Policy

Executive Summary The Market Has Priced An Aggressive Path For US Rate Hikes The Federal Reserve has joined other G10 central banks in increasing interest rates this week. However, this has been well priced by both the dollar and short rates in the US (Feature Chart). The key call for currencies therefore is whether the Fed delivers more or less hikes than is currently priced by markets over the course of the next few months. More aggressive rate hikes will boost US bond yields, and send the dollar higher. But it will also undermine US equity multiples, given the tight correlation between the price-to-earnings ratio in the US and the real bond yield. More importantly, US equity market leadership has been an important driver of portfolio inflows into the dollar. Should the Fed deliver less hikes than the aggressive path currently priced by markets, currency investors will also be caught offside. This conundrum puts the DXY at risk. The caveat is that if the US economy is genuinely stronger than the rest of the world, and more insulated from the Russo-Ukrainian conflict, this will warrant higher real US interest rates. We went short NOK/SEK last week given our bias that oil prices had overshot. Tighten stops to protect profits. Bottom Line: Being long the dollar is a consensus trade. While in the near term, this could prove to be the right call, the dollar is also expensive and overbought, which is bearish from a contrarian perspective. Feature The 25 basis point interest rate hike by the Federal Reserve this week has probably been one of the most telegraphed macro events. Interest rate expectations in the US have risen sharply compared to last year (Chart 1). More importantly, as Chart 2 shows, two-year bond yields (a proxy for short rates) have climbed in the US relative to pretty much every other G10 country. Correspondingly, rising interest rate expectations in the US have led to substantial speculative flows into the US dollar. Chart 2The Market Expects The Fed To Hike Faster Than Other Central Banks This Year Chart 1The Market Has Priced An Aggressive Path For US Rate Hikes On the flipside, the outperformance of the US equity market is being threatened by rising interest rates. If rates rise substantially, that could derate US equity multiples, as portfolio inflows are curtailed. US profits also tend to underperform when rates rise. However, if US rates rise by less than what the market expects, net long speculative positioning in the dollar will surely reverse. Non-US Markets Benefit More When Bond Yields Rise Profits tend to drive the equity market over the short run, with valuation starting to matter over longer horizons. When it comes to the US, it is also true that profits tend to underperform the rest of the world as bond yields rise. Why it matters for the dollar is because a better profit picture in the US helps drive portfolio flows into US equities, buffeting the exchange rate (Chart 3). Related Report  Global Investment StrategyA Two-Stage Fed Tightening Cycle Chart 4 shows that US profits lag the rest of the world when bond yields are in an uptrend. This is because of the composition of the US equity market. Specifically, the US equity market is underweight financials, energy, materials, and industrials, while overweight information technology, health care, and communication services. Rising inflation benefits commodity-linked sectors, the income statements of which are directly juiced by rising prices. Similarly, banks tend to do better as interest rates rise because net interest margins improve. In a nutshell, rising rates and inflation tend to be better for the profits of value stocks and cyclicals, sectors that are underrepresented in the US. Chart 3The Dollar And US Equities Chart 4Bond Yields And US Profits There is also a valuation angle to higher rates. Because the US market is more overweight sectors with cash flows that backwardated, higher rates will undermine the valuation premium currently commanded by these sectors. This is true both in absolute terms and relative to other markets (Chart 5A and 5B). Chart 5AThe S&P 500 P/E Ratio And Real ##br##Yields Chart 5BThe Valuation Premium In The US Is Inversely Correlated To Bond Yields The key point is that the US equity market is at risk relatively from higher global yields that could undermine relative profit growth and its valuation premium. The US trade deficit currently runs at $90 billion. In 2021, at least 45% of that was financed via foreign equity purchases. A reversal in these flows could undermine the dollar. The Dollar And Relative Interest Rates While portfolio flows into US equities have been reversing, bond inflows have improved (Chart 6). Over the long term, bond flows tend to be the key driver of the US dollar. As Chart 2 shows, most market participants expect the Fed to be among the most hawkish central banks in 2022 and beyond. In fact, December Eurodollar contracts are pricing the Fed to hike interest rates by 218 bps more than the ECB, and 235 bps more than the Bank of Japan (allowing for a small risk premium in this pricing) (Chart 7). Chart 7Investors Are Very Bullish On US Rate Expectations Chart 6Investors Have Been Aggressively Purchasing US Treasurys There are two key risks to a hawkish Fed view, relative to other central banks: First, the Fed is already behind the curve relative to its G10 counterparts. The BoE, RBNZ, BoC, and the Norges Bank have already increased rates. Even the rhetoric at the ECB is shifiting. Relative bond yields do not reflect this reality. Second, and related, rising inflation is a global phenomenon and not specific to the US. Almost every central bank is acknowledging that inflation is a key risk to their mandate, compared to the transitory narrative last year. Chart 8 plots headline inflation across G10 countries. On this basis, it becomes difficult to justify why two-year yields in the UK, for example, are much lower, compared to the US. Chart 8Rising Inflation Is Not A US-Centric Problem If inflation does indeed prove to be sticky, other central banks will have to keep hiking interest rates along with the Fed. If inflation subsides, the Fed might not be as aggressive in tightening policy as the market expects. On a relative basis, this suggests there is a mispricing of how the market views Fed action, relative to other central banks. The key risk to this view is that the US economy can actually withstand much higher rates compared to the rest of the world. While this could be the case, higher rates in Norway and New Zealand are not yet hurting domestic conditions. In fact, it can be argued that weakness in their currencies has unwound a lot of the tightening in financial conditions from higher interest rates. A commodity boom also suggests that these currencies will benefit from rising terms of trade. Conclusion Bond markets have priced higher relative rates in the US, but the Fed could actually lag market expectations, especially relative to commodity-linked currencies (Chart 9). Chart 9Commodity Currencies Have Been Tracking Rate Expectations With A Lag Specifically, higher rates than the market expects in the US will undermine US equity market leadership, reversing substantial portfolio inflows in recent years. This is already occurring at the margin. On the other hand, fewer rate hikes will severely unwind speculative inflows into the US dollar. Housekeeping We went short NOK/SEK on the expectation that oil prices had overshot, especially relative to forward markets (Chart 10). We are tightening the stop loss on this trade to 1.09. Finally, the Bank of England met this week and its transcript reinforced our stance that the BoE will be cornered as it attempts to raise rates amidst a slowing economy. Stay long EUR/GBP. Chart 10Stay Short NOK/SEK But Tighten Stops   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Special Report

Executive Summary Major EM’s Defense Spends Will Be Comparable To That Of Developed Countries​​​​ Tectonic geopolitical trends are taking shape in Emerging Markets (EMs) today that will leave an indelible imprint on the next decade. First, EMs have gone on a relatively unnoticed public debt binge at a time when the economic prospects of the median EM citizen have deteriorated. This raises the spectre of sudden fiscal populism, aggressive foreign policy or social unrest in EMs. China, Brazil and Saudi Arabia appear most vulnerable to these risks. Second, the defense bill of major EMs could be comparable to that of the top developed countries of the world in a decade from now. Investors must brace for EMs to play a central role in the defense market and in wars, in the coming years. To profit from ascendant geopolitical risks in China, we reiterate shorting TWD-USD and the CNY against an equal-weighted basket of Euro and USD. To extract most from the theme of EM militarization, we suggest a Long on European Aerospace & Defense relative to European Tech stocks.   Trade Recommendation Inception Date Return LONG EUROPEAN AEROSPACE & DEFENSE / EUROPEAN TECH EQUITIES (STRATEGIC) 2022-03-18   Bottom Line: Even as EMs are set to emerge as protagonists on the world stage, investors must prepare for these countries to exhibit sudden fiscal expansions, bouts of social unrest or a newfound propensity to initiate wars. The only way to dodge these volatility-inducing events is to leverage geopolitics to foresee these shocks. Feature Only a few weeks before Russia’s war with Ukraine broke out, a client told us that he was having trouble seeing the importance of geopolitics in investing. “It seems like geopolitics was a lot more relevant a few years back, with the European debt crisis, Brexit, and Trump. Now it does not seem to drive markets at all”, said the client. To this we gave our frequent explanation which is, “Our strategic themes of Great Power Struggle, Hypo-Globalization, and Nationalism/Populism are now embedded in the international system and responsible for an observable rise in geopolitical risk that is reshaping markets”. In particular we highlighted our pessimistic view on both Russia and Iran, which have incidentally crystallized most clearly since we had this client conversation. Related Report  Geopolitical StrategyBrazil: The Road To Elections Won't Be Paved With Good Intentions Globally key geopolitical changes are afoot with Russia at war. In the coming weeks and months, we will write extensively about the dramatic changes we see taking shape in the realm of geopolitics and investing. We underscored the dramatic geopolitical realignment taking place as Russia severs ties with the West and throws itself into China’s arms in a report titled “From Nixon-Mao To Putin-Xi”. In this Special Report we highlight two key geopolitical themes that will affect emerging markets (EMs) over the coming decade. The aim is to help investors spot these trends early, so that they can profit from these tectonic changes that are sure to spawn a new generation of winners and losers in financial markets. (For BCA Research’s in-depth views on EMs, do refer to the Emerging Markets Strategy (EMS) webpage). Trend #1: Beware The Wrath Of EMs On A Debt Binge Chart 1The Pace Of Debt Accumulation Has Accelerated In Major EMs Investors are generally aware of the debt build-up that has taken place in the developed world since Covid-19. The gross public debt held by the six most developed countries of the world (spanning US, Japan, Germany, UK, France and Italy) now stands at an eye-watering $60 trillion or about 140% of GDP. This debt pile is enormous in both absolute and relative terms. But at the same time, the debt simultaneously being taken on by EMs has largely gone unnoticed. The cumulative public debt held by eight major EMs today (spanning China, Taiwan, Korea, India, Brazil, Russia, Saudi Arabia and Turkey) stands at $20tn i.e., about 70% of GDP. Whilst the absolute value of EM debt appears manageable, what is worrying is the pace of debt accumulation. The average public debt to GDP ratio of these EMs fell over the early 2000s but their public debt ratios have now doubled over the last decade (Chart 1). EMs have been accumulating public debt at such a rapid clip that the pace of debt expansion in EMs is substantially higher than that of the top six developed countries (Chart 1). These six DMs have a larger combined GDP than the eight EMs with which they are compared. Related Report  Geopolitical StrategyIndia's Politics: Know When To Hold 'Em, Know When To Fold 'Em (For in-depth views on China’s debt, do refer to China Investment Strategy (CIS) report here). Now developed countries taking on more debt makes logical sense for two reasons. Firstly, most developed countries are ageing, and their populations have stopped growing. So one way to prop up falling demand is to get governments to spend more using debt. Secondly, this practice seems manageable because developed country central banks have deep pockets (in the form of reserves) and their central banks are issuers of some of the safest currencies of the world. But EMs using the same formula and getting addicted to debt at an earlier stage of development is risky and could prove to be lethal in some cases. Also distinct from reasons of macroeconomics, the debt binge in EMs this time is problematic for geopolitical reasons. This Time Is Different EMs getting reliant on debt is problematic this time because their median citizen’s economic prospects have deteriorated. Growth is slowing, inflation is high, and job creation is stalling; thereby creating a problematic socio-political backdrop to the EM debt build-up. Growth Is Slowing: In the 2000s EMs could hope to grow out of their social or economic problems. The cumulative nominal GDP of eight major EMs more than quadrupled over the early 2000s but a decade later, these EMs haven not been able to grow their nominal GDP even at half the rate (Chart 2). Inflation Remains High: Despite poorer growth prospects, inflation is accelerating. Inflation was high in most major EMs in 2021 (Chart 3) i.e., even before the surge seen in 2022. Chart 2Major EM’s Growth Engine Is No Longer Humming Like A Well-Tuned Machine​​​​​ Chart 3Despite Slower Growth, Inflation In Major EMs Remains High​​​​​ Rising Unemployment: Employment levels have improved globally from the precipice they had fallen into in 2020. But unemployment today is a far bigger problem for major EMs as compared to developed markets (Chart 4). If the economic miseries of the median EM citizen are not addressed, then they can produce disruptive sociopolitical effects that will fan market volatility. This problem of rising economic misery alongside a rapid debt build-up, can also be seen for the next tier of EMs i.e. Mexico, Indonesia, Iran, Poland, Thailand, Nigeria, Argentina, Egypt, South Africa and Vietnam. While the average public debt to GDP ratios of these EMs fell over the early 2000s, the pace of debt accumulation has almost doubled over the last decade (Chart 5). Furthermore, the growth engine in these smaller EMs is no longer humming like a well-tuned machine and inflation remains at large (Chart 5). Chart 4Unemployment - A Bigger Problem In Major EMs Today​​​​​ Chart 5Smaller EMs Must Also Deal With Rising Debt, Alongside Slowing Growth​​​​​ Chart 6The Debt Surge In EMs This Time, Poses Unique Challenges History suggests that periods of economic tumult are frequently followed by social unrest. The eruption of the so-called Arab Spring after the Great Recession illustrated the power of this dynamic. Then following the outbreak of Covid-19 in 2020 we had highlighted that Turkey, Brazil, and South Africa are at the greatest risk of significant social unrest. We also showed that even EMs that looked stable on paper faced unrest in the post-Covid world, including China and Russia. In this report we take a decadal perspective which reveals that growth is slowing, and debt is growing in EMs. Given that EMs suffer from rising economic miseries alongside growing debt and lower political freedoms (Chart 6), it appears that some of these markets could be socio-political tinderboxes in the making. Policy Implications Of The EM Debt Surge “As it turns out, we don't 'all' have to pay our debts. Only some of us do.” – David Graeber, Debt: The First 5,000 Years (Melville House Publishing, 2011) The trifecta of fast-growing debt, slowing growth and/or low political freedoms in EMs can add to the volatility engendered by EMs as an asset class. Given the growing economic misery in EMs today, politicians will be wary of outbreaks of social unrest. To quell this unrest, they may resort broadly to fiscal expansion and/or aggressive foreign policy. Both of these policy choices can dampen market returns in EMs. Chart 7India's Performance Had Flatlined Post Mild Populist Tilt Policy Choice #1: More Fiscal Spending Despite High Debt Policymakers in some EMs may respond by de-prioritizing contentious structural reforms and prioritizing fiscal expansion. The Indian government’s decision to repeal progressive changes to farm laws in late 2021, launch a $7 billion home-building program in early 2022 and withholding hikes in retail prices of fuel, illustrates how policymakers are resorting to populism despite high public debt levels. As a result, it is no surprise that MSCI India had been underperforming MSCI EM even before the war in Ukraine broke out (Chart 7). Brazil is another EM which falls into this category, while China’s attempts to run tighter budgets have failed in the face of slowing growth. Policy Choice #2: Foreign Policy Aggression EMs may also adopt an aggressive foreign policy stance. Russia’s decision to invade Ukraine, Turkey’s interventions in several countries, and China’s increasing assertiveness in its neighboring seas and the Taiwan Strait provide examples. Wars by EMs are known to dampen returns as the experience of the Russian stock market shows. Russian stocks fell by 14% during its invasion of Georgia in 2008 and are down 40% from 24 February 2022 until March 9, 2022, i.e. when MSCI halted trading. If politicians fail to pursue either of these policies, then they run the risk of social unrest erupting due to tight fiscal policy or domestic political disputes. In fact, early signs of social discontent are already evident from large protests seen in major EMs over the last year (see Table 1). Table 1Social Unrest In Major EMs Is Already Ascendant Bottom Line: The last decade has seen major EMs go on a relatively unnoticed public debt binge. This is problematic because this debt surge has come at a time when economic prospects of the median EM citizen have deteriorated. Politicians will be keen to quell the resultant discontent. This raises the specter of excessive fiscal expansion, aggressive foreign policy, and/or social unrest. All three outcomes are negative from an EM volatility perspective. Trend #2: The Rise And Rise Of EM Defense Spends Great Power Rivalry is an outgrowth of the multipolar structure of international relations. This theme will drive higher defense spending globally. In this report we highlight that even after accounting for a historic rearmament in developed countries following Russia’s invasion of Ukraine, a decade from now EMs will play a key role in driving global military spends. The defense bill of the six richest developed countries of the world (the US, Japan, Germany, UK, France and Italy) will increasingly be rivaled by that of the top eight EMs (China, Taiwan, Korea, India, Brazil, Russia, Saudi Arabia and Turkey). While key developed markets like Japan and Germany in specific (and Europe more broadly) are now embarking on increasing defense spends, the unstable global backdrop will force EMs to increase their military budgets as well. The combination of these forces could mean that the top eight EM’s defense spends could be comparable to that of the top six developed markets in a decade from now i.e., by 2032 (Chart 8). This is true even though the six DMs have a larger GDP. The assumptions made while arriving at the 2032 defense spend projections include: Substantially Higher Pace Of Defense Spends For Developed Countries: To reflect the fact that Russia’s invasion of Ukraine will trigger a historical wave of armament in developed markets we assume that: (a) NATO members France, Germany and Italy (who spent about 1.5% of GDP on an average on defense spends in 2019) will ramp up defense spending to 2% of GDP by 2032, (b) US and UK i.e. NATO members who already spend substantially more than 2% of GDP on defense spends will still ‘increase’ defense spends by another 0.4% of GDP each by 2032 and finally (c) Japan which spends less than 1% of GDP on defense spends today, in a structural break from the past will increase its spending which will rise to 1.5% of GDP by 2032. China And Hence Taiwan As Well As India Will Boost Spends: To capture China’s increasingly aggressive foreign policy stance and the fact that India as well as Taiwan will be forced to respond to the Chinese threat; we assume that China increases its stated defense spends from 1.7% of GDP in 2019 to 3% by 2032. Taiwan follows in lockstep and increases its defense spends from 1.8% of GDP in 2019 to 3% by 2032. India which is experiencing a pincer movement from China to its east and Pakistan to its west will have no choice but to respond to the high and rising geopolitical risks in South Asia. The coming decade is in fact likely to see India’s focus on its naval firepower increase meaningfully as it feels the need to fend off threats in the Indo-Pacific. India currently maintains high defense spends at 2.5% of GDP and will boost this by at least 100bps to 3.5% of GDP by 2032. Defense Spending Trends For Five EMs: For the rest of the EMs (namely Russia, Saudi Arabia, South Korea and Brazil), the pace of growth in defense spending seen over 2009-19 is extrapolated to 2032. For Turkey, we assume that defense spends as a share of GDP increases to 3% of GDP by 2032. Extrapolation Of Past GDP Growth For All Countries: For all 14 countries, we extrapolate the nominal GDP growth calculated by the IMF for 2022-26 as per its last full data update, to 2032. This tectonic change in defense spending patterns has important historical roots. Back in 1900, UK and Japan i.e., the two seafaring powers were top defense spenders (Chart 9). Developed countries of the world continued to lead defense spending league tables through the twentieth century as they fought expensive world wars. Chart 8Major EM’s Defense Spends Will Be Comparable To That Of Developed Countries​​​​​​ Chart 9Back In 1900, Developed Countries Like UK And Japan Were Top Military Spenders​​​​​​ Chart 10By 2000, EMs Had Begun Spending Generously On Armament But things began changing after WWII. Jaded by the world wars, developed countries began lowering their defense spending. By the early 2000s EMs had now begun spending generously on armament (Chart 10). The turn of the century saw growth in developed markets fade while EMs like China and India’s geopolitical power began rising (Chart 11). Then a commodities boom ensued, resulting in petro-states like Saudi Arabia establishing their position as a high military spender. The confluence of these factors meant that by 2020 EMs had becomes major defense spenders in both relative and absolute terms too (Chart 12). Going forward, we expect the coming renaissance in DM defense spending in the face of Russian aggression, alongside rising geopolitical aspirations of China, to exacerbate this trend of rising EM militarization. Chart 11The 21st Century Saw Developed Countries’ Geopolitical Power Ebb Chart 12EMs Today Are Top Military Spenders, Even In Absolute Terms Why Does EM Weaponizing Matter? History suggests that wars are often preceded by an increase in defense spends: Well before WWI, a perceptible increase in defense spending could be seen in Austria-Hungary, Germany, and Italy (Chart 13). These three countries would go on to be known as the Triple Alliance in WWI. Correspondingly France, Britain and Russia (i.e., countries that would constitute the Triple Entente) also ramped up military spending before WWI (Chart 14). Chart 13Well Before WWI; Austria-Hungary, Germany, And Italy Had Begun Ramping Up Defense Spends​​​​​​ Chart 14The ‘Triple Entente’ Too Had Increased Defense Spends In The Run Up To WWI​​​​​​ History tragically repeated itself a few decades later. Besides Japan (which invaded China in 1937); Germany and Italy too ramped up defense spending well before WWII broke out (Chart 15). These three countries would come to be known as the Axis Powers and initiated WWII. Notably, Britain and Russia (who would go on to counter the Axis Powers) had also been weaponizing since the mid-1930s (Chart 16). Chart 15Axis Powers Had Been Increasing Defense Spends Well Before WWII​​​​​ Chart 16Allied Powers Too Had Been Increasing Defense Spends In The Run Up To WWII​​​​​ Chart 17Militarily Active States Have Been Ramping Up Defense Spends Russia, Ukraine, Turkey and Gulf Arab states like Iraq have been involved in wars in the recent past and noticeably increased their defense budgets in the lead-up to military activity (Chart 17). Given that a rise in military spending is often a leading indicator of war and given that EMs are set to spend more on defense, it appears that significant wars are becoming more rather than less likely, which Russia’s invasion of Ukraine obviously implies. A large number of “Black Swan Risks” are clustered in the spheres of influence of Russia, China, and Iran, which are the key powers attempting to revise the US-led global order today (Map 1). Map 1Black Swan Risks Are Clustered Around China, Russia & Iran Distinct from major EMs, eight small countries pose meaningful risks of being involved in wars over the next. These countries are small (in terms of their nominal GDPs) but spend large sums on defense both in absolute terms (>$4 billion) and in relative terms (>4% of GDP). Incidentally all these countries are located around the Eurasian rimland and include Israel, Pakistan, Algeria, Iran, Kuwait, Oman, Ukraine and Morocco (Map 2). In fact, the combined sum of spending undertaken by these countries is so meaningful that it exceeds the defense budgets of countries like Russia and UK (Chart 18). Map 2Eight Small Countries That Spend Generously On Defense Chart 188 Countries Located Near The Eurasian Rimland, Spend Large Sums On Defense​​​​ Bottom Line: As EM geopolitical power and aspirations rise, the defense bill of top developed countries will be challenged by the defense spending undertaken by major EMs. On one hand this change will mean that certain EMs may be at the epicenter of wars and concomitant market volatility. On the other hand, this change could spawn a new generation of winners amongst defense suppliers. Investment Conclusions In this section we highlight strategic trades that can be launched to play the two trends highlighted above. Trend #1: Beware The Wrath Of EMs On A Debt Binge Investors must prepare for EMs to witness sudden fiscal expansions, unusually aggressive foreign policy stances, and/or bouts of social unrest over the next few years. The only way to dodge these volatility-inducing events in EMs is to leverage geopolitics to foresee socio-political shocks. Using a simple method called the “Tinderbox Framework” (Table 2), we highlight that: Table 2Tinderbox Framework: Identifying Countries Most Exposed To Socio-Political Risks Within the eight major EMs; China, Brazil, Russia and Saudi Arabia face elevated socio-political risks. Amongst the smaller ten EMs, these risks appear most elevated for Egypt, South Africa and Argentina. It is worth noting that Brazil, South Africa and Turkey appeared most vulnerable as per our Covid-19 Social Unrest Index that we launched in 2020. We used the tinderbox framework in the current context to fade out effects of Covid-19 and to add weight to the debt problem that is brewing in EMs. Client portfolios that are overweight on most countries that fare poorly on our “Tinderbox Framework” should consider actively hedging for volatility at the stock-specific level. To profit from ascendant geopolitical risks in China, we reiterate shorting TWD-USD and the CNY against an equal-weighted basket of Euro and USD. China’s public debt ratio is high and social pressures may be building with limited valves in place to release these pressures (Table 2). The renminbi has performed well amid the Russian war, which has weighed down the euro, but China faces a confluence of domestic and international risks that will ultimately drag on the currency, while the euro will benefit from the European Union’s awakening as a geopolitical entity in the face of the Russian military threat. Trend #2: EM’s Will Drive Wars In The 21st Century Wars are detrimental to market returns.1 Furthermore, as the history of world wars proves, even the aftermath of a war often yields poor investment outcomes as wars can be followed by recessions. It is in this context that investors must prepare for the rise of EMs as protagonists in the defense market, by leveraging geopolitics to identify EMs that are most likely to be engaged in wars. While we are not arguing that WWIII will erupt, investors must brace for proxy wars as an added source of volatility that could affect EMs as an asset class. To profit from these structural changes underway we highlight two strategic trades namely: 1.  Long Global Aerospace & Defense / Broad Market Thanks to the higher spending on defense being undertaken by major EMs, global defense spends will grow at a faster rate over the next decade as compared to the last. We hence reiterate our Buy on Global Aerospace & Defense relative to the broader market. 2.  Long European Aerospace & Defense / European Tech Up until Russia invaded Ukraine and was hit with economic sanctions, Russia was the second largest exporter of arms globally accounting for 20% global arms exports. With Russia’s ability to sell goods in the global market now impaired, the two other major suppliers of defense goods that appear best placed to tap into EM’s demand for defense goods are the US (37% share in the global defense exports market) and Europe (+25% share in the global defense exports market). Chart 19American Defense Stocks Have Outperformed, European Defense Stocks Have Underperformed​​​​​​ Chart 20Defense Market: Russia’s Loss Could Be Europe’s Gain​​​​​ But given that (a) American aerospace & defense stocks have rallied (Chart 19) and given that (b) France, Germany, and Italy are major suppliers of defense equipment to countries that Russia used to supply defense goods to (Chart 20), we suggest a Buy on European Aerospace & Defense relative to European Tech stocks to extract more from this theme. In fact, this trade also stands to benefit from the pursuance of rearmament by major European democracies which so far have maintained lower defense spends as compared to America and UK. This view from a geopolitical perspective is echoed by our European Investment Strategy (EIS) team too who also recommend a Long on European defense stocks and a short on European tech stocks. Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1      Please see: Andrew Leigh et al, “What do financial markets think of war in Iraq?”, NBER Working Paper No. 9587, March 2003, nber.org.  David Le Bris, “Wars, Inflation and Stock Market Returns in France, 1870-1945”, Financial History Review 19.3 pp. 337-361, December 2012, ssrn.com. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary For the Fed, maintaining its credibility with a long sequence of rate hikes that does not crash the economy, real estate market, and stock market is akin to the ‘Hail Mary’ move of (American) football. The likelihood that the Fed completes the straight sequence of eight rate hikes which the market is now pricing seems very low. Hence, today we are opening a new trade. Go long the September 2023 Eurodollar futures contract. Additionally, stay underweight Treasury Inflation Protected Securities (TIPS) versus T-bonds. And on a 12-month horizon, underweight the commodity complex, whose elevated prices are highly vulnerable to a near-certain upcoming demand destruction. Fractal trading watchlist: US interest rate futures, 3-year T-bond, Canada versus Japan, AUD/KRW, and EUR/CHF. Spending On Goods Looks Like An Earthquake On A Seismograph Bottom Line: The likelihood that the Fed completes the straight sequence of eight rate hikes which the market is now pricing seems very low. Feature Amid the uncertainties of the Ukraine crisis, there is one certainty. The latest surge in energy and grain prices is a classic supply shock. Prices have spiked because vital supplies of Russian and Ukrainian energy and grains have been cut. This matters for central banks, because to the extent that they can bring down inflation, they can do so by depressing demand. They can do nothing to boost supply. In fact, depressing demand during a supply shock is a sure way to start a recession. But what about the inflation that came before the Ukraine crisis, wasn’t that due to excess demand? No, that inflation came not from a demand shock, but from a displacement of demand shock – as consumers displaced their firepower from services to goods on a massive scale. This matters because central banks are also ill placed to fix such a misallocation of demand. Chart I-1 looks like a seismograph after a huge earthquake, and in a sense that is exactly what it is. The chart shows the growth in spending on durable goods, which has just suffered an earthquake unlike any in history. Zooming in, we can see the clear causality between the surges in spending on durables and the surges in core inflation. The important corollary being that when the binge on durables ends – as it surely must – or worse, when durable spending goes into recession, inflation will plummet (Chart I-2). Chart I-1Spending On Goods Looks Like An Earthquake On A Seismograph Chart I-2The Goods Binges Caused The Core Inflation Spikes But, argue the detractors, what about the uncomfortably high price inflation in services? What about the uncomfortably high inflation expectations? Most worrying, what about the recent surge in wage inflation? Let’s address these questions. Underlying US Inflation Is Running At Around 3 Percent In the US, the dominant component of services inflation is housing rent, which comprises 40 percent of the core consumer price index. Housing rent combines actual rent for those that rent their home, with the near-identically behaving owners’ equivalent rent (OER) for those that own their home. Given the state of the jobs market, there is nothing unusual in the current level of rent inflation. Housing rent inflation closely tracks the tightness of the jobs market, because you need a job to pay the rent. With the unemployment rate today at the same low as it was in 2006, rent inflation is at the same high as it was in 2006: 4.3 percent. In other words, given the state of the jobs market, there is nothing unusual in the current level of rent inflation (Chart I-3). Chart I-3Given The Jobs Market, Rent Inflation Is Where It Should Be Given its dominance in core inflation, rent inflation running at 4.3 percent would usually be associated with core inflation running at around 3 percent – modestly above the Fed’s target, rather than the current 6.5 percent (Chart I-4). Confirming that it is the outsized displacement of spending into goods, and its associated inflation, that is giving the Fed and other central banks a massive headache. Yet, to repeat, monetary policy is ill placed to fix such a misallocation of demand. Chart I-4Given Rent Inflation, Core Inflation Should Be 3 Percent Still, what about the surging expectations for inflation? Many people believe that these are an independent and forward-looking assessment of how inflation will evolve. Yet nothing could be further from the truth. The bond market’s expected inflation is just the result of an algorithm that uses historic inflation. And at that, an extremely short period of historic inflation, just six months.1  The upshot is that when the backward-looking six month inflation rate is low, like it was in the depths of the global financial crisis in late 2008 or the pandemic recession in early 2020, the market assumes that the forward-looking ten year inflation rate will be low. And when the backward-looking six-month inflation rate is high, like early-2008 or now, the bond market assumes that the forward-looking ten year inflation rate will be high. In other words: Inflation expectations are nothing more than a reflection of the last six months’ inflation rate (Chart I-5). Chart I-5Inflation Expectations Are Just A Reflection Of The Last Six Months' Inflation Rate Turning to wage inflation, with US average hourly earnings inflation running close to 6 percent, it would appear to be game, set, and match to ‘Team Inflation.’  Except that this is a flawed argument. To the extent that wages contribute to inflation, it must come from the inflation in unit labour costs, meaning the ratio of hourly compensation to labour productivity. After all, if you get paid 6 percent more but produce 6 percent more, then it is not inflationary (Chart I-6). Chart I-6If You Get Paid 6 Percent More But Produce 6 Percent More, Then It Is Not Inflationary In this regard, US unit labour costs increased by 3.5 percent through 2021, and slowed to just a 0.9 percent (annualised) increase in the fourth quarter.2 Still, 3.5 percent, and slowing, is modestly above the Fed’s inflation target, and could justify a slight nudging up of the Fed funds rate. But it could not justify the straight sequence of eight rate hikes which the market is now pricing. The Fed Is Praying For A ‘Hail Mary’ Fortunately, the bond market understands all of this. How else could you say 7 percent inflation and 2 percent long bond yield in the same breath?! This is crucial, because it is the long bond yield that drives rate-sensitive parts of the economy, such as housing and construction. And it is the long bond yield that sets the level of all asset prices, including real estate and stocks. Although the Fed cannot admit it, the central bank also understands all of this and hopes that the bond market continues to ‘get it.’ Meaning that it hopes that the long end of the interest rate curve does not lift too far and crash the economy, real estate market, and stock market. So why is the Fed hiking the policy interest rate? The answer is that there will be a time in the future when it does need to lift the entire interest rate curve, and for that it will need its credibility intact. Not hiking now could potentially shred the credibility that is the lifeblood of any central bank. Still, to maintain its credibility without crashing the economy the Fed will have to make the ‘Hail Mary’ move of (American) football. For our non-American readers, the Hail Mary is a high-risk desperate move with little hope of completion. Go long the September 2023 Eurodollar futures contract. To sum up, the likelihood that the Fed completes the straight sequence of eight rate hikes which the market is now pricing seems very low. Hence, today we are opening a new trade. Go long the September 2023 Eurodollar futures contract (Chart I-7). Chart I-7The Likelihood That The Fed Completes A Straight Sequence Of Eight Rate Hikes Seems Low Additionally, stay underweight Treasury Inflation Protected Securities (TIPS) versus T-bonds (Chart I-8). Chart I-8Underweight TIPS Versus T-Bonds And on a 12-month horizon, underweight the commodity complex, whose elevated prices are highly vulnerable to a near-certain upcoming demand destruction. Fractal Trading Watchlist Confirming the fundamental analysis in the preceding sections, the strong trend in both the 18 month out US interest rate future and the equivalent 3 year T-bond has reached the point of fragility that has identified previous turning-points in 2018 and 2021 (Chart I-9 and Chart I-10). This week we are also adding to our watchlist the commodity plays Canada versus Japan and AUD/KRW, whose outperformances are vulnerable to reversal. From next week you will be able to see the full watchlist of investments that are vulnerable to reversal on our website. Stay tuned. Finally, the underperformance of EUR/CHF has reached the point of fragility on its 260-day fractal structure that has identified the previous major turning-points in 2018 and 2020 (Chart I-11). Accordingly, this week’s recommended trade is long EUR/CHF, setting a profit target and symmetrical stop-loss at 3.6 percent. Chart I-9The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart I-10The Strong Trend In The 3 Year T-Bond Is Fragile Chart I-11Go Long EUR/CHF Canada Versus Japan Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The expected 10-year inflation rate = (deviation of 6-month annualized inflation from 1.6)*0.2 + 1.6. 2  Source: Bureau of Labor Statistics Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Executive Summary Global Oil Price Pushes Up Inflation Expectations The US cut off of Russian energy exports has limited immediate impact because EU trade with Russia continues. Russia is unlikely to embargo the EU as it needs revenues to wage war. However, the EU will diversify away from Russia over time, which means that Russia will intensify its efforts to replace the government in Ukraine. The Biden administration began with an adversarial posture toward the energy sector, both US producers and Gulf Arab petro-states. Now it is adjusting its stance as prices surge. The OPEC states do not favor Biden but have an interest in calibrating production to avoid global recession and prolong their profit windfall. Even if the US restores the 2015 nuclear deal with Iran, which we doubt, investors should fade the oil price implications and stay focused on OPEC. Recommendation (Tactical) Inception Level Inception Date Return Long DXY (Dollar Index) 96.19 Feb 23, 2022 2.9% Bottom Line: Stagflation is the likeliest economic outcome of today’s global supply constraints. Feature Biden’s Oil Policy: Implications Will the Ukraine crisis lead to a US recession? The probability of a recession is 7.7% today, according to the bond market, but the oil price shock suggests that the probability will only increase from here. Stagflation, at least, is now highly likely. Short-term interest rates are rising faster than long-term rates, causing the 2-year/10-year Treasury slope to slide toward inversion, though it is not there yet. That would be a telltale sign of a looming recession (Chart 1). The 3-mo/10-year Treasury yield slope is nowhere near inverting and has a better record of predicting recessions than the 2-year/10-year. The Federal Reserve’s interest rate hikes are expected to cause the 10-year yield to rise and the yield curve to steepen. But exogenous shocks may push short rates even higher. When the oil price doubles, a recession often ensues. Out of the past seven recessions, five of them witnessed an oil spike beforehand. True, not every spike causes a recession. But the causality is clear. Today’s spike is large enough to be recessionary (Chart 2). The critical question is where will the price settle? If it settles above $90-$100 per barrel then it will erode global demand. Chart 1An End-Of-Cycle Crisis? Chart 2Oil Price Often Doubles Before Recessions Most likely the price will settle at around $85 per barrel by the end of 2022, and average $85 in 2023, according to our Commodity & Energy Strategy. High prices will discourage consumption and incentivize new production, leading to a price drop and new equilibrium. The OPEC cartel will increase production because they want to prolong the business cycle. Non-OPEC producers like US shale oil companies will also increase production. It is not likely that the US will significantly lift sanctions on Iran and Venezuela, though that would free up 1.3 million barrels per day and 700,000 barrels per day respectively. More on this below. Even so, this year’s energy spike will feed into a larger bout of inflation that is eroding real incomes. Headline consumer price inflation is running at 7.9% as of February, the highest in four decades. Core inflation is running at 6.4%. The Ukraine war did not prevent the European Central Bank from delivering a hawkish surprise in its fight against inflation on March 10, so it is even less likely to prevent the Fed from delivering a hawkish surprise on March 16. The Fed has a history of hiking rates even during geopolitical crises (as during the Arab oil embargo of 1973), which implies that the war in Ukraine will not prevent the Fed from hiking rates four times or more this year. There is a close relationship between the global oil price and the financial market’s long-term inflation expectations (Chart 3). When the costs of production and transportation go up, investors start to expect higher prices. Expectations are already rising because of the global pandemic, stimulus, supply constraints, wage pressure, and tardy policy normalization. Gasoline prices at the pump will shape consumer expectations (Chart 4). Chart 3Global Oil Price Pushes Up Inflation Expectations Chart 4Geopolitics Compound Inflation Yet high commodity prices are not coinciding with strong global growth and a weak dollar, as one might suspect. Global growth is falling and the dollar is strengthening. The energy shock from Russia will rattle importing countries like Europe, China, and India and thus enhance the dollar’s rise (Chart 5). Investor sentiment will suffer as the war in Ukraine reinforces the secular rise in geopolitical risk. Global policy uncertainty is also rising sharply, which will reinforce the dollar, weighing on global economic activity. Chart 5Dollar Strengthens on Weak Global Growth Bottom Line: A stagflationary dynamic is taking shape. Moreover the risk of recession is underrated by the bond market’s measure of recession probability. Investors should maintain tactically bearish trades and cut losses on cyclically bullish trades that suffer from higher rates and persistent inflation. US Boycotts Russia And Begs OPEC The Biden administration’s decision to ban Russian oil exports – and to encourage private sector boycotts of the Russian energy trade – raises the potential for the Russian conflict to escalate beyond Ukraine’s borders. While a total boycott of Russian oil exports is unlikely, it would be one of the larger oil shocks in modern history (Chart 6). Unlike the Iranian attack on the Saudi oil refinery in 2019, the Russian shock would come amid an existing energy shortage. Chart 6Worst Case Oil Risk in Historical Context There are two critical questions about US policy at this stage: Will the US foist its energy boycott on Europe, triggering a Russian retaliation? This could plunge Europe into recession and further upset the global economy. Will the US convince the OPEC cartel to increase oil production? A production boost would reduce prices and help to rebalance the economy, salvaging the business cycle. The next two sections discuss these options. US Boycotts Russia The first question is how Russia will respond to the US boycott and whether the Biden administration will try to force Europe to adopt the boycott. The US is comfortable boycotting Russian energy because oil and gas imports only account for 0.6% of GDP and those from Russia only 0.04%. Europe cannot make the same decision. While O&G imports are only 2.21% of GDP, and Russian O&G imports at 0.4%, these numbers will spike to near 2008 levels as a result of the price shock (Charts 7A & 7B). Major European countries, notably Germany, have already rejected the US boycott, and any EU direct sanctions require unanimity. The EU is instead outlining a plan to diversify away from Russia more gradually. This is a medium-term threat to Russia and hence a major concern for global stability but it is not an instant cutoff, which would cause an immediate recession in Europe. Chart 7AThe US Is Energy Independent... Chart 7B...The EU Is Not The EU’s plan would theoretically reduce its dependency on Russian energy by 66% by the end of the year. But that is easier said than done. Also, Europe cannot simply swap the US for Russia. American exports to the rest of the world could be redirected to Europe, but the switch requires an overhaul of supply chains. A total switch of US exports to Europe is impracticable in the short run and would leave other US allies dependent on Russian exports (Charts 8A & 8B). Chart 8AUS Will Not Replace Russian Energy Anytime Soon Chart 8BUS Will Not Replace Russian Energy Anytime Soon US shale producers are only starting to increase production. With WTI crude oil at $100, and Henry Hub natural gas spot price at $4.6 per million BTU, American production will speed up. But US companies are more focused on profitability and returns to shareholders than they were at the beginning of the shale boom, which has restrained oil production (Charts 9A & (9B). Chart 9AUS Production And Exports Increase After Pandemic Lull Chart 9BUS Production And Exports Increase After Pandemic Lull   The Biden administration has not yet fully adopted the tactics necessary: promoting the domestic fossil fuel industry and coordinating it for purposes of national strategy. American oil executives complain that while the Biden administration courts foreign energy producers and contemplates arbitrarily lifting sanctions on Iran and Venezuela, it has not approached domestic producers about facilitating production.1 Meanwhile there is a risk that Russia will retaliate against western sanctions by cutting off natural gas to the EU, for instance via the Nord Stream I pipeline. This is a risk, rather than a base case, because Moscow would prefer to sell energy as long as Europe is buying – and even increase the amount it produces at today’s high prices. Russian energy exports to the EU account for 5% of Russian GDP and thus provide an important lifeline at a time when the country is suffering heavily under banking, technology, and trade sanctions (Chart 10). Russian natural resource exports on average provide 43% of government revenue, which is essential for Moscow to carry on its war effort (Chart 11). Chart 10Russia Will Not Punish EU For US Boycott Chart 11Russia Needs EU Energy Imports And yet Russians are now slapping an embargo on agricultural exports, constricting global food supply and pushing up food prices. The implication is that a reduction in energy exports to the EU is not out of the question, especially an incremental reduction aimed at increasing Russian diplomatic pressure on Europe. If the Russians cut off Europe, it will fall into a severe recession and the energy shock will risk a global recession. While US direct trade exposure to Europe is limited, at about 3.8% of GDP (Chart 12A), nevertheless the US would suffer from price pressures. The US is already seeing import prices rise toward 2008 levels (Chart 12B). Chart 12AUS Exposure To The EU Is Limited... Chart 12B...But Its Import Prices Will Rise Bottom Line: The US is boycotting Russian oil but not forcing the EU to join the boycott. Europe is pursuing gradual diversification but Russia is unlikely to cut off Europe’s supply. However, this dynamic is showing signs of faltering, which means investors are justified in taking further risk off the table. US Begs OPEC The Biden administration started off on the wrong foot with the Gulf Arab states by criticizing them for autocratic government and human rights abuses, threatening to withhold arms sales, and trying to restore the 2015 nuclear deal and détente with Iran. Now, with a global energy shock unfolding, Biden is going back to Saudi Arabia and the UAE and imploring them to increase oil production and ease the supply pressure. The Arab states are reportedly giving him the cold shoulder, ignoring his phone calls while answering Russian President Vladimir Putin’s calls.2 These states never have an interest in producing oil at any US president’s beck and call. The US and Iran have also reached a critical stage in nuclear negotiations. So it is only fitting that the Arab states play hard to get. While the UAE ambassador to the US suggested that his country supporting increasing production on March 9, the country’s energy minister said the opposite. However, the core OPEC states are even less likely to do Russia’s bidding. Moscow propped up the Syrian regime, arms and subsidizes Iran, and aspires to gain ever greater control over Middle East exports to Europe. The Gulf states also know that the Russians will produce as much energy as they can since they need the revenues to sustain their war (Chart 13). Chart 13Core OPEC Countries Have An Interest In Increasing Oil Supply The Gulf states rely on the US military for national security, they fear that US-Iran détente will lead to US abandonment and Iranian regional ascendancy, and they seek to sustain their centrality to the global oil market. They want to prolong their export revenues in the context of a growing global economy for the sake of their own delicate internal stability and reforms. They do not aim to incentivize non-OPEC oil production and renewable energy transition with excessive prices, or to trigger a global recession (Chart 14). Hence the Saudi and UAE strategy will be to lower the oil price closer to their fiscal breakeven rate of $82.3 and $62.8 (oil price consistent with a balanced budget) and prolong the business cycle (Chart 15). Chart 14Core OPEC Does Not Want To Threaten Their Fiscal Future Chart 15Current Oil Price Comfortably Supports Fiscal Spending In OPEC The critical factor in the negotiation with the Biden administration will be Iran, their chief rival. Biden is trying to rejoin the 2015 nuclear deal, which would require removing sanctions in exchange for Iran’s halting its nuclear progress. A deal would bring 1.3 million barrels per day online, at least for the next two years or so. It could also prompt the Saudis or others to increase production to prevent Iran from stealing market share, as occurred in 2014 (Chart 16). Any deal would reduce the risk of military conflict in the short term and as such would remove some risk premium from oil prices. If Biden agrees to walk away from the Iran deal, then perhaps the Saudis and UAE will oblige him with a larger and quicker production boost. They know the Democratic Party is doomed in this year’s midterm elections anyway. Sanctions are not preventing the Iranians from exporting oil today and there is very little chance that they will truly abandon their quest for nuclear weapons (Chart 17). Chart 16Production Ramped Up Ahead Of The Iran Deal In 2015 Chart 17Production May Ramp Up Again As Iran Managed To Evade Sanction Either way the core OPEC members need to adjust the oil supply to maintain market share and prolong the business cycle. Taking it all together, investors should expect oil prices to remain volatile and for oil supply risks to remain elevated, meaning that oil prices will likely resume their rise after the expected OPEC intervention. Biden is also tinkering with the idea of easing sanctions on Venezuela. This would take a long time and require regime change to come to fruition. Venezuela produces about 700,000 barrels per day at present, down from about 2 million bpd in 2017.Given the lack of capital, investment, and engineering expertise, the Venezuelans probably cannot increase production beyond 1 million bpd over the next year or so. Of that, maybe 600,000 barrels could be sent to export markets, according to our Commodity & Energy Strategist Bob Ryan. The US cannot remove all sanctions from Venezuela as it does not recognize the legitimacy of President Nicolas Maduro’s regime. The Department of Justice indicted Maduro in 2020. Accommodating Maduro will create even more bad blood between the Democrats and the Cuban-American voters in electorally critical Florida. US companies will be reluctant to get involved in oil production in Venezuela on such a flimsy basis, as they will fear future sanctions if Republicans win in 2024. So investment in Venezuela, and hence oil production, will remain limited even if Biden waives some sanctions. Bottom Line: Biden’s attempts to ease sanctions on Iran and Venezuela are unlikely to have a lasting impact on oil prices. But it is possible that he will convince the OPEC states to increase production, as their own interests support such a move. Investment Takeaways Comparing Russia’s 2022 invasion of Ukraine to the original invasion in 2014, the major trends are parallel: stocks are falling relative to bonds, cyclical sectors are underperforming defensives, and small caps are outperforming large caps (Chart 18A). Chart 18AMarket Response 2022 Versus 2014 Chart 18BMarket Response 2022 Versus 2014 If Russia imposes an energy embargo or OPEC refuses to increase production, then there will be an even larger global energy shock and a European recession that will weigh on global growth. The dollar will stay well bid in the near term. Value stocks are far outpacing growth stocks in the 2022 crisis, in keeping with high inflation and rising bond yields (Chart 18B). While we favor value over growth on a structural basis, we took the opposite stance as a tactical trade at the beginning of this year in expectation of falling bond yields, which has backfired. We are closing this trade for a loss of 7.7%.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com     Footnotes 1     See Shannon Pettypiece, “White House, oil industry spar anew over drilling as gas prices surge”, NBC News, March 12, nbcnews.com. 2     See Holman Jenkins, “The Putin Endgame,” The Wall Street Journal, March 1, 2022, wsj.com   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets

Executive Summary The Fed is in a tough spot. On the one hand, rising long-dated inflation expectations will incentivize it to tighten more quickly. On the other hand, the flat yield curve and poor risky asset performance point to a heightened risk of recession if it tightens too aggressively. The Fed will try to split the difference by lifting rates at a steady pace of 25 bps per meeting, starting this week. Though upside risks have increased, it remains likely that core inflation will peak within the next couple of months. This will allow the Fed to continue tightening at a steady pace, one that is already well discounted in the market. Monthly Core Inflation By Major Component Bottom Line: Investors should keep portfolio duration close to benchmark and favor yield curve steepeners. Corporate bond spreads will continue to widen in the near-term, but a buying opportunity will soon emerge. A Tough Spot For The Fed A lot has happened since we shifted our portfolio duration recommendation from “below benchmark” to “at benchmark” on February 15. The Russian invasion of Ukraine sent bond yields sharply lower the following week but yields have since recovered and are now close to where they were when we upgraded our duration view (Chart 1). That said, the round-trip in nominal yields masks some significant moves in the real and inflation components. The 10-year TIPS breakeven inflation rate is currently 2.98%, up from 2.45% on February 15, and the 5-year/5-year forward TIPS breakeven inflation rate has moved up to 2.38% from 2.05% (Chart 2). In the past two weeks we’ve also seen a further flattening of the yield curve (Chart 2, panel 3) and widening of credit spreads (Chart 2, bottom panel). Chart 2A Stagflationary Shock Chart 1Round-Trip Taken together, recent market moves are consistent with a stagflationary shock. Long-dated inflation expectations are higher, but the yield curve is flatter and risk assets have sold off. This sort of environment is a complicated one for Fed policy. On the one hand, rising long-dated inflation expectations give the Fed a greater incentive to tighten quickly. On the other hand, rapidly tightening financial conditions increase the risk that the Fed may move too aggressively and push the economy into recession. So what’s the Fed to do? For now, it will try to split the difference. In practice, this means that the Fed will start tightening policy this week and proceed with a steady rate hike pace of 25 basis points per meeting. Once this process starts, we see two possible scenarios. The first possible scenario is that the Fed achieves its “soft landing”. A steady hike pace of 25 bps per meeting proves to be slow enough that financial conditions tighten only gradually, the yield curve retains its positive slope and inflation peaks within the next couple of months, halting the upward trend in long-dated inflation expectations. This benign scenario is still more likely than many people appreciate. For starters, the bond market is already priced for close to seven 25 basis point rate hikes this year, the equivalent of one 25 bps hike per meeting (Chart 3). This means a 50 bps hike at some point this year is required for the Fed to deliver a hawkish surprise to near-term expectations. In our view, a 50 bps hike is unlikely unless long-dated inflation expectations continue to move higher and become obviously “un-anchored”. If inflation peaks within the next couple of months, in line with our base case outlook, then so will long-dated expectations. Chart 3Rate Expectations The second possible scenario is that we see no near-term relief on the inflation front. Global supply chains remain disrupted by the war in Ukraine and surging COVID cases in China, and commodity prices continue their upward march. This would initially lead to even higher long-dated inflation expectations and an even faster pace of expected Fed tightening. It could even lead to a 50 bps Fed rate hike at some point, though we think it’s more likely that it would lead to an inverted yield curve and a severe tightening of financial conditions (i.e. sell off in equities and credit markets) before the Fed even gets the chance to deliver a 50 bps hike. Investment Implications The “soft landing” scenario remains our base case view. The Fed will start tightening in line with current market expectations and core inflation will peak within the next couple of months, keeping long-dated inflation expectations in check. Related Report  US Investment StrategyQ&A On Ukraine, Financial Markets And The Economy The correct investment strategy for this outcome is to keep portfolio duration close to benchmark and to favor a 2/10 yield curve steepener (buy the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note). Not only is the front-end of the bond market fully priced for a steady hike pace of 25 bps per meeting, but the 5-year/5-year forward Treasury yield is close to median survey estimates of the long-run neutral fed funds rate. This suggests that the upside in long-dated bond yields is limited (Chart 4). As for the yield curve, assuming that the Fed’s well-discounted steady pace of tightening is unlikely to invert the curve, then it makes sense to grab the extremely attractive yield pick-up available in the 2-year note versus a duration-matched cash/10 barbell (Chart 5). Chart 4Close to Fair Value Chart 5A Huge Yield Pick-Up In Steepeners The investment implications of our second “un-anchored inflation expectations scenario” are more difficult to game out. However, we think the most likely outcome is that bond yields would rise initially, driven by inflation expectations, and then plunge once the yield curve inverts and it becomes clear that the Fed will be forced to tighten the economy into recession. This is not our base case scenario, but investors with a 6-12 month investment horizon who wish to position for this outcome should probably extend portfolio duration rather than shorten it. The 2022 Inflation Outlook A key pillar of the “soft landing” scenario described above is that core inflation peaks within the next couple of months and starts to head lower in H2 2022. Today, we’ll assess the likelihood of that occurring by looking at the three main components of core CPI inflation: goods, shelter, and services (excluding shelter). The first fact to consider is that month-over-month core CPI has printed between 0.5% and 0.6% in each of the past five months, almost matching the extreme inflation readings seen between April and June 2021 (Chart 6). If month-over-month core inflation continues to print at 0.5%, then year-over-year core CPI will drop between March and June before rising again to reach 6.3% by the end of the year (Chart 7). Conversely, if month-over-month core inflation declines to 0.3%, then year-over-year core inflation will fall steadily to 4.2% by the end of 2022. Chart 6Monthly Core Inflation By Major Component Chart 7Annual Inflation These two outcomes likely have different implications for policy and markets. The world where core inflation remains sticky above 6% probably coincides with expectations of rapid Fed tightening, a near-term inversion of the yield curve and rising expectations of recession. Conversely, the world where core inflation falls to 4.2% by the end of 2022 and appears to be on a downward trend probably coincides with well-contained inflation expectations and a steady pace of Fed tightening. We therefore want to know which of these outcomes is more likely. To do that we consider the outlooks for core inflation’s three main components. 1. Core Goods Chart 8Goods Inflation Goods have been the main driver of elevated inflation during the past year, especially the new and used car segments (Chart 8). Prior to the pandemic, core goods inflation tended to fluctuate around 0%. Currently, the year-over-year rate is up around 12%. We view a significant decline in core goods inflation as highly likely this year. First off, used car prices – as measured by the Manheim Used Vehicle Index – have already moderated (Chart 8, panel 2), while other measures of supply bottleneck pressures like the ISM manufacturing supplier deliveries and prices paid indexes are rolling over, albeit from high levels (Chart 8, panel 3). Reduced demand should also ease some of the upward pressure on goods prices this year. Consumer spending on goods dramatically overshot its pre-COVID trend during the past two years (Chart 8, bottom panel) as spending on services was often not possible. With US COVID restrictions on the verge of being completely lifted, some spending is likely to shift away from goods and towards services in 2022. The recent news of a surging omicron COVID wave in China and renewed lockdown measures already in place in Shenzhen province may delay the re-normalization of supply chains. As of yet, we think it’s premature for this to alter our view. The omicron experience of other countries suggests that the wave will be quick and that restrictions will not be as severe as in past COVID waves.  2. Shelter Shelter is the largest component of core CPI and it is also the most tightly correlated with the economic cycle. That is, it tends to accelerate when economic growth is trending up and the unemployment rate is falling, and vice-versa. Shelter faces two-way risk in 2022. The upside risk comes from private measures of asking rents and home prices that have already surged. The Zillow Rent Index is up 15% during the past 12 months and the Zillow Home Price Index is up 20% (Chart 9A). Recent research has shown that these private measures tend to feed into core CPI with a lag of about one year.1 The downside risk to shelter inflation this year comes from the economic cycle itself. Chart 9B shows that there is a tight correlation between shelter inflation and the unemployment rate, and between shelter inflation and aggregate weekly payrolls (employment x hours x wages). The unemployment rate’s rapid 2021 decline will not persist this year. The labor market is nearing full employment and last year’s fiscal impulse has faded. Chart 9BShelter Inflation II Chart 9AShelter Inflation I Netting it all out, we think shelter inflation will continue to trend higher for the next few months but will eventually level-off near the end of this year as economic growth slows. 3. Core Services (excluding Shelter) Services inflation printed an extremely strong 0.55% month-over-month in February, though a large portion of that increase was driven by pandemic-related services like airfares and admission to events, increases that will moderate now that the omicron wave has passed. More fundamentally, wage growth is the key driver of services inflation, and it has been extremely strong. The Atlanta Fed’s Wage Growth Tracker is up to 4.3% year-over-year, its highest since 2002, and it is showing signs of broadening out to wage earners of all levels (Chart 10). Though we see wage growth remaining strong, its acceleration is also likely to moderate in the coming months. The Census Bureau’s most recent Household Pulse Survey showed that almost 8 million people were absent from work in February because they were either sick with COVID themselves or caring for someone with COVID symptoms (Chart 11). Near-term wage demands will moderate during the next few months as the pandemic ebbs and these people return to work. Chart 10Wage Growth Is Strong Chart 11Covid Still Weighing On Labor Supply We also must grapple with the possible deflationary fall-out from the recent energy and gasoline price shock. Real household incomes are declining (Chart 12A), and while consumers have ample room to either tap their savings or increase debt to support spending (Chart 12B, top panel), the recent plunge in consumer sentiment suggests that they may behave more cautiously (Chart 12B, bottom panel). Chart 12AReal Incomes Are Falling Chart 12BConsumer Confidence Is Low Putting It Together We could see core goods inflation falling all the way back to a monthly rate of 0% this year. This would be consistent with its pre-pandemic level, but also wouldn’t incorporate any outright price declines – which are also possible. If we additionally assume some further acceleration in Owner’s Equivalent Rent and Rent of Primary Residence, to 0.6% per month, and a slight pullback in services inflation to a still-strong 0.3% per month, then overall core CPI inflation would hit a monthly rate of 0.34%, consistent with annual core CPI inflation of 4.2%. We think this is a reasonable forecast though we see risks to the upside driven by another bout of supply chain pressures in manufactured goods. In general, we expect year-over-year core CPI inflation to reach a range of 4% to 5% by the end of this year. That would be consistent with the “soft landing” scenario described earlier in this report. Corporate Bonds: Waiting For A Buying Opportunity To Emerge Chart 13Corporate Bond Valuation Finally, a quick update on our corporate bond allocation. Corporate bonds have sold off sharply versus Treasuries since February 15. The investment grade corporate bond index has underperformed a duration-equivalent position in Treasury securities by 217 bps while High-Yield has underperformed by a less dramatic 120 bps. With economic risks high and the Fed on the cusp of a tightening cycle, we think further spread widening is likely in the near-term. However, if the “soft landing” scenario described earlier in this report pans out, then we will soon see a buying opportunity in corporate bonds. The 12-month quality-adjusted breakeven spread for the investment grade corporate index has risen close to its historical median, from near all-time expensive levels only a few months ago (Chart 13). While a flat yield curve poses a risk to corporate bond returns, wide spreads may soon become too attractive to ignore. Table 1A shows average historical 12-month investment grade corporate bond excess returns given different starting points for the 3-year/10-year Treasury slope and the 12-month corporate breakeven spread. Table 1B shows 90% confidence intervals for those average returns and Table 1C shows the percentage of instances in which excess returns were above 0%. Table 1AAverage 12-Month Future Investment Grade Corporate ##br##Bond Excess Returns* (BPs) Table 1B90 Percent Confidence Interval Of 12-Month Investment Grade Corporate Bond Excess Returns* (BPs) Table 1CPercentage Of Episodes With Positive 12-Month Investment Grade Corporate Bond Excess Returns* At present, the 3-year/10-year Treasury slope is +9 bps and the 12-month breakeven spread is 18 bps. Historically, this sort of environment is consistent with positive excess corporate bond returns 59% of the time, but with a negative average return overall. That said, if the yield curve retains its positive slope, then a further 18 bps of corporate index spread widening would push the 12-month breakeven spread above the 20 bps threshold. The historical record suggests that this would be an unambiguous buy signal. Bottom Line: We are sticking with our recommended 6-12 month corporate bond allocations for now. We are neutral (3 out of 5) on investment grade and overweight (4 out of 5) on high-yield. A yield curve inversion and heightened risk of recession would cause us to turn more cautious, but we think it’s more likely that widening spreads present us with an opportunity to upgrade our corporate bond allocations within the next few months. Stay tuned. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.frbsf.org/economic-research/publications/economic-letter/2022/february/will-rising-rents-push-up-future-inflation/ Treasury Index Returns Spread Product Returns Recommended Portfolio Specification Other Recommendations

Special Report

Dear client, This week we are sending you a joint Special Report with my colleague Chester Ntonifor, Foreign Exchange Strategist. The Special Report provides our outlook on the RMB. I trust that you will find the report very insightful. Best regards, Jing Sima China Strategist Executive Summary The RMB And Real Interest Rates The RMB has overshot and will likely consolidate gains in the coming months. That said, the yuan remains underpinned by a current account surplus, positive real rates, and a valuation cushion. This will support modest appreciation over the next 12-18 months (Feature Chart). The dollar is likely to enter a period of weakness beyond the Russo-Ukrainian crisis, underpinning a firm RMB. Yield spreads between China and the US will narrow across the bond curve, slowing the pace of any RMB appreciation. In its quest to dominate Asian trade flows, China will also seek a stable yuan which can be an anchor for regional currencies. Low volatility in the Chinese bond and currency market will increasingly make it an attractive hedge for global portfolio managers. This will encourage RMB inflows. The financial sanctions on Russia from the ongoing Ukrainian conflict will accelerate Chinese diversification from US assets. It will also boost the use of RMB in global trade, lifting its share in global FX reserves. Bottom Line: In the near term, USD/CNY is due for a bounce and could retrace to 6.5. It is also the case that a lot of the gains in the Chinese RMB have been frontloaded, suggesting a flattish path ahead. Beyond the near term, we expect the DXY to hit 90 in the next 12-18 months, which will boost the RMB towards 6.0. Feature The RMB has been strong across the board versus most major currencies (Chart 1). Year-to-date, the DXY dollar index is up 2% while the CFETS basket is up 3%. This places the Chinese yuan as one of the best performing major currencies this year. Such a configuration where USD/CNY diverges from the broad dollar trend has been very rare in recent history (Chart 2). More importantly, this has occurred amidst very low volatility. Chart 1A Bull Market In Yuans Chart 2USD/CNY And The Dollar Diverge In this Special Report, we try to understand the driving forces behind a rising RMB, to gauge its likely path going forward. In our view, while the yuan is vulnerable tactically, it is underpinned by strong structural forces that support modest appreciation over the next 12-18 months. The Chinese Economy, Interest Rates, And The RMB An exchange rate is simply a mechanism to equalize rates of returns across countries. For most currencies, the key determinants of this arbitrage window are real interest rate differentials. In China, while nominal interest rates vis-à-vis the US have been collapsing, real interest rate differentials are near a record high. This has been the key driver of a rising RMB (Chart 3). Real interest rates tend to matter because high and rising inflation destroys the purchasing power of any currency. Our bias is that higher real rates in China versus the US will persist and keep the RMB firm. Five key reasons underpin this view: The Chinese economy is expected to accelerate this year relative to the US. The IMF expects 4.8% GDP growth in China, versus 4% in the US. Bloomberg consensus estimates corroborate this view – 5.2% growth is expected for China this year, versus 3.6% for the US. Even the Chinese government’s GDP growth target this year is 5.5%, much higher than street estimates. US interest rates are likely to rise over the medium term, but so will those in China. The Chinese credit impulse has bottomed, and it is usually a good precursor to both stronger economic activity and higher relative government bond yields (Chart 4). Chart 3The RMB And Real Versus Nominal Rates Chart 4Interest Rate Differentials And The Credit Impulse While Chinese productivity growth is slowing, it remains structurally higher compared to that in the US or Europe. Stronger productivity growth suggests the neutral rate of interest in China will remain higher than in Western economies for years to come. This will continue to attract further fixed-income inflows. The RMB is a procyclical currency and tends to benefit when flows into emerging market assets in general, and Chinese stocks in particular, are fervent. While the Chinese authorities have cracked down on the property and information technology/communication service sectors, they have done so without causing widespread capital flight and hurting the RMB (Chart 5). Going forward, odds are that the interest from foreign bargain hunters will rise as these sectors reset from lower and much cheaper levels. It is well known that the Chinese economy has excess capacity, which is inherently deflationary (and positive for real rates). Like Japan, China has excess savings and deficient demand (Chart 6). However, in an inflationary world, this excess capacity can easily be exported, especially to the US, which is on the verge of overheating. A healthy trade balance in China suggests there is little reason for the RMB to depreciate meaningfully. Chart 6Excess Savings In China And Low Inflation Chart 5The RMB And Chinese Equities It is remarkable that despite being the largest commodity importer in the world, terms of trade in China is picking up. Rising terms of trade is usually synonymous with a stronger currency. On the flip side, a stronger currency will also temper inflationary pressures in China (Chart 7). Chart 7The RMB, Terms Of Trade And Inflation The bottom line is that real interest rates will remain relatively high in China, even as the US begins to tighten monetary policy while China eases. The reason is that the US economy is much more inflationary, and Chinese bond yields tend to rise when the PBoC stimulates growth. Market Liberalization And Portfolio Flows With attractive real yields, Chinese bonds have been gaining widespread investor appeal. Their inclusion in the world’s three major bond indices has been a seminal milestone in the process of liberalizing the Chinese fixed-income market. Chinese bonds have also acted as perfect portfolio hedges, moving inversely to US and global equities (Chart 8). The result has been significant portfolio inflows into Chinese bonds. As a reminder, Chinese bonds were initially included in the Bloomberg Barclays Global Aggregate Index (BBGA) in April 2019. Following that, they were added to the JP Morgan Government Bond - Emerging Market Index (GBI-EM) in February 2020. Finally, FTSE Russell announced their inclusion of in the FTSE World Government Bond Index (WGBI) as of October 2021. Since their inclusion, a net US$350 billion has flowed into Chinese bonds. We estimate that about 35% of that has been due to index inclusion. The amount of Chinese onshore bonds held by overseas investors has breached US$600 billion, a record high (Chart 9). Chart 9A Healthy Appetite From Foreign Investors Chart 8RMB Bonds As A Portfolio Hedge In a nutshell, the path of the RMB in the short term will follow relative growth dynamics between China and the rest of the world, but structural factors such the inclusion of RMB bonds in global portfolios will underpin strong inflows into the Chinese fixed-income market. The Dollar, Trade, And Lessons From The Ukrainian Conflict Chart 10China Is Destocking USDs Another factor to consider vis-à-vis the RMB is the dollar’s reserve status, and the overreach that it commands. Quite simply, transactions conducted in US dollars anywhere fall under US law. This means that if a company in any country buys energy from Iran and the transaction is done in US dollars, the Treasury has powers to sanction the parties involved. Russian holdings of US Treasurys peaked during the Georgian war and have since fallen to near 0% of total reserves. Even so, the world has witnessed how vulnerable the Russian economy has been to a cut-off from the Society For Worldwide Interbank Financial Telecommunication (SWIFT) messaging system. China is the largest holder of US Treasurys and what it decides to do with this war chest of savings is of critical importance. At a minimum, a few trends that have been underway in recent years are likely to accelerate. China will continue to destock its holding of Treasurys into gold and other currencies (Chart 10). This will put downward pressure on the dollar and boost the RMB. In fact, ever since China started destocking Treasurys in earnest in 2015, the DXY has been unable to sustainably punch through the 100 level. Trade flows in Asia remain rather buoyant, even as globalization has peaked (Chart 11A and 11B). With most Asian countries having China as a large trading partner, the logical step will be more and more invoicing in RMB. Most global trade hubs in history (such as Hong Kong for example) have always sought a stable currency with low volatility to instill confidence in trade. China is likely to also favor a stable RMB. Chart 11AChina Could Dominate Asian Trade Chart 11BAsian Trade Is Booming As Asian trade continues to expand, the PBoC can step in as the regional central bank and lender of last resort. It is notable that China is already engaging in this role. Since the global financial crisis, the number of bilateral swap lines offered to foreign central banks by the PBoC has ballooned (Chart 12). According to the most recent data (from the PBoC), the Chinese central bank had bilateral local currency swap agreements with central banks or monetary authorities in 40 countries and regions, with a total amount of around 4 trillion yuan. The People’s Bank of China has massive foreign exchange reserves, worth about US$3.2 trillion. This means it can provide swap agreements that will almost cover the totality of EM foreign dollar debt. The Cross-Border Interbank Payment System (CIPS) already allows the transfer and clearing of yuan-denominated payments. In 2021, the system processed US$12.7 trillion, a 75% increase in turnover from the previous year.1 While the system still largely relies on SWIFT messaging for most cross-border transactions, progress towards independence is moving fast. The key point is that as China continues to rise as an economic power and increases the share of RMB trade within its sphere of influence, the yuan will naturally become the de facto Asian currency. This will allow the RMB to continue to gain international appeal (Chart 13). Chart 12The People's Bank Of Asia? Chart 13The RMB And International Appeal Valuation Concerns Most of the discussion above has focused on the cyclical outlook for the Chinese economy and bond yields, as well as the geopolitical ramifications from the Russo-Ukrainian conflict. While the macro environment is by far the most important driver of currencies, valuation and sentiment tend to matter as well. On this note: Our productivity model suggests the RMB is at fair value. Productivity in China remains higher than among its western trading partners, but the gap has been closing. This has flattened the slope of the fair-value model (Chart 14). That said, the US and Europe are generating much higher inflation than China, suggesting there is higher pressure for unit labor costs to rise in these countries. This will improve the competitive profile of the RMB. Our PPP model for the RMB, using an apples-to-apples consumer basket vis-à-vis the US suggests the RMB is undervalued by 11% (Chart 15). Historically, such levels of undervaluation have seen the RMB appreciate by 2% per year over the next 4 years (Chart 16). Chart 14The RMB Is At Fair Value Based On Productivity Trends Chart 15The RMB Is Cheap Based On Relative Prices   Chart 16Potential RMB Returns For Foreign Investors Valuation tends to be important because it is usually the trigger for imbalances to manifest themselves. Back in 2015-20162  when Chinese capital outflows (especially illicit flows) were rampant amongst global and Chinese concerns, the RMB also happened to be very overvalued. Today, such a risk is much limited. Concluding Thoughts The RMB and the dollar tend to move in harmony, and so a discussion of one entails talking about the other. We have characterized the dollar this year as caught in a tug of war. Specifically, aggressive rate hikes by the Federal Reserve will boost interest rate differentials in favor of the US but undermine the equity market via a derating in stocks. This will tighten financial conditions, nudging the Fed to pivot. On the other hand, less accommodation by the Fed will significantly unwind the rate-driven rally that has nudged the DXY close to 100.  On the other hand, the Chinese credit impulse has bottomed meaning bond investors will benefit from rising bond yields in China. Equity investors will also benefit from a cheaper market, as well as exposure to sectors that are primed to benefit as the global economy reopens. This combination could sustain the pace of foreign capital inflows. In the near term, USD/CNY is due for a bounce and could retrace to 6.5. It is also the case that a lot of the gains in the Chinese RMB have been front loaded, suggesting a flattish path ahead. Beyond the near term, we expect the DXY to hit 90 in the next 12-18 months, which will boost the RMB towards 6.0. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Reuters: https://www.reuters.com/markets/europe/what-is-chinas-onshore-yuan-clearing-settlement-system-cips-2022-02-28/ 2 Please see Chinese Investment Strategy Special Report, titled “Monitoring Chinese Capital Outflows,” dated March 20, 2019, available at cis.bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations

Special Report

Executive Summary The RMB And Real Interest Rates The RMB has overshot and will likely consolidate gains in the coming months. That said, the yuan remains underpinned by a current account surplus, positive real rates, and a valuation cushion. This will support modest appreciation over the next 12-18 months (Feature Chart). The dollar is likely to enter a period of weakness beyond the Russo-Ukrainian crisis, underpinning a firm RMB. Yield spreads between China and the US will narrow across the bond curve, slowing the pace of any RMB appreciation. In its quest to dominate Asian trade flows, China will also seek a stable yuan which can be an anchor for regional currencies. Low volatility in the Chinese bond and currency market will increasingly make it an attractive hedge for global portfolio managers. This will encourage RMB inflows. The financial sanctions on Russia from the ongoing Ukrainian conflict will accelerate Chinese diversification from US assets. It will also boost the use of RMB in global trade, lifting its share in global FX reserves. Bottom Line: In the near term, USD/CNY is due for a bounce and could retrace to 6.5. It is also the case that a lot of the gains in the Chinese RMB have been frontloaded, suggesting a flattish path ahead. Beyond the near term, we expect the DXY to hit 90 in the next 12-18 months, which will boost the RMB towards 6.0. Feature The RMB has been strong across the board versus most major currencies (Chart 1). Year-to-date, the DXY dollar index is up 2% while the CFETS basket is up 3%. This places the Chinese yuan as one of the best performing major currencies this year. Such a configuration where USD/CNY diverges from the broad dollar trend has been very rare in recent history (Chart 2). More importantly, this has occurred amidst very low volatility. Chart 1A Bull Market In Yuans Chart 2USD/CNY And The Dollar Diverge In this Special Report, we try to understand the driving forces behind a rising RMB, to gauge its likely path going forward. In our view, while the yuan is vulnerable tactically, it is underpinned by strong structural forces that support modest appreciation over the next 12-18 months. The Chinese Economy, Interest Rates, And The RMB An exchange rate is simply a mechanism to equalize rates of returns across countries. For most currencies, the key determinants of this arbitrage window are real interest rate differentials. In China, while nominal interest rates vis-à-vis the US have been collapsing, real interest rate differentials are near a record high. This has been the key driver of a rising RMB (Chart 3). Real interest rates tend to matter because high and rising inflation destroys the purchasing power of any currency. Our bias is that higher real rates in China versus the US will persist and keep the RMB firm. Five key reasons underpin this view: The Chinese economy is expected to accelerate this year relative to the US. The IMF expects 4.8% GDP growth in China, versus 4% in the US. Bloomberg consensus estimates corroborate this view – 5.2% growth is expected for China this year, versus 3.6% for the US. Even the Chinese government’s GDP growth target this year is 5.5%, much higher than street estimates. US interest rates are likely to rise over the medium term, but so will those in China. The Chinese credit impulse has bottomed, and it is usually a good precursor to both stronger economic activity and higher relative government bond yields (Chart 4). Chart 3The RMB And Real Versus Nominal Rates Chart 4Interest Rate Differentials And The Credit Impulse While Chinese productivity growth is slowing, it remains structurally higher compared to that in the US or Europe. Stronger productivity growth suggests the neutral rate of interest in China will remain higher than in Western economies for years to come. This will continue to attract further fixed-income inflows. The RMB is a procyclical currency and tends to benefit when flows into emerging market assets in general, and Chinese stocks in particular, are fervent. While the Chinese authorities have cracked down on the property and information technology/communication service sectors, they have done so without causing widespread capital flight and hurting the RMB (Chart 5). Going forward, odds are that the interest from foreign bargain hunters will rise as these sectors reset from lower and much cheaper levels. It is well known that the Chinese economy has excess capacity, which is inherently deflationary (and positive for real rates). Like Japan, China has excess savings and deficient demand (Chart 6). However, in an inflationary world, this excess capacity can easily be exported, especially to the US, which is on the verge of overheating. A healthy trade balance in China suggests there is little reason for the RMB to depreciate meaningfully. Chart 6Excess Savings In China And Low Inflation Chart 5The RMB And Chinese Equities It is remarkable that despite being the largest commodity importer in the world, terms of trade in China is picking up. Rising terms of trade is usually synonymous with a stronger currency. On the flip side, a stronger currency will also temper inflationary pressures in China (Chart 7). Chart 7The RMB, Terms Of Trade And Inflation The bottom line is that real interest rates will remain relatively high in China, even as the US begins to tighten monetary policy while China eases. The reason is that the US economy is much more inflationary, and Chinese bond yields tend to rise when the PBoC stimulates growth. Market Liberalization And Portfolio Flows With attractive real yields, Chinese bonds have been gaining widespread investor appeal. Their inclusion in the world’s three major bond indices has been a seminal milestone in the process of liberalizing the Chinese fixed-income market. Chinese bonds have also acted as perfect portfolio hedges, moving inversely to US and global equities (Chart 8). The result has been significant portfolio inflows into Chinese bonds. As a reminder, Chinese bonds were initially included in the Bloomberg Barclays Global Aggregate Index (BBGA) in April 2019. Following that, they were added to the JP Morgan Government Bond - Emerging Market Index (GBI-EM) in February 2020. Finally, FTSE Russell announced their inclusion of in the FTSE World Government Bond Index (WGBI) as of October 2021. Since their inclusion, a net US$350 billion has flowed into Chinese bonds. We estimate that about 35% of that has been due to index inclusion. The amount of Chinese onshore bonds held by overseas investors has breached US$600 billion, a record high (Chart 9). Chart 9A Healthy Appetite From Foreign Investors Chart 8RMB Bonds As A Portfolio Hedge In a nutshell, the path of the RMB in the short term will follow relative growth dynamics between China and the rest of the world, but structural factors such the inclusion of RMB bonds in global portfolios will underpin strong inflows into the Chinese fixed-income market. The Dollar, Trade, And Lessons From The Ukrainian Conflict Chart 10China Is Destocking USDs Another factor to consider vis-à-vis the RMB is the dollar’s reserve status, and the overreach that it commands. Quite simply, transactions conducted in US dollars anywhere fall under US law. This means that if a company in any country buys energy from Iran and the transaction is done in US dollars, the Treasury has powers to sanction the parties involved. Russian holdings of US Treasurys peaked during the Georgian war and have since fallen to near 0% of total reserves. Even so, the world has witnessed how vulnerable the Russian economy has been to a cut-off from the Society For Worldwide Interbank Financial Telecommunication (SWIFT) messaging system. China is the largest holder of US Treasurys and what it decides to do with this war chest of savings is of critical importance. At a minimum, a few trends that have been underway in recent years are likely to accelerate. China will continue to destock its holding of Treasurys into gold and other currencies (Chart 10). This will put downward pressure on the dollar and boost the RMB. In fact, ever since China started destocking Treasurys in earnest in 2015, the DXY has been unable to sustainably punch through the 100 level. Trade flows in Asia remain rather buoyant, even as globalization has peaked (Chart 11A and 11B). With most Asian countries having China as a large trading partner, the logical step will be more and more invoicing in RMB. Most global trade hubs in history (such as Hong Kong for example) have always sought a stable currency with low volatility to instill confidence in trade. China is likely to also favor a stable RMB. Chart 11AChina Could Dominate Asian Trade Chart 11BAsian Trade Is Booming As Asian trade continues to expand, the PBoC can step in as the regional central bank and lender of last resort. It is notable that China is already engaging in this role. Since the global financial crisis, the number of bilateral swap lines offered to foreign central banks by the PBoC has ballooned (Chart 12). According to the most recent data (from the PBoC), the Chinese central bank had bilateral local currency swap agreements with central banks or monetary authorities in 40 countries and regions, with a total amount of around 4 trillion yuan. The People’s Bank of China has massive foreign exchange reserves, worth about US$3.2 trillion. This means it can provide swap agreements that will almost cover the totality of EM foreign dollar debt. The Cross-Border Interbank Payment System (CIPS) already allows the transfer and clearing of yuan-denominated payments. In 2021, the system processed US$12.7 trillion, a 75% increase in turnover from the previous year.1 While the system still largely relies on SWIFT messaging for most cross-border transactions, progress towards independence is moving fast. The key point is that as China continues to rise as an economic power and increases the share of RMB trade within its sphere of influence, the yuan will naturally become the de facto Asian currency. This will allow the RMB to continue to gain international appeal (Chart 13). Chart 12The People's Bank Of Asia? Chart 13The RMB And International Appeal Valuation Concerns Most of the discussion above has focused on the cyclical outlook for the Chinese economy and bond yields, as well as the geopolitical ramifications from the Russo-Ukrainian conflict. While the macro environment is by far the most important driver of currencies, valuation and sentiment tend to matter as well. On this note: Our productivity model suggests the RMB is at fair value. Productivity in China remains higher than among its western trading partners, but the gap has been closing. This has flattened the slope of the fair-value model (Chart 14). That said, the US and Europe are generating much higher inflation than China, suggesting there is higher pressure for unit labor costs to rise in these countries. This will improve the competitive profile of the RMB. Our PPP model for the RMB, using an apples-to-apples consumer basket vis-à-vis the US suggests the RMB is undervalued by 11% (Chart 15). Historically, such levels of undervaluation have seen the RMB appreciate by 2% per year over the next 4 years (Chart 16). Chart 14The RMB Is At Fair Value Based On Productivity Trends Chart 15The RMB Is Cheap Based On Relative Prices   Chart 16Potential RMB Returns For Foreign Investors Valuation tends to be important because it is usually the trigger for imbalances to manifest themselves. Back in 2015-20162  when Chinese capital outflows (especially illicit flows) were rampant amongst global and Chinese concerns, the RMB also happened to be very overvalued. Today, such a risk is much limited. Concluding Thoughts The RMB and the dollar tend to move in harmony, and so a discussion of one entails talking about the other. We have characterized the dollar this year as caught in a tug of war. Specifically, aggressive rate hikes by the Federal Reserve will boost interest rate differentials in favor of the US but undermine the equity market via a derating in stocks. This will tighten financial conditions, nudging the Fed to pivot. On the other hand, less accommodation by the Fed will significantly unwind the rate-driven rally that has nudged the DXY close to 100.  On the other hand, the Chinese credit impulse has bottomed meaning bond investors will benefit from rising bond yields in China. Equity investors will also benefit from a cheaper market, as well as exposure to sectors that are primed to benefit as the global economy reopens. This combination could sustain the pace of foreign capital inflows. In the near term, USD/CNY is due for a bounce and could retrace to 6.5. It is also the case that a lot of the gains in the Chinese RMB have been front loaded, suggesting a flattish path ahead. Beyond the near term, we expect the DXY to hit 90 in the next 12-18 months, which will boost the RMB towards 6.0. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Reuters: https://www.reuters.com/markets/europe/what-is-chinas-onshore-yuan-clearing-settlement-system-cips-2022-02-28/ 2 Please see Chinese Investment Strategy Special Report, titled “Monitoring Chinese Capital Outflows,” dated March 20, 2019, available at cis.bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Special Report

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