China

Highlights US inflation expectations will moderate, and US real yields will rise. This will support the US dollar. The potential rebound in the US dollar will cap any upside in EM ex-TMT stocks. Rising US real yields are a risk to high-multiple global growth stocks. Maintain a neutral allocation to EM in global equity and credit portfolios. Feature In this week’s report we identify market-relevant issues and topics and then present the investment implications of these potential developments. Current key investment-relevant topics and issues are as follows: 1. Implications of the US elections Fiscal Stimulus: In the context of Biden’s victory and the Senate remaining Republican, the odds of a meaningful fiscal package in the next several months are quite low. The Republican Senate did not support a fiscal package going into the elections. Odds are low that it will now agree to a fiscal package larger than $750 billion. Chart 1Rising US Real Yields Are Positive For The US Dollar According to the US Congressional Budget Office’s calculations, without a new fiscal package, the fiscal thrust in 2021 will be -7.5% of GDP or $1.5 trillion. Hence, fiscal stimulus should be more than $1 trillion to avoid a slump in growth. Granted that the recovery in US consumer income and spending that has been underway since April has to a large extent been supported by US fiscal transfers, the lack of current government income support to households poses a risk to the economy.  Of course, if US economic activity tanks again and the stock market plunges, Republicans will support a much larger package. However, as things stand now, the probability of a substantial (more than $1 trillion) fiscal package is low. The lack of fiscal stimulus implies that US growth and inflation expectations will moderate. Chart 1 shows that US inflation expectations have probably reached an apex and will downshift for now. US nominal bond yields are capped on the upside (by the Fed’s purchases and its commitment not to raise interest rates for several years) and on the downside (by the Fed’s reluctance to reach negative interest rates). Consequently, swings in inflation expectations will drive fluctuations in real yields, as has been occurring in recent months. As inflation expectations decline, real yields will rise. Impact of rising US real yields on financial markets: A stronger US dollar and lower prices for Nasdaq stocks. Rising real rates will support the US dollar (Chart 1, bottom panel). Chart 5 on page 5 reveals that the real rates differential between the US and the euro area has recently been moving in favor of the greenback.  Chart 2Rising US Real Yields Are Negative For Growth Stocks Budding investor realization that the US might not pursue an aggressively expansionary fiscal policy, as has been expected since spring, could also support the greenback. Less issuance of Treasury securities might be interpreted as less public debt monetization and less money creation by the Federal Reserve. Such a viewpoint will also be marginally positive for the US dollar. As to the equity market, US real (TIPS) yields have been negatively correlated with the Nasdaq index (Chart 2). As US real yields continue to rise, odds are that global growth stocks will come under selling pressure. Geopolitical ramifications: The impact of the forthcoming change in the White House on US foreign policy has been widely anticipated and has already been priced in by financial markets. A Biden administration will have a positive impact on the euro area, Canada, Mexico and Asia Pacific countries with the exception of China – as was not the case under the Trump administration. On the other end, Russia, Turkey and Saudi Arabia will be under heat from Biden’s White House. In our view, the impact on China will be neutral, not better than during Trump’s administration. It might be mildly positive in the near term but negative in the long run. In the short run, the new US administration will be less likely to use global trade as a weapon. In the long run, however, Biden will likely mobilize Europe to join its geopolitical confrontation with China. This will be negative for the Middle Kingdom.   One country where the impact of Biden’s administration has not been fully priced in is Brazil. The US executive branch will take a tougher stance in its dealings with Brazil’s right-wing government because their social values are not aligned and policy priorities differ. We remain short the BRL and underweight Brazilian equity and fixed-income markets within their respective EM portfolios. 2. Vaccines We have no better expertise than the market’s judgement on the timing of vaccine availability and its effectiveness in containing the pandemic in EM ex-China countries. It is clear, however, that the process of vaccine acquisition and distribution might be slower in EM ex-China than in advanced countries. On all three fronts – the spread of the pandemic, policy stimulus and vaccine distribution – EM excluding China, Korea and Taiwan will continue lagging DM. Therefore, EM ex-China domestic demand will continue to underperform relative to expectations and versus those in DM. This argues for continuous underweight, or at best a neutral allocation, in EM ex-China, Korea and Taiwan equities versus their DM peers. Chart 3Chinese Onshore Equities Have Been In A Trading Range Since Early July 3. China: the business cycle and regulatory clampdown China’s business cycle recovery has further to go. The stimulus injected into the economy has been considerable and will continue to work its way into the economy. Even though we believe that China has reached peak stimulus, the latter works with a time lag of 6-12 months and economic growth will top only around mid-2021. That said, Chinese onshore share prices have been in a consolidation phase since early July and this is likely not over yet (Chart 3).  In turn, Chinese investable stocks have been surging in absolute terms and outperforming the global equity index (Chart 4, top panel). However, the entire Chinese equity outperformance has been due to growth stocks (TMT/new economy). Excluding these, the absolute and relative performance of Chinese investable stocks has been lackluster (Chart 4, top and bottom panels). Chart 4Chinese Investable Stocks: Surging TMT And Lackluster Performance By Ex-TMT Stocks In short, the spectacular performance of Chinese investable stocks this year has been attributed to three new economy stocks: Alibaba, Tencent and Meituan. These three stocks presently account for 40.5% of China’s MSCI Investable Index and 17.5% of the aggregate EM MSCI equity index. Concerns about regulatory clampdowns on new economy stocks have been, and remain, a major risk, not only in China but also in advanced economies. It is impossible to time regulatory actions. Nevertheless, investors should take into account the possibility that regulation may curb the profitability of new economy companies, especially if they are de-facto monopolies or oligopolies. Chinese authorities will not back down from imposing new regulation and scrutiny over the activities of giant new economy companies. Hence, risks of further de-rating remain elevated. In short, even though the mainland business cycle recovery is on a track, Chinese share prices remain at risk of correction due to overbought conditions and re-pricing of regulatory risks for new economy stocks. Will The US Dollar Capture Some Of Its Luster? US real yields are rising not only in absolute terms, but also relative to real yields in the euro area (Chart 5). Rising real yields in the US versus the euro area generally lead to a dollar rally against the euro.  Apart from rising US real bond yields, there are a number of other factors that will likely support the greenback: Investor sentiment on the US dollar is very low (Chart 6). From a contrarian perspective, this is positive. Chart 5The US Versus Euro Area: Real Yield Differentials And Exchange Rate Chart 6Investors Are Downbeat On The US Dollar   Consistently, investors are very short the US dollar, especially versus DM currencies (Charts 7and 8). Positioning is less short in the US dollar versus cyclical DM and high-beta EM currencies (Chart 8). That said, the fundamentals of EM high-beta currencies such as BRL, TRY, ZAR and IDR are poor. Chart 7Investors Are Very Long Safe-Haven Currencies… Chart 8...And Modestly Long Cyclical Currencies   The Republican Senate will block corporate tax increases and limit any regulatory initiatives by Democrats in Congress. Such business-friendly policies are currency bullish. In short, a Republican Senate is broadly positive for the US dollar, and markets have not priced it in. The fact that broad US equity averages – such as small caps and equal-weighted equity indexes – continue outperforming the rest of the world in local currency terms is also dollar bullish (Chart 9). The reasoning is that US equity outperformance versus the rest of the world suggests better profitability and return on capital in the US versus its peers. That favors a firmer US dollar. Finally, the broad-trade weighted US dollar is oversold and is sitting on a long-term technical resistance level (Chart 10). Chart 9US Relative Equity Outperformance Heralds A Stronger US Dollar Chart 10The US Dollar Is Very Oversold   Bottom Line: We have been highlighting downside risks to the US dollar since July 9. However, the conclusion of the US election raises the odds of a playable US dollar rebound. EM Strategy EM Equities We have been advocating for a neutral allocation toward EM in a global equity portfolio since July 30. If the US dollar rebounds, as we expect, EM stocks will not outperform the global equity index (Chart 11). Notably, excluding Chinese investable stocks, EM share prices have not outperformed the global benchmark (Chart 12). Besides, as shown in the top panel of Chart 4 on page 4, China’s outperformance against the global equity benchmark has been driven exclusively by new economy stocks. Chart 11EM Stocks Do Not Outperform When The Dollar Rallies Chart 12EM Versus Global Equity Performance: With And Without China   All in all, Charts 4 and 12 reveal that excluding three large Chinese new economy stocks – Alibaba, Tencent and Meituan – EM share prices have underperformed the global equity benchmark. Going forward, the potential rebound in the US dollar will cap any upside in EM ex-TMT stocks. Meanwhile, the correction in the NASDAQ and the increased scrutiny on the part of Chinese authorities over new economy stocks poses a risk to Chinese mega-cap TMT share prices. In absolute terms, we have been waiting for a pullback to buy EM equities, but they have surged following the US elections and the news on Pfizer’s vaccine. Chart 13EM Equity Index: No Breakout Yet The EM equity index could still advance and reach its 2011 or 2018 highs before rolling over (Chart 13). However, given our view on the US currency and risks to EM stemming from a rising US dollar, we refrain from playing such limited upside. EM currencies EM currencies will be at a risk if the US dollar stages a rebound. Since July 9, we have been shorting a basket of BRL, CLP, TRY, KRW, ZAR and IDR versus an equally-weighted basket of the euro, CHF and JPY. We are sticking with this strategy. Even if the US dollar rebounds, downsides in the euro, CHF and JPY against the greenback will be relatively limited. However, investors might consider adding the US dollar to the long side of this strategy. EM local bonds and EM credit markets We continue recommending long duration in EM local rates. However, we remain reluctant to take on currency risk. We maintain our recommendations from April 23 about receiving 10-year swap rates in Mexico, Colombia, Russia, India, China and Korea. We are also receiving 2-year rates in Malaysia and South Africa as a bet on rate cuts in these economies. In the EM credit space, we are also neutral. Our sovereign credit overweights are Mexico, Colombia, Peru, Russia, Thailand, Malaysia and the Philippines. Our underweights are South Africa, Turkey, Indonesia, Argentina and Brazil. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

The global semiconductor industry has been experiencing a record amount of IPOs and M&A deals in recent months. A flurry of IPOs and M&As in any industry often serves as a sign of a top in share prices (Chart 1). Chat 1Will Booming Semiconductor IPOs And M&As Mark A Peak In Share Prices? The basis is that IPO and M&A booms usually occur when investor sentiment on that industry is super optimistic, which often coincides with a top in share prices. Does this mean that semiconductor stocks in general, and the ones in Taiwan and Korea in particular, are at their zenith? Our broad judgement is that semi stocks have not reached a secular peak. First, as we argued in a recent Special Report, the semiconductor industry is in a structural uptrend due to the continuing rollout of 5G networks and phones, a wider adoption of data centers, further technological advancements in artificial intelligence, cloud computing, edge computing and smaller nodes for chip manufacturing. Second, it is critical to differentiate a macro call on semiconductors from a bottom-up call on individual stocks. Not all semi companies have rallied in recent years, i.e., there has been great divergence among global semi stocks as shown in Chart 2. Chat 2The Performance Of Semiconductor Stocks Has Varied Greatly Several semiconductor companies – like TSMC, Nvidia and AMD – have achieved technological breakthroughs, putting them in a position to enjoy high order volumes and charge higher prices. Not surprisingly, revenues of these companies have outpaced the industry average by a wide margin (Chart 3). Chat 3Semiconductor Companies' Revenues Have Diverged Others – like Intel and Analog Devices - have posted inferior revenue gains because they have fallen behind technologically or because they are specializing in certain types of semiconductors for which demand and pricing have been lackluster. Chat 4One-Off Surge In Demand For Semis Might Be Over Finally, if the global reflation trade resumes and global stocks continue advancing, as the first post-US election day suggests, there is little reason for global semiconductor stocks to falter at this moment. From the macro perspective, lower interest rates in the long run will support not-so-cheap semiconductor stock valuations. In addition, companies with access to unique technological capabilities will be able to raise their product prices benefiting their profits.    That said, there are also several signs that the global semi demand cycle might have entered a period of indigestion: The one-off demand surge for personal computers and gadgets and one-off ramp up of global server shipments due to the pandemic might be drawing to a close (Chart 4, top panel). Digitimes Research has reported that global server shipments are estimated to have slipped 6% sequentially in Q3 from Q2 and are projected to drop another 12% in Q4 (Chart 4, bottom panel). Unlike those in March-April, renewed lockdowns are unlikely to produce another surge in demand for digital equipment and, hence, for semis. Many people and companies have already settled into working from home. In short, as the effect of the one-off demand surge for digital hardware fades, global semi demand will moderate.  Semiconductor companies in general, and the ones in Korea and Taiwan in particular, have greatly benefited from China having stockpiled semiconductors in 2019 and 2020 in preparation for US sanctions on Huawei that went into effect on September 15, 2020 (Chart 5). The US supply ban on semiconductors to China for 5G technology will remain in place regardless of the outcome of the US presidential elections. Restrictions on semi sales to China will weigh on certain semi producers. In addition, smartphone sales in China generally, including 5G smartphone sales, have plunged as of late (Chart 6). Chat 5China Has Been Accumulating Semis Inventories Chat 6China: Smartphone Shipments, Including 5G, Are Weak   Finally, the PMI new orders sub-index for Taiwan’s electronic industry has rolled over, signaling a slowdown in its growth rate (Chart 7).   Similarly, the memory chip revenue indicator has recently rolled over, signaling a potential risk to memory stocks such as Samsung and Hynix which make up the Korean technology index (Chart 8). Chat 7A Moderation In The Taiwanese Semis Industry? Chat 8Proxy for Value Of Memory Chips And Korean Tech Stocks   We have been advocating a neutral allocation to both the Korean and Taiwanese stock markets within the EM equity universe. One of our arguments for this strategy has been a potential escalation in the US-China confrontation going into the US elections. However, this risk has not materialized. We are upgrading the Korean bourse to overweight. As to Taiwan, a contested US election and the resulting vacuum of power in the next couple of months might lead to a rise in all types of geopolitical risks around the world. Taiwan could be one of these. We maintain a neutral allocation to the Taiwanese bourse within an EM equity portfolio. Bottom Line: In absolute terms, Korean and Taiwanese equity performance depends on the direction of global stocks. We will discuss the outlook for global and EM stocks in a Strategy Report to be published early next week when there is more clarity on the outcome of the US presidential elections. Within an EM equity universe, we are upgrading Korean stocks from neutral to overweight but keeping Taiwan’s allocation at neutral. Arthur Budaghyan Chief Emerging Markets Strategist arthur@bcaresearch.com Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Footnotes

The 14th Five-Year Plan has more strategic importance than in the past decade. Spending on national defense, technological self-sufficiency, public welfare and green energy will likely see substantial increases under the guidelines of a strong central government. The Proposal from the Five-Year Plan does not change our cyclical view on Chinese assets. Beyond mid-2021, the differences in sectoral performance will widen. We will likely begin to trim our position in China’s “old economy” stocks in the first half of 2021.