soviet Union has lagged its investment in the Middle East and the rest of Asia but the Ukraine war will change that. China will have an historic opportunity to invest in the former Soviet Union, on favorable terms, to secure strategic access all the way to the Middle East (Chart 9). China will always prioritize its East Asian neighbors as investment destinations but it will also need alternatives as the US will inevitably seek to upgrade relations with Southeast Asia. Another reason China must accept Russia’s overtures is that China is aware that it would be strategically isolated if the West pulled off a “Reverse Kissinger” maneuver and allied with Russia. This option seems far-fetched today but when President Putin dies or is overthrown it will become a fear for the Chinese. There has never been deep trust between the Chinese and Russians and the future Russian elite may reject the idea of vassalage to China. Therefore just as Russia needs China today, China will need Russia in the future. Why The Middle East Will Rumble Again The Middle East is destabilizing once again and Russia’s invasion of Ukraine will reinforce this trajectory. Most directly, the reduction in grain exports from Russia and Ukraine will have a disproportionate impact on food supplies and prices in countries like Pakistan, Turkey, Egypt, Libya, and Lebanon (Chart 10).   A new shatter-belt will take shape not only in Russia’s and China’s neighborhood, as they seek to establish spheres of influence, but also in the Middle East, which becomes more important to Europe as Europe diversifies away from Russia. Part of the strategic purpose of Russia’s invasion is to gain greater naval access to the Black Sea and Mediterranean, and hence to expand its ability to project power across the Middle East and North Africa. This is both for general strategic purposes and to gain greater leverage over Europe via its non-Russian energy and supply sources. Chart 10A New Shatter-Belt Emerging The Geopolitical Consequences Of The Ukraine War The Geopolitical Consequences Of The Ukraine War The critical strategic factor in the Middle East is the US-Iran relationship. If the two sides arrange a strategic détente, then Iranian oil reserves will be developed, the risk of Iraqi civil war will decline, and the risk of general war in the Middle East will decline. This would be an important reduction of oil supply risk in the short and medium term (Chart 11). But our base case is the opposite: we expect either no deal, or a flimsy deal that does not truly reduce regional tensions. Chart 11Middle East Still Unstable, Still Essential The Geopolitical Consequences Of The Ukraine War The Geopolitical Consequences Of The Ukraine War A US-Iran nuclear deal might come together soon – we cannot rule it out. The Biden administration is willing to lift sanctions if Iran freezes its nuclear program and pledges to reduce its militant activities in the region. Biden has reportedly even provided Russia with guarantees that it can continue trading with Iran. Theoretically the US and Russia can cooperate to prevent Iran from getting nuclear weapons. Russia’s pound of flesh is that Ukraine be neutralized as a national security threat. However, any US-Iran deal will be a short-term, stop-gap measure that will fall short of a strategic détente. Iran is an impregnable mountain fortress and has a distinct national interest in obtaining deliverable nuclear weapons. Iran will not give up the pursuit of nuclear weapons because it cannot rely on other powers for its security. Iran obviously cannot rely on the United States, as any security guarantees could be overturned with the next party change in the White House. Tehran cannot rely on the US to prevent Israel from attacking it. Therefore Iran must pursue its own national survival and security through the same means as the North Koreans. It must avoid the predicaments of Ukraine, Libya, and Iraq, which never obtained nuclear weaponization and were ultimately invaded. Insofar as Iran wants to avoid isolation, it needs to ally with Russia and China, it cannot embark on a foreign policy revolution of engagement with the West. The Russians and Chinese are unreliable but at least they have an interest in undermining the United States. The more the US is undermined, the more of a chance Iran has to make progress toward nuclear weapons without being subject to a future US attack. Chart 12Iran’s Other Nuclear Option The Geopolitical Consequences Of The Ukraine War The Geopolitical Consequences Of The Ukraine War Of course, the US and Israel have declared that nuclear weaponization is a red line. Israel is willing to attack Iran whereas Japan was not willing to attack North Korea – and where there is a will there is a way. But Iran may also believe that Israel would be unsuccessful. It would be an extremely difficult operation. The US has not shown willingness to attack states to prevent them from going nuclear. A split between the US and Israel would be an excellent foreign policy achievement for Tehran. The US may desire to pivot away from the Middle East to focus on containing Russia and China. But the Middle East is critical territory for that same containment policy. If the US abandons the region, it will become less stable until a new security order emerges. If the US stays involved in the region, it will be to contain Iran aggressively or prevent it from acquiring nuclear weapons by force. Whatever happens, the region faces instability in the coming decade and the world faces oil supply disruptions as a result. Iran has significant leverage due to its ability to shutter the Strait of Hormuz, the world’s premier oil chokepoint (Chart 12). Why A Fourth Taiwan Strait Crisis Looms Chart 13US Cannot Deter China Without Triggering Crisis US Cannot Deter China Without Triggering Crisis US Cannot Deter China Without Triggering Crisis There is a valid analogy between Ukraine and Taiwan: both receive western military support, hence both pose a fundamental threat to the national security of Russia and China. Yet both lack a mutual defense treaty that obligates the US alliance to come to their defense. This predicament led to war in Ukraine and the odds of an eventual war in Taiwan will go up for the same reason. In the past, China could not prevent the US from arming Taiwan. But it is increasingly gaining the ability to take Taiwan by force and deter the US from military intervention. The US is slated to deliver at least $8.6 billion worth of arms by 2026, a substantial increase in arms sales reminiscent of the 1990s, when the Third Taiwan Strait Crisis occurred (Chart 13). The US will learn from Russian aggression that it needs to improve its vigilance and deterrence against China over Taiwan. China will view this American response as disproportionate and unfair given that China did nothing to Ukraine. Chart 14Taiwanese Opinion Hard To Reconcile With Mainland Rule The Geopolitical Consequences Of The Ukraine War The Geopolitical Consequences Of The Ukraine War China is probably just capable of defeating Taiwan in a war but Beijing has powerful economic and political incentives not to take such an enormous risk today, on Russia’s time frame. However, if the 2022-24 election cycle in Taiwan returns the nominally pro-independence Democratic Progressive Party to power, then China may begin to conclude that peaceful reunification will be politically unachievable. Already it is clear from the steady course of Taiwanese opinion since the Great Recession that China is failing to absorb Taiwan through economic attraction (Chart 14). As China’s trend economic growth falters, it will face greater sociopolitical instability at home and an even less compelling case for Taiwan to accept absorption. This will be a very dangerous strategic environment. Taiwan is the epicenter of the US-China strategic competition, which is the primary geopolitical competition of the century because China has stronger economic foundations than Russia. China will become even more of a threat to the US if fortified by Russian alliance – and China’s fears over US support for Taiwan necessitate that alliance. Why The US Will Avoid Civil War None of the headline geopolitical risks outlined above – NATO-Russia war, Israeli-Iranian war, or Sino-Taiwanese war – would be as great of risks if the United States could be relied on to play a stable and predictable role as the world’s leading power. The problem is that the US is divided internally, which has led to erratic and at times belligerent foreign policy, thus feeding the paranoia of US rivals and encouraging self-interested and hawkish foreign policies, and hence global instability. Chart 15True, A Second US Civil War Is Conceivable The Geopolitical Consequences Of The Ukraine War The Geopolitical Consequences Of The Ukraine War It seems likely that US political polarization will remain at historic peaks over the 2022-24 election cycle. The Ukraine war will probably feed polarization by adding to the Democratic Party’s woes. Inflation and energy prices have already generated high odds that Republicans will retake control of Congress. But midterm churn is standard political clockwork in the US. The bigger risk is stagflation or even recession, which could produce another diametric reversal of White House policy over a mere four-year period. Former President Donald Trump is favored to be the Republican presidential nominee in 2024 – he is anathema to the left wing and unorthodox and aggressive in his foreign and trade policies. If he is reelected, it will be destabilizing both at home and abroad. But even if Trump is not the candidate, the US is flirting with disaster due to polarization and uncertainties regarding the constitution and electoral system. Chart 16Yet US Polarization Is Peaking... Aided By Foreign Threats Yet US Polarization Is Peaking... Aided By Foreign Threats Yet US Polarization Is Peaking... Aided By Foreign Threats US polarization is rooted in ethnic, ideological, regional, and economic disparities that have congealed into pseudo-tribalism. The potential for domestic terrorism of whatever stripe is high. These divisions cannot said to be incapable of leading to widespread political violence, since Americans possess far more firearms per capita than other nations (Chart 15). In the event of a series of negative economic shocks and/or constitutional breakdown, US political instability could get much worse than what was witnessed in 2020-21, when the country saw large-scale social unrest, a contested election, and a rebellion at the Capitol. Yet we would take the other side of the bet. US polarization will likely peak in the coming decade, if it has not peaked already. The US has been extremely polarized since the election of 1800, but polarization collapsed during World War I, the Great Depression, and World War II. True, it rose during the Cold War, but it only really ignited during the Reagan revolution and economic boom of the 1980s, when wealth inequality soared and the Soviet Union collapsed (Chart 16). The return of proactive fiscal policy and serious national security threats will likely drive polarization down going forward. Investment Takeaways The good news is that the war in Ukraine is unlikely to spread to the rest of Europe and engender World War III. The bad news is that the risk of such a war has not been higher for decades. Investors should hedge against the tail risk by maintaining significant safe-haven assets such as gold, cash, Treasuries, and farmland. Chart 17Investment Takeaways Investment Takeaways Investment Takeaways Europe and China will strive to maintain their economic relationship, which will delay a total breakdown in East-West relations. However, Germany and Europe will ultimately cleave to the US, while China will ultimately cleave to Russia, and the pace of transition into a new bifurcated world will accelerate depending on events. If the energy shock escalates to the point of triggering a European or global economic crash, the pace of strategic confrontation will accelerate. The global peace that emerged in 1945 is encountering very significant strains comparable to the most precarious moments of the Cold War. The Cold War period was not peaceful everywhere but the US and USSR avoided World War III. They did so on the basis of the peace settlement of 1945. The reason the 1945 peace regime is decaying is because the US, the preponderant power, is capable of achieving global hegemony, which is threatening to other great powers. The US combines the greatest share of wealth and military power and no single power can resist it. Yet a number of powers are capable of challenging and undermining it, namely China, but also Russia in a military sense, as well as lesser powers. The US is internally divided and struggling to maintain its power and prestige. The result is a return to the normal, anarchic structure of international relations throughout history. Several powerful states are competing for national security in a world that lacks overarching law. Great Power struggle is here to stay. Investors must adjust their portfolios to keep them in tune with foreign policies – in addition to monetary and fiscal policies. Given that US and Indian equities are already richly valued, in great part reflecting this geopolitical dynamic, investors should look for opportunities in international markets that are relatively secure from geopolitical risk, such as in the Americas, Western Europe, and Oceania (Chart 17).   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Executive Summary Petrocurrencies Have Lagged Terms Of Trade Petrocurrencies Have Lagged Terms Of Trade Petrocurrencies Have Lagged Terms Of Trade  Petrocurrencies have lagged the surge in crude prices. This has been specific to the currency space since energy stocks have been in an epic bull market.Both cyclical and structural factors explain this conundrum.Cyclically, rising interest rate expectations in the US have dwarfed the terms-of-trade boost that the CAD, NOK, MXN, COP and even BRL typically enjoy (Feature Chart).Structurally, the US is now the biggest oil producer in the world (and a net exporter of natural gas). This has permanently shifted the relationship between the foreign exchange of traditional oil producers and the US dollar.Oil prices are overbought and vulnerable tactically to any resolution in the Russo-Ukrainian conflict. That said, they are likely to remain well bid over a medium-term horizon, ultimately supporting petrocurrencies.Petrocurrencies also offer a significant valuation cushion and carry relative to the US dollar, making them attractive for longer-term investors.Tactically, the currencies of oil producers relative to consumers could mean revert. It also suggests the Japanese yen, which is under pressure from rising energy imports, could find some footing, even as oil prices remain volatile.RECOMMENDATIONINCEPTION LEVELINCEPTION DATERETURNShort NOK/SEK1.112022-03-24-Bottom Line: Given our thesis of lower oil prices in the near term, but firmer prices in the medium term, we will be selling a basket of oil producers relative to oil consumers, with the aim of reversing that trade from lower levels.FeatureOil price volatility is once again dominating global market action. After hitting a low of close to $96/barrel on March 16th, Brent crude is once again at $120 as we go to press. Over the last two years, Brent crude has been as cheap as $16, and as expensive as $140. Energy stocks (and their respective bourses) have been the proximate winner from rising oil prices (Chart 1).Related ReportForeign Exchange StrategyWhat Next For The RMB?In foreign exchange markets, the currencies of commodity-producing countries have surprisingly lagged the improvement in oil prices (Chart 2). Historically, higher oil prices have had a profound impact on the external balance of oil producing versus consuming countries in general and petrocurrencies in particular. Chart 1Energy Stocks Have Tracked Forward Oil Prices Energy Stocks Have Tracked Forward Oil Prices Energy Stocks Have Tracked Forward Oil Prices   Chart 2Petrocurrencies Have Lagged Oil Prices Petrocurrencies Have Lagged Oil Prices Petrocurrencies Have Lagged Oil Prices  Based on the observation above, this report addresses three key questions:Are there cyclical factors depressing the performance of petrocurrencies?Are there structural factors that have changed the relationship of these currencies with the US dollar?What is the outlook for oil, and the impact on short term versus longer-term currency strategy?We will begin our discussion with the outlook for oil.Russia, Oil, And PetrocurrenciesA high-level forecast from our Commodity & Energy Strategy colleagues calls for oil prices to average $93 per barrel this year and next.1 The deduction from this forecast is that we could see spot prices head lower from current levels this year but remain firm in 2023. From our perspective, there are a few factors that support this view:Forward prices tend to move in tandem with the spot fixing (Chart 3), but recently have also been a fair predictor of where current prices will settle over the medium term. Forward oil prices are trading at a significant discount to spot, suggesting some measure of mean reversion (Chart 4). Chart 3Forward And Spot Oil Prices Move Together Forward And Spot Oil Prices Move Together Forward And Spot Oil Prices Move Together   Chart 4The Oil Curve And Spot Prices The Oil Curve And Spot Prices The Oil Curve And Spot Prices  There is a significant geopolitical risk premium embedded in oil prices. According to the New York Federal Reserve model, the demand/supply balance would have caused oil prices to fall between February 11 and February 25 this year. They however rose. This geopolitical risk premium has surely increased since then (Chart 5).Chart 5Oil Prices Embed A Significant Geopolitical Risk Premium The Oil-Petrocurrency Conundrum The Oil-Petrocurrency Conundrum  Russian crude is trading at a sizeable discount compared to other benchmarks. This means that the incentive for substitution has risen significantly. Our Chief Commodity expert, Robert Ryan, noted on BLU today that intake from India is rising. This is helping put a floor on the Russian URAL/Brent discount blend at around $30 (Chart 6). Oil is fungible, and seaborne crude can be rerouted from unwilling buyers to satiate demand in starved markets.A fortnight ago, we noted how the US sanctions on Russia could shift the foreign exchange landscape, especially vis-à-vis the RMB. Specifically, RMB-denominated trade in oil is likely to increase significantly going forward. China has massively increased the number of bilateral swap lines it has with foreign countries, while stabilizing the RMB versus the US dollar.2Finally, smaller open economies such as Canada, Norway and even Mexico are opening the oil spigots (Chart 7). While individually these countries cannot fill any potential gap in Russian production, collectively they could help in the redistribution of oil supplies. Chart 6Russian Oil Is Selling At A Discount Russian Oil Is Selling At A Discount Russian Oil Is Selling At A Discount   Chart 7Small Oil Producers Will Benefit From High Prices Small Oil Producers Will Benefit From High Prices Small Oil Producers Will Benefit From High Prices  The observations above suggest that the currencies of small oil-producing nations are likely to benefit in the medium term from a redistribution in oil demand. Remarkably, there has been little demand destruction yet from the rise in prices, according to the New York Fed. This suggests that as the global economy reopens, and the demand/supply balance tightens, longer-term oil prices will remain well bid.The key risk in the short term is the geopolitical risk premium embedded in oil prices fades, especially given the potential that Europe, China, and India continue to buy Russian supplies. We have been playing this very volatile theme via a short NOK/SEK position. We are stopped out this week for a modest profit and are reinitiating the trade if NOK/SEK hits 1.11.On The Underperformance Of Petrocurrencies? Chart 8Petrocurrencies Have Lagged Terms Of Trade Petrocurrencies Have Lagged Terms Of Trade Petrocurrencies Have Lagged Terms Of Trade  The more important question is why the currencies of oil producers like the CAD, NOK, MXN or even BRL have not kept pace with oil prices as they historically have. As our feature chart shows (Chart 8), petrocurrencies have severely lagged the improvement in their terms of trade. This has been driven by both cyclical and structural factors.Cyclically, the underlying driver of FX in recent quarters has been the nominal interest rate spread between the US and its G10 counterparts. We have written at length on this topic, and on why we think there is a big mispricing in market behavior in our report – “The Biggest Macro Question By FX Investors Could Potentially Be The Least Relevant.” In a nutshell, two-year yields in the G10 have been lagging US rates, despite other central banks being ahead of the curve in hiking interest rates. This means that rising interest rate expectations in the US have dwarfed the terms of trade boost that the CAD, NOK, MXN, COP and even BRL typically enjoy.Structurally, the US is now the biggest oil producer in the world (Chart 9). This means the CAD/USD and NOK/USD exchange rates are experiencing a tectonic shift on a terms-of-trade basis. In 2010, the US accounted for only about 6% of global crude output. Collectively, Canada, Norway, and Mexico shared about 10% of global oil production. The elephant in the room was OPEC, with a market share just north of 40%. Today, the US produces over 14%, with Russia and Saudi Arabia around 13% each, the US having grabbed market share from many other countries. Chart 9The US Dominates Oil Production The US Dominates Oil Production The US Dominates Oil Production   Chart 10The US Dollar Is Becoming Increasingly Correlated To Oil The US Dollar Is Becoming Increasingly Correlated To Oil The US Dollar Is Becoming Increasingly Correlated To Oil  As a result of this shift, the positive correlation between petrocurrencies and oil has gradually eroded. Measured statistically, the dollar had a near-perfect negative correlation with oil around the time US production was about to take off. Since then, that correlation has risen from around -0.9 to around -0.2 (Chart 10).A Few Trade IdeasThe analysis above suggests a few trade ideas are likely to generate alpha over the medium term:Long Oil Producers Versus Oil Consumers: This trade will suffer in the near term as oil prices correct but benefit from a relatively tighter market over a longer horizon. It will also benefit from the positive carry that many oil producers provide (Chart 11). We will go long a currency basket of the CAD, NOK, MXN, BRL, and COP versus the euro at 5% below current levels.Chart 11Real Rates Are High Amongst Petrocurrencies The Oil-Petrocurrency Conundrum The Oil-Petrocurrency Conundrum  Sell CAD/NOK As A Trade: Norway is at the epicenter of the likely redistribution that will occur with a Russian blockade of crude, while Canada is further away from it. Terms of trade in Norway are doing much better than a relative measure in Canada (Chart 12). The discount between Western Canadian Select crude oil and Brent has also widened, which has historically heralded a lower CAD/NOK exchange rate. Chart 12CAD/NOK And Terms Of Trade CAD/NOK And Terms Of Trade CAD/NOK And Terms Of Trade  Follow The Money: Oil now trades above the cash costs for many oil-producing countries. This means the incentive to boost production, especially when demand recovers, is quite high. This incentivizes players with strong balance sheets to keep the taps open. This could be a particular longer-term boon for the Canadian dollar which is seeing massive portfolio inflows (Chart 13). Chart 13Canadian Oil Export Boom And Portfolio Flows Canadian Oil Export Boom And Portfolio Flows Canadian Oil Export Boom And Portfolio Flows  On The Yen (And Euro): Rising oil prices have been a death knell for the yen which is trading in lockstep with spot prices. Ditto for the euro. However, the yen benefits from very cheap valuations and extremely depressed sentiment. Any temporary reversal in oil prices will boost the yen (Chart 14). In our trading book, we were stopped out of a short CHF/JPY position last Friday, and we will look to reinitiate this trade in the coming days.  Chart 14The Yen And Oil Prices The Yen And Oil Prices The Yen And Oil Prices   Chester NtoniforForeign Exchange Strategistchestern@bcaresearch.comFootnotes1 Please see Commodity & Energy Strategy Weekly Report, “Uncertainty Tightens Oil Supply”, dated March 17, 2022.2 Please see Foreign Exchange Strategy Special Report, “What Next For The RMB?”, dated March 11, 2022.Trades & ForecastsStrategic ViewTactical Holdings (0-6 months)Limit OrdersForecast Summary

Executive Summary Oil Remains A Prominent Inflation Variable WTI Futures Strongly Linked To US Inflation Expectations WTI Futures Strongly Linked To US Inflation Expectations Tight oil and metals markets will translate into persistently high inflation and inflation expectations over the next 5 – 10 years. High and volatile commodity prices caused by low capex will keep global inventories tight for years.  This will keep the key 5-year/5-year (5y5y) CPI swap rates used by policy makers elevated, given the strong relationship between commodity prices – particularly longer-dated oil prices – and inflation expectations. Central banks will exacerbate this tightness if they follow through on more aggressive policy.  This would increase the cost of capital for commodity producers and could induce a recession.  All the same, commodity supplies still will remain tight, and will keep inflationary pressures emanating from the real economy elevated.  Stagflation is the likely outcome. Gold is lagging as an inflation hedge vs. the average return of our commodity recommendations.  We expect this to persist.  Still, as a safe-haven and store of value during recessionary and inflationary periods, we continue to recommend gold as a portfolio hedge. Bottom Line: The dearth of capex in oil, gas and base metals markets makes persistently high inflation a foregone conclusion for the next 5-10 years.  We remain long the S&P GSCI and the COMT ETF for direct commodity-index exposure, and the XOP, XME and PICK ETFs for exposure to commodity producers' equity. Feature That's all well and good in practice, but how does it work in theory? - Seen on a T-shirt at the University of Chicago1 Related Report  Commodity & Energy StrategyCommodities' Watershed Moment   Central banks are signaling they expect higher inflation and inflation expectations to persist, and now are communicating their collective resolve to deal with this aggressively, if needs be.2 As central-bank policy evolves, commodities – particularly oil – will become even more important as coincident and leading indicators used to assess the likely course of inflation and inflation expectations, particularly their persistence. The ECB notes oil prices have become more than just one of the input costs of manufacturing, or of mining, agriculture and the production of other forms of energy essential to powering modern economies, and delivering these goods globally. For the ECB, "oil is barometer of global economic activity as well as a financial asset."3 Likewise, the BIS stresses the importance of augmenting conventional Phillips curve models with commodity inputs to more accurately capture inflation dynamics.4 This Special Report follows our earlier report published on March 10, 2022 entitled Commodities' Watershed Moment. Here we explore the consequences of tightening commodity markets, especially as regards inflation and inflation expectations, and attempt to dispel some notions about commodities and markets that could lead to policy errors. We also evaluate our commodity recommendations' performance as inflation hedges compared to gold's performance. Modeling Inflation And Inflation Expectations Our own research and modeling broadly aligns with the ECB and BIS approaches. We periodically estimate cointegrating regressions of inflation expectations using WTI futures prices to forecast 5y5y CPI swap rates (Chart 1).5 Our results are strongest when we use 3-years forward WTI prices to forecast 5y5y CPI swap rates, but shorter-term futures also provide useful information and are cointegrated with inflation expectations discovered in the 5y5y market (Chart 2). The prompt-delivery WTI futures are cointegrated with the longer-dated 3-years forward futures contract, indicating that, over time, these different maturities are following a common long-term trend. This also explains why a similar equilibrium obtains using commodity indexes – the Bloomberg Commodity Index, the S&P GSCI, etc. – as regressors in estimating inflation expectations via the 5y5y CPI swap rates. Chart 1WTI Futures Strongly Linked To US Inflation Expectations WTI Futures Strongly Linked To US Inflation Expectations WTI Futures Strongly Linked To US Inflation Expectations Chart 2US Oil Output Slightly Higher US Oil Output Slightly Higher US Oil Output Slightly Higher Globalization of production, distribution and consumption across markets weaves these markets together – e.g., global fertilizer markets experienced a supply shock this past winter when large consuming markets in Asia and Europe got into a bidding war for limited LNG supplies – and transmits shocks across commodity markets. This partly explains the common long-term trend commodities generally share. Another feature weaving markets together globally is the fact that most global trade is invoiced and funded in USD, which means that the Fed's monetary policy decisions reverberate around the world when rates are increased or dollar liquidity is reduced.6 Lastly, trading markets are global. Commodity markets have evolved – as the ECB notes – into asset markets as well as hedging markets. This means arbitrage across commodity and rates markets (interest rates, inflation rates, FX rates, etc.) accelerates the impounding of information into prices quickly. In this environment, cointegration is strengthened among physical and financial trading markets, creating prices that share long-term equilibria. This makes the current time especially fraught, as the Fed embarks on a policy-tightening course against the backdrop of war in Europe and global commodity shortages. These effects are experienced across geographies and across time, forming a dynamic system in which supply, demand and inventories are constantly adjusting to new information. This affects current and expected fundamentals and financial conditions, which arrives to markets instantaneously. It is not surprising, then, that prices in these markets are, for the most part, cointegrated over the long run.7 Policy Errors Likely On The Way Monetary policy is not well suited to dealing with commodity scarcity. Nor is fiscal policy – e.g., government subsidies to soften the blow of rising energy prices only encourage over-consumption of scarce resources, which accelerates inventory depletion and tightens markets further. The Fed, in particular, likely is reviewing its 1970s playbook for lessons learned in the last major supply shock to hit the world – the Arab Oil Embargo of 1973, which was followed by the Iran-Iraq war in 1979. Together, these events triggered a surge in real oil prices, which rose by 4.5x – from $21.55/bbl in 1970 to $116.11/bbl in 1980, according to the EIA (Chart 3). Chart 3Fed Will Look Back At 1970s Playbook Tight Commodity Markets: Persistently High Inflation Tight Commodity Markets: Persistently High Inflation In setting policy, economists generally – at the Fed, the IMF, the World Bank and elsewhere – mistakenly view commodity forward curves as something of a forecast.8 This use of the futures curve is mistaken because it only reflects the price levels as which transactions occurred on any given day. So while a non-specialist might view a backwardated forward curve for Brent as a market-based forecast for lower prices in the future – since prompt prices are trading below deferred prices – a more accurate reading would suggest markets are tight and likely will remain tight. This particular term structure indicates physical inventories are tight, and will remain so until sufficient supply is brought to market to allow refiners to restock. Steep backwardations also predispose markets to higher price volatility, because because of low inventory levels: The market's shock absorber (inventories) is low, so volatility increases.9 Suppose policy makers are counting on lower oil prices – per a forward curve's "forecast" – to bring inflation down. In that case, they likely will be disappointed unless additional supplies arrive. Should the Fed act on the belief that backwardation is a forecast for lower prices and continue to provide forward guidance to markets suggesting inflation will be lower next year, e.g., any delay in its rate hikes will leave it behind the inflation curve. Additional policy errors can come from the fiscal side, for example, when governments provide subsidies to soften the blow of higher oil prices. This retards the function of the price mechanism, and incentivizes higher consumption, which will exacerbate price increases. This would be bullish for oil prices in the short and medium term (6 months – 2 years). Commodity markets are tight globally – at or near scarcity levels in many cases, as can be seen by the continually declining inventories in oil and base metals (Chart 4 and 5). Base metals markets are extremely tight, and are on the back foot – i.e., with physical deficits and low inventories – just as the world's largest economic blocks (EU, US, China) are launching massive buildouts of their renewable-generation fleets and electric grids, and embarking on massive military buildups. These applications will require huge increases in base metals supplies to pull off. Grain markets will tighten as the impact of the Russian invasion of Ukraine unfolds in the spring, when winter wheat crops in Ukraine will need to be fertilized and tended. Chart 4Oil Markets Remain Tight... Oil Markets Remain Tight... Oil Markets Remain Tight... Chart 5…As Do Metals Tight Commodity Markets: Persistently High Inflation Tight Commodity Markets: Persistently High Inflation Barring an extremely deep recession that sharply reduces aggregate demand globally, it is difficult to see how this is not inflationary for years to come. Nonetheless, even a deep recession will still leave markets massively short base metals, and, after core-OPEC producers Saudi Arabia and the UAE bring what left of their spare capacity to market, oil. Investment Implications In days gone by, gold served as a go-to inflation hedge. At present, gold is lagging as an inflation hedge vs. the average return of our direct and equity-related commodity recommendations (Chart 6). We expect this to persist. Gold has performed well against the broad-trade weighted USD, however (Chart 7). We continue to recommend gold as a portfolio hedge, as it remains responsive to policy and geopolitical shocks. And it remains a safe-haven and store of value during recessionary and inflationary periods. Chart 6Commodity Recommendations Outperform Gold Commodity Recommendations Outperform Gold Commodity Recommendations Outperform Gold Chart 7Gold Outperforms USD Gold Outperforms USD Gold Outperforms USD The dearth of capex in oil, gas and base metals markets makes persistently high inflation a foregone conclusion for the next 5-10 years, barring a steep recession. Such a turn of events diminishes in probability, as governments keep funneling subsidies to households to soften the blow of higher prices and stave off a recessionary contraction in GDP. These subsidies only succeed in retarding the price signal the market is sending to reduce consumption of scarce commodities, which means available inventories will be drawn down more quickly. We remain long the S&P GSCI and the COMT ETF for direct commodity-index exposure, and the XOP, XME and PICK ETFs for exposure to commodity producers' equity. These are long-term holdings, given our view the commodities bull market will run for years.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Footnotes 1     Please see That Works Very Well in Practice, But How Does It Work In Theory? Published by quoteinvestigator.com for a history of how this phrase made it to UChicago's T-shirts. 2     Please see Between A Rock And A Hard Place, published 21 March 2022 by our US Investment Strategy, which is led by Doug Peta, a UChicago alum. 3    For insight into how central banks assess inflation and inflation expectations vis-à-vis commodity markets, particularly oil, please see the ECB's September 2020 working paper entitled " Global financial markets and oil price shocks in real time," by Fabrizio Venditti, Giovanni Veronese.  In it, the authors note, "The role that the price of oil plays in economic analysis in central banks and in financial markets has evolved over time. Oil is not seen anymore just as a (sic) input to production but also as a barometer of global economic activity as well as a financial asset."   4    The BIS recently noted augmenting standard Phillips Curve models with information from commodities and FX markets to reflect the profound changes wrought by globalization is critical for improving inflation forecasts, and explaining the dynamics of inflation and inflation expectations. Please see "Has globalization changed the inflation process?" by Kristin J. Forbes, published by the Bank for International Settlements in June 2019.  She notes, "The results in this paper suggest it is necessary to incorporate additional “global” factors in models of inflation dynamics, including global slack, non-fuel commodity prices (as well as oil prices), the exchange rate, and global price competition" to accurately explain and forecast inflation.  See below for further discussion. 5    In our modeling, the regressor with the best fit in our 5y5y CPI swap forecasts is the WTI 3-years forward futures contract. Both the 5y5y CPI swap rate and the WTI futures are non-stationary variables sharing a common long-term trend, meaning these are cointegrated random variables. The time series we use start in 2010, so post-GFC, which was a regime change for markets globally. The regression diagnostics are very strong, particularly for the ARDL model. We also find the 3-years forward WTI price is cointegrated with the prompt WTI futures contract, indicating these variables – one calling for delivery of crude oil in 3 years, the other in one month – are cointegrated. We get similar cointegration results using commodity indexes – e.g., the Bloomberg Commodity Index, and the LME base metals index – which tend to use futures contracts closer to delivery. This indicates commodity prices generally can be thought of as non-stationary variables vibrating randomly around a common long-term trend. We use cointegration models to avoid spurious relationships – e.g., regressing a stationary variable on a non-stationary variable. Statistically, cointegration is much stronger than simple correlation because it avoids the trap of spurious relationships. Please see Granger, C.W.J., Developments in the Study of Cointegrated Variables, Chapter 4 in Engle and Granger (eds): 1991, Long-Run Economic Relationships. Readings in Cointegration, Oxford University Press. This is an a article by Clive Granger, who received the Nobel prize in economics in 2003 for his pioneering work developing the mathematics of cointegration. See also Geman, H. (2007), Mean reversion versus random walk in oil and natural gas prices, in Advances in Mathematical Finance (pp. 219-228), for a rigorous discussion of random-walking oil and gas variables. 6    Please see Global Dimensions of U.S. Monetary Policy by Maurice Obstfeld, which appeared in the February 2020 issue of International Journal of Central Banking for an excellent discussion of the Fed's role in global trade. This is not all a one-way street, as Obstfeld notes, in that policy decisions can create "potential spillback onto the U.S. economy from the disproportionate influence of U.S. monetary policy on the outside world." 7     These cointegrating features of commodity markets, inflation rates and USD effects are not agreed by all economists. See, e.g., the Oxford Institute for Energy Studies report of August 2021 Is the Oil Price-Inflation Relationship Transitory? by Ilia Bouchouev. The paper notes, "In theory, the fundamental relationship that exists between short-term inflation and gasoline futures should be fading away with time, and for 5y5y breakeven it should indeed be close to zero. In practice, however, it is not." 8    Please see Forecasting the price of oil, which was published by the ECB in Issue 4 of its 2015. The Bank notes, "Oil price futures are frequently used as the baseline for oil price assumptions in economic projections. They are used, for example, in the Eurosystem/ECB staff macroeconomic projections and in the projections of many other central banks and international institutions. The main reason for using futures as a baseline for oil price assumptions is that they provide a simple and transparent method which is easy to communicate." (p. 90) 9    Please see Kogan, Leonid, Dmitry Livdan and Amir Yaron (2009), " Oil Futures Prices in a Production Economy With Investment Constraints," The Journal of Finance, 64:3, pp. 1345-1375.   Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image

Due to travel commitments, there will be no Counterpoint report next week. Instead, we will send you a timely update and analysis of the Ukraine Crisis written by my colleague Matt Gertken, BCA Chief Geopolitical Strategist. Executive Summary The tight connection between the oil price and inflation expectations is intuitive, appealing… and wrong. The inflation market is tiny, and its principle function is not to predict inflation per se, but to serve as a hedging investment in an inflation scare, such as that which follows an oil price spike. Hence, we should treat inflation expectations and the real bond yield that is derived from them with extreme care – especially after an oil price spike, which will give the illusion that the real bond yield is lower than it really is. In the near term, the Ukraine crisis has added to already elevated fears about inflation, which will pressure both bonds and stocks. However, looking beyond the next few months, the Ukraine crisis triggered supply shock will cause demand destruction, while central banks also choke demand, and the recent massive displacement of demand into goods, and its associated inflationary impulse, reverses. The 12-month asset allocation conclusion is to overweight stocks and bonds, and to underweight TIPS and commodities. Fractal trading watchlist: The sell-off in some T-bonds is approaching capitulation. The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Wrong The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive,Appealing... And Wrong The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive,Appealing... And Wrong Bottom Line: In the near term, an inflationary impulse will dominate, but on a 12-month horizon, a disinflationary impulse will dominate. Feature In his seminal work Thinking Fast And Slow, Nobel Laureate psychologist Daniel Kahneman presented the bat-and-ball puzzle. A bat and ball cost $1.10. The bat costs one dollar more than the ball. How much does the ball cost? “A number came to your mind. The number, of course, is 10: 10 cents. The distinctive mark of this easy puzzle is that it evokes an answer that is intuitive, appealing, and wrong. Do the math, and you will see. If the ball costs 10 cents, then the total cost will be $1.20 (10 cents for the ball and $1.10 for the bat), not $1.10. The correct answer is 5 cents. It is safe to assume that the intuitive answer also came to the mind of those who ended up with the correct number – they somehow managed to resist the intuition.” Kahneman’s crucial finding is that many people are prone to place too much faith in an intuitive answer, an intuitive answer that they could have rejected with a small investment of effort. The Connection Between The Oil Price and Inflation Expectations Is Intuitive, Appealing… And Wrong Today, the financial markets are presenting their very own bat-and-ball puzzle. The surging price of crude oil is driving up the market expectation for inflation over the next ten years (Chart I-1). This tight relationship is intuitive and appealing, because we associate a high oil price with a high inflation rate. But the intuitive and appealing relationship is wrong, and it requires just a small investment of effort to prove the fallacy. Chart I-1The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Wrong The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Wrong The Tight Relationship Between The Oil Price And Inflation Expectations Is Intuitive, Appealing... And Wrong Inflation over the next ten years equals the price in ten years’ time divided by the current price. So, to the extent that there is any relationship between the current price and expected inflation, dividing by a higher price today means a lower prospective inflation rate. Empirically, the last fifty years of evidence confirms this very clear inverse relationship (Chart I-2). Chart I-2A High Oil Price Means Lower Subsequent Inflation A High Oil Price Means Lower Subsequent Inflation A High Oil Price Means Lower Subsequent Inflation This raises an obvious question: while many people accept the intuitive (wrong) relationship between the oil price and expected inflation, how can the market make such a glaring error? The answer is that the inflation market is relatively tiny, and that its principle function is not to predict inflation per se, but to serve as a hedging investment in an inflation scare. Compared to the $25 trillion T-bond market, the Treasury Inflation Protected Securities (TIPS) market is worth just $1.5 trillion, slightly more than the market capitalisation of Tesla. Just as we do not expect Tesla to represent the view of the entire stock market, we should not expect TIPS to represent the view of the entire bond market. A high oil price means lower subsequent inflation. A recent paper by The Oxford Institute For Energy Studies explains: “the tight relationship between the oil price and inflation expectations defies not only the thesis of economics, but the norms of statistics as well, with a correlation that has reached 90 percent over the last ten years and a corresponding r-squared of 82 percent (Chart I-3 and Chart I-4). The root cause of this phenomenon should probably be searched for in the behaviour of another large group of market participants, the systematic portfolio allocators, and factor investors.”1  Chart I-3Inflation Expectations Are Just A Mathematical Function Of The Oil Price... Inflation Expectations Are Just A Mathematical Function Of The Oil Price... Inflation Expectations Are Just A Mathematical Function Of The Oil Price... Chart I-4...Therefore 'The Real Bond Yield' Is Just A Mathematical Function Of The Oil Price ...Therefore 'The Real Bond Yield' Is Just A Mathematical Function Of The Oil Price ...Therefore 'The Real Bond Yield' Is Just A Mathematical Function Of The Oil Price So, here’s the explanation for the intuitive, appealing, but wrong connection between the oil price and inflation expectations. In the inflation scare that a surging oil price unleashes, the two main asset-classes – bonds and equities – are vulnerable to sharp losses, leaving TIPS as one of the very few assets that can provide a genuine hedge against inflation. But given that bonds and equities dwarf the $1.5 trillion TIPS (and other inflation) markets, the inflation hedger quickly becomes the dominant force in this tiny market. This large volume of hedging demand chasing limited supply drives down the real yields on TIPS to artificial lows, both in absolute terms and relative to T-bond yields. And as the difference between nominal and real yields defines the ‘market’s expected inflation’, it explains the surge in expected inflation. Be Careful How You Use ‘The Real Bond Yield’ It is an unfortunate reality that we often close the stable door after the horse has bolted, meaning that we react after, rather than before, the event. In financial market terms, this means that we demand inflation protection after, rather than before, it happens, and end up overpaying for it. A high oil price unleashes a massive hedging demand for the tiny TIPS market, driving down the real TIPS yield versus the nominal T-bond yield. To repeat, a high oil price unleashes a massive hedging demand for the tiny TIPS market, driving down the real TIPS yield versus the nominal T-bond yield. The upshot is that the performance of TIPS versus T-bonds is nothing more than a play on the oil price (Chart I-5). Chart I-5The Performance Of TIPS Versus T-Bonds Is Just A Play On The Oil Price The Performance Of TIPS Versus T-Bonds Is Just A Play On The Oil Price The Performance Of TIPS Versus T-Bonds Is Just A Play On The Oil Price A bigger message is that we should interpret the oft-quoted ‘real bond yield’ with extreme care. The real bond yield is nothing more than the nominal bond yield less a mathematical function of the oil price. So, when the oil price is high, it will give the illusion that the real bond yield is low. The danger is that if we value equities against the real bond yield when the oil price is high – such as through 2011-14 or now – equities will appear cheaper than they really are (Chart I-6). Chart I-6When The Oil Price Is High, 'The Real Bond Yield' Will Appear Lower Than It Really Is When The Oil Price Is High, 'The Real Bond Yield' Will Appear Lower Than It Really Is When The Oil Price Is High, 'The Real Bond Yield' Will Appear Lower Than It Really Is In The Case Against A ‘Super Bubble’ (And The Case For) we explained the much better way to value equities is versus the product of the nominal bond price and current profits. This valuation approach perfectly explains the US stock market’s evolution both over the long term (Chart I-7) and the short term. Specifically, over the past year, the dominant driver of the US stock market has been the 30-year T-bond price (Chart I-8). Chart I-7The US Stock Market = Profits Times The 30-Year T-Bond Price (Long-Term Chart) The US Stock Market = Profits Times The 30-Year T-Bond Price (Long-Term Chart) The US Stock Market = Profits Times The 30-Year T-Bond Price (Long-Term Chart) Chart I-8The US Stock Market = Profits Times The 30-Year T-Bond Price (Short-Term Chart) The US Stock Market = Profits Times The 30-Year T-Bond Price (Short-Term Chart) The US Stock Market = Profits Times The 30-Year T-Bond Price (Short-Term Chart) 12-Month Asset Allocation Conclusion The current inflation scare comes not from an aggregate demand shock, but from a massive displacement of demand (into goods) followed by the more recent supply shock for energy and food triggered by the Ukraine crisis. In response, central banks are trying to douse the inflation in the only way they can – by choking aggregate demand. Hence, there is a dangerous mismatch between the malady and the remedy. In the near term, the Ukraine crisis has added to already elevated fears about inflation – and this will pressure both bonds and stocks. However, looking beyond the next few months, the near-term inflationary impulse will unleash a disinflationary response from three sources. First, a supply shock means higher prices without stronger demand, which causes an inevitable demand destruction that then pulls down prices. Second, central banks are explicitly trying to pull down prices – or at least price inflation – by choking demand. And third, the massive displacement of demand into goods, and its associated inflationary impulse, is reversing. On a 12-month horizon, the disinflationary impulse will outweigh the inflationary impulse. Therefore, on a 12-month horizon, the disinflationary impulse will outweigh the inflationary impulse. The asset allocation conclusion is to overweight stocks and bonds, and to underweight TIPS and commodities. Is The Bond Sell-Off Close To Capitulation? Finally, several clients have asked if the recent sell-off in bonds is close to capitulation, based on the fragility of its fractal structures. The answer is yes, but only for the shorter maturity T-bonds. Specifically, the 5-year T-bond has reached the point of fragility on its composite 130-day/260-day fractal structure that marked the bottom of the sell-off in 2018, as well as the top of the rally in 2020 (Chart I-9). Chart I-9The Sell-Off In Shorter-Dated T-Bonds Is Close To Capitulation The Sell-Off In Shorter-Dated T-Bonds Is Close To Capitulation The Sell-Off In Shorter-Dated T-Bonds Is Close To Capitulation Accordingly, this week’s trade recommendation is to buy the 5-year T-bond, setting the profit target and symmetrical stop-loss at 4 percent, and with a maximum holding period of 1 year. Please note that our full fractal trading watchlist is now available on our website:  cpt.bcaresearch.com     Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 https://www.oxfordenergy.org/wpcms/wp-content/uploads/2021/08/Is-the-Oil-Price-Inflation-Relationship-Transitory.pdf Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Chart 5Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Vs. Software Approaching A Reversal US Healthcare Vs. Software Approaching A Reversal US Healthcare Vs. Software Approaching A Reversal Chart 7The Euro’s Underperformance Could Be Approaching a Resistance Level The Euro's Underperformance Could Be Approaching a Resistance Level The Euro's Underperformance Could Be Approaching a Resistance Level Chart 8A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 9Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 10Biotech Approaching A Major Buy Biotech Approaching A Major Buy Biotech Approaching A Major Buy Chart 11CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 12Financials Versus Industrials Is Reversing Financials Versus Industrials Is Reversing Financials Versus Industrials Is Reversing Chart 13Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 14Greece's Brief Outperformance Has Ended Greece's Brief Outperformance Has Ended Greece's Brief Outperformance Has Ended Chart 15BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Fractal Trading System Fractal Trades Solved: The Mystery Of The Oil Price And Inflation Expectations Solved: The Mystery Of The Oil Price And Inflation Expectations Solved: The Mystery Of The Oil Price And Inflation Expectations Solved: The Mystery Of The Oil Price And Inflation Expectations 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary Higher Prices Expected Higher Prices Expected Higher Prices Expected Global oil supply will move lower for a few months, until shipping can be re-routed and re-priced in response to sanctions against Russian oil producers and refiners.  In the wake of another outbreak of COVID-19 in China, oil demand will likely move marginally lower in the near term.  Chinese fiscal stimulus to support demand and Chinese equity markets will be bullish for oil, natgas and metals. Work-arounds by China and India to circumvent Western sanctions likely will keep the hit to Russian oil production contained to March and April.  However, longer term – 2024 and beyond – sanctions will put Russia's oil output on a downward trajectory. Saudi Arabia will launch an experiment this year to be paid in yuan for oil exports to China.  As a risk-management strategy, KSA needs USD alternatives for storing wealth and retaining access to its foreign reserves, given the success of sanctions in restricting Russia's access to its foreign reserves following its invasion of Ukraine. Our Brent forecast is higher, averaging $93/bbl for this year and in 2023. Bottom Line: We recommend buying the dip in any oil-and-gas equity sell-off.  We remain long the XOP ETF.  We also remain long the S&P GSCI and COMT ETF – long commodity-index based vehicles that benefit from higher commodity prices and increasing backwardation in these markets, particularly oil. Feature Shipping delays in the wake of sanctions – official and self-imposed – against Russian oil and gas exports will stretch out global hydrocarbon supply chains in 1H22. This will have the effect of reducing actual supply, as these vessels are re-routed, and work-arounds are found to get oil to ports accepting Russian material.1 Related Report  Commodity & Energy Strategy2022 Key Views: Past As Prelude For Commodities So far, China and India appear to be moving quickly to develop sanctions work-arounds. Both have long-term trading relationships with Russia, and, in the case of India, the capacity to revive a treaty covering rupee-invoicing of trade in commodities and arms. Estimates of the total hit to Russian oil production resulting from export sanctions imposed by the West following its invasion of Ukraine last month range as high as 5mm b/d in output losses, but we do not share that view.2 There is a strong desire for discounted oil in China and India, and to find alternatives to USD-denominated trade. This has been catalyzed by the sanctions on Russia's central bank and the shutdown of access to its foreign reserves. Payment-messaging systems competitive with the Brussels-based SWIFT network have been stood up already. These will be refined in the wake of the Ukraine war by states with a long-standing desire to diversify payment systems away from the world's reserve currency (i.e., the USD). Among these states, the Kingdom of Saudi Arabia (KSA) is reported to be exploring alternatives for diversifying away from USD-based payment systems, and foreign-reserves custodial relationships dependent on Western central-bank oversight – particularly the US Fed.3 In addition, as ties between China and GCC states have strengthened, the Kingdom might also be looking to diversify its defense partnerships, particularly given the open hostility between the Biden administration in the US and KSA's leadership. Monitoring Chinese state media coverage of this will provide a good indication of the extent of such cooperation. Assessing Highly Uncertain Supply In our base case, Russian output likely falls by ~ 1mm b/d over the March-April period because of shipping delays that force production to be throttled back at the margin due to storage constraints. In its magnitude, this is a similar assumption to the reference case considered by the Oxford Institute for Energy Studies (OIES) but is extended for two months (Table 1).4 We expect shipping delays and payment work-arounds to be sorted out in a couple of months, which, given the incentives of all involved, does not seem unreasonable. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Uncertainty Tightens Oil Supply Uncertainty Tightens Oil Supply In our base case modeling, supply changes by core-OPEC 2.0 in 2022 are required to meet physical deficits brought about by less-than-expected volumes returned to the market by the entire coalition from August 2021 to now. This amounts to ~ 1.2mm b/d by our reckoning. For all of 2022, we assume core-OPEC 2.0 will lift supply by 1.3mm b/d, with most of this being provided to markets beginning in May 2022. In 2023, supplies from KSA, UAE and Kuwait are assumed to increase by roughly 0.2mm b/d, led by KSA (Chart 1). This is higher relative to our previous estimates, given our expectation, this core group will have to lift output to compensate not only for reduced Russian output and supply-chain delays this year and next, but falling output within the producer coalition's other non-core states. Outside OPEC 2.0, stronger WTI futures prices in spot markets and along the entire forward curve drive our estimate of US shale output (L48 ex-GoM) to 9.89mm b/d in 2022 (0.86mm b/d above 2021 levels) and 10.58mm b/d in 2023 (0.69mm above our 2022 levels). Supply-chain disruptions and cost inflation showing up in US shale producers' operations likely will dampen output increases.5 For the US, we expect 2022 average US production of 12.1mm b/d, or 900k b/d higher than 2021 output, and 12.8mm b/d in 2023, which is 700k b/d higher than 2022 levels (Chart 2). Chart 1Still Expecting Core-OPEC 2.0 Production Increases Uncertainty Tightens Oil Supply Uncertainty Tightens Oil Supply Chart 2US Oil Output Slightly Higher US Oil Output Slightly Higher US Oil Output Slightly Higher   Higher Brent prices will encourage short-term production increases from North Sea producers and others. However, it is not clear whether this will incentivize the years-long projects that will be needed to offset the lack of capex in the sector over the past decade or so. One of our high-conviction views resulting from the dearth of capex in oil and gas production is increasingly tighter markets by mid-decade – likely apparent by 2024 – which will require higher prices to reverse the lack of investment in new production. In line with our House view, we are not restoring the return of up to 1.3mm b/d of Iranian production to markets, given the guidance from this source proved unreliable earlier this month when it suspended talks with the US on its nuclear deal. We also are not assuming ceasefire talks between Ukraine and Russia will end to the Ukraine war, given the unreliability of the source (Russia) in these reports. Softer Demand Near Term Over the next few months, we expect the recent upsurge in COVID-19 cases in China to reduce Asian demand, but not tank it relative to our existing assumptions.6 Even though this was expected in our balances estimates, we are reducing our 2Q22 demand estimate by an additional 250k b/d, which is split evenly between DM and EM economies. This reflects the direct short-term hit to EM demand from China's lockdowns and a stronger USD, which raises the local-currency costs of oil, as well as the knock-on effects of additional supply-chain disruptions. Global consumption for 2022 is expected to be 4.4mm b/d higher on average vs 2021 levels, coming in at 101.54mm b/d, and 1.7mm b/d higher in 2023 vs. 2022 levels. We expect the Russian sanctions work-arounds being pursued by China and India – together accounting for a bit more than 20% of global oil demand – will be effective and will put overall EM demand back on trend in 2H22, assuming China's COVID-19 outbreak is brought under control (Chart 3).   Chart 3COVID-19 Hits China Demand, But Does Not Tank EM Overall COVID-19 Hits China Demand, But Does Not Tank EM Overall COVID-19 Hits China Demand, But Does Not Tank EM Overall While markets remain highly fluid – subject to sharp changes in perceptions of fundaments and their trajectories – these supply-demand estimates continue to point to relatively a balanced market this year and next (Chart 4). That said, the supply-demand fundamentals still leave inventories extremely tight, which means they will  provide limited buffering against sudden shifts in supply, demand or both (Chart 5). This will, in our estimation, keep forward curves backwardated, which will support our long-term positions in long commodity-index exposure (i.e., the S&P GSCI and the COMT ETF).  Chart 4Markets Remain Balanced... Markets Remain Balanced... Markets Remain Balanced... Chart 5...And Inventories Remain Tight ...And Inventories Remain Tight ...And Inventories Remain Tight Our base-case balances estimates translate into a 2022 Brent price forecast that averages $93/bbl, and a 2023 average estimate of $93/bbl, which are lower than our previous forecasts of $94/bbl and $98/bbl, respectively. For 1Q22, we now expect prices to average $98/bbl; 2Q22 to average $98.25/bbl; 3Q22 $88.45/bbl; and 4Q22 $87.30/bbl. Risks To Our View The supply side of our modeling remains exposed to exogenous political risks, chiefly: A failure on the part of core-OPEC 2.0 to increase production to offset lower-than-expected output outside the coalition's core; Lower-than-expected US oil output, given stronger-than-expected production discipline; and A return of up to 1.3mm b/d of Iranian barrels, which we no longer are assuming in our balances. We continue to believe core-OPEC 2.0 will increase production because it is in their interest not to allow inventory depletion to accelerate and for prices to move higher faster. The local-currency cost of oil in EM economies – the growth engine for oil demand – is high and going higher. In real terms – i.e., inflation-adjusted terms – it is even higher, as the real effective USD trade-weighted FX rate exceeds that of the nominal rate (Chart 6). This can be seen in the local-currency costs of oil in the world's largest consumers (Chart 7). We expect an announcement from core-OPEC 2.0 by the end of this month regarding a production increase. Chart 6High Real USD FX Rates Increase Local Oil Costs Uncertainty Tightens Oil Supply Uncertainty Tightens Oil Supply Chart 7Local-Currency Oil Costs In Large Consuming States Local-Currency Oil Costs In Large Consuming States Local-Currency Oil Costs In Large Consuming States   Of course, KSA's diversification to USD alternatives as a risk-management strategy makes it less certain it will lead an output increase in exchange for an increased US commitment to its defense. Regarding US shale output, producers remain disciplined in their capital allocation. Even though we expect higher prices across the WTI forward curve will incentivize additional production, we could be over-estimating the extent of this increase in our modeling. Lastly, as noted above, Iran and Russia are indicating their trade concerns have been addressed by the US, which presumably will presumably will be followed by the return up to 1.3mm b/d of production to export markets. However, forward guidance from these producers has not been particularly reliable, and we could be wrong here as well. This would be a bearish fundamental on the supply side, which would pressure prices lower. Investment Implications Given the breakdown in talks between the US and Iran – presumably under pressure from Russia for guarantees the US would not sanction its trade with Iran – our Brent price forecast remains above $90/bbl (Chart 8). We expect the near-term price increase will dissipate as the sanctions work-arounds – particularly by China and India – re-route oil flows. Core OPEC 2.0 producers – KSA, the UAE and Kuwait – have sufficient surplus capacity to increase production to allow refiners to re-build inventories. This big question for markets now is will they bring it to market in the near term? KSA's interest in exploring yuan-linked oil trade with China adds an element of uncertainty to whether production will be increased. Perhaps that is a goal of this exercise: The US is being shown there are alternatives available to large oil exporters re terms of trade and providers of defense services. Chart 8Higher Prices Expected Higher Prices Expected Higher Prices Expected There is sufficient spare capacity available at present to address the current physical deficits in global markets. Our analysis indicates markets are balanced but still tight, as can be seen in current and expected inventory levels. We remain long the XOP ETF and the S&P GSCI and COMT ETF. The latter ETFs provide long commodity-index based exposure that benefits from higher commodity prices and increasing backwardation in commodity markets generally, particularly oil.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com     Commodities Round-Up Precious Metals: Bullish Markets expected the Federal Reserve's rate hike of 25 basis points in the March and was not disappointed. Further rate hikes this year will occur against the backdrop of high geopolitical uncertainty and inflation, both of which are bullish for gold. The Russia-Ukraine crisis has added a new layer of complexity, and the Fed will need to proceed with caution to curb inflation but not over-tighten the economy.       Footnotes 1     Please see All at sea: Russian-linked oil tanker seeks a port, published by straitstimes.com on March 10, 2022 for examples of shipping delays. 2     Please see Could Russia Look to China to Export More Oil and Natural Gas? published by naturalgasintell.com on March 9, and India says it’s in talks with Russia about increasing oil imports., published on March 15, for additional reporting. See also Besides China, Putin Has Another Potential De-dollarization Partner in Asia published by cfr.org, which discusses India-Russia trade agreements between 1953-92 with the signing of the 1953 Indo-Soviet Trade Agreement. 3    Please see Saudi considering China’s yuan for oil purchases published by al-monitor.com on March 16. 4    Please see the OIES Oil Monthly published on March 14. 5    Oil producers in a ‘dire situation’ and unable to ramp up output, says Oxy CEO published on March 8 by cnbc.com. 6    A resurgence of COVID-19 in China was not unexpected. It was one of our key views going into 2022. Please see 2022 Key Views: Past As Prelude For Commodities, which we published on December 16, 2021. In that report, we noted, "… China still is operating under a zero-tolerance COVID-19 policy, and has relied on less efficacious vaccines that appear to offer no protection against the omicron variant of the coronavirus. This also is a risk for EM economies that rely on these vaccines. However, the roll-out of mRNA vaccines globally via joint ventures will be gathering steam in 2H22, which is bullish for commodity demand." We continue to expect Chinese authorities to deploy mRNA vaccines or antivirals to combat this outbreak.   Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image