China
According to BCA Research’s China Investment Strategy service, China’s auto sales are set to have a gradual recovery in 2022H2. The team expects auto sales to reach 26.2-26.8 million units by the end of this year, with new energy vehicles (NEVs) and…
China’s service sector is expanding anew after 3 months of contraction. The China Caixin non-manufacturing PMI surged to 54.5 in June from 41.4 in May, handily exceeding expectations of 49.6, and pointing to the strongest increase in service sector…
Executive Summary China: GeoRisk Indicator A new equilibrium between NATO, which now includes Sweden and Finland, and Russia needs to be reestablished before geopolitical risks in Europe subside. Russia aims to inflict a recession on the EU which will revive dormant geopolitical risks embedded in each country. Investors should ignore the apparent drop in China’s geopolitical risk as it could rise further until Xi Jinping consolidates power at the Party Congress this fall. Stay on the sideline on Brazilian, South African, Australian, and Canadian equities despite the commodity bull market, at least until China’s growth stabilizes. Korean risk will rise, albeit by less than Taiwanese risk. The US political cycle ensures that Biden may take further actions against adversaries in Europe, Middle East, and East Asia, putting a floor under global geopolitical risk. Tactical Recommendation Inception Date Return LONG GLOBAL AEROSPACE & DEFENSE / BROAD MARKET EQUITIES 2020-11-27 9.3% Bottom Line: Geopolitical risk will rise in the near term. Stay long gold and global defensive stocks. Feature This month we update our GeoRisk Indicators and make observations about the status of political risk for each territory, and where risks are underrated or overrated by global financial markets. Russia GeoRisk Indicator Our “Original” quantitative measure of Russian political risk – the Russian “geopolitical risk premium” shown in the dotted red line below – has fallen to new lows (Chart 1). One must keep in mind that this geopolitical premium is operating under the assumption of a “free market” but the Russian market in the past few months had been anything but free. The Russian government and central bank had been manipulating the ruble and preventing capital outflows. Hence, Russian assets and any indicator derived from it does not reflect its true risk premium, merely the resolve of its government in the geopolitical struggle. Chart 1Russia: GeoRisk Indicator While the Russia Risk Premium accurately detected the build-up in tensions before the invasion of Ukraine this year, today it gives the misleading impression that Russian geopolitical risk is low. In reality the risk level remains high due to the lack of strategic stability between Russia and the West, particularly the United States, and particularly over the question of NATO enlargement. Our “Old” Russia GeoRisk Indicator remains elevated but has slightly fallen back. This measure failed to detect the rise in risk ahead of this year’s invasion of Ukraine. We predicted the war based on non-market variables, including qualitative analysis. As a result of the failure of our indicator, we devised a “New” Russia GeoRisk Indicator after this year’s invasion, shown as the green line below. This measure provides the most accurate reading. It is pushing the upper limits, which we truncated at 4, as it did during the invasion of Georgia in 2008 and initial invasion of Ukraine in 2014. Related Report Geopolitical StrategyThird Quarter Geopolitical Outlook: Thunder And Lightning Has Russian geopolitical risk peaked for Europe and the rest of the world? Not until a new strategic equilibrium is established between the US and Russia. That will require a ceasefire in Ukraine and a US-Russia understanding about the role of Finland and Sweden within NATO. However, Hungary is signaling that the EU should impose no further sanctions on Russia. Russia’s cutoff of natural gas exports to Europe will create economic hardship that will start driving change in European governments or policies. A full ban on Russian natural gas may not be implemented in the coming years due to lack of EU unanimity. Still, the EU cannot lift sanctions on Russia because that would enable economic recovery and hence military rehabilitation, which could enable new aggression. Also, Russia will not relinquish the territories it has taken from Ukraine even if President Putin exits the scene. No Russian leader will have the political capital to do that given the sacrifices that Russia has made. Bottom Line: Russia’s management of the ruble is distorting some of our risk indicators. Russia remains un-investable for western investors. Substantial sanction relief will not come until late in the decade, if at all. UK GeoRisk Indicator British political risk is rising, and it may surpass the peaks of the Brexit referendum period in 2016 now that Scotland is pursuing another independence referendum (Chart 2). Chart 2United Kingdom: GeoRisk Indicator New elections are not due until January 25, 2025 and the ruling Conservative Party has every reason to avoid an election over the whole period so that inflation can come down and the economy can recover. But an early election is possible between now and 2025. Prime Minister Boris Johnson has become a liability to his party but he is still a more compelling leader than the alternatives. If Johnson is replaced, then the change of leadership will only temporarily boost the Tories’ public approval. It will ultimately compound the party’s difficulties by dividing the party without resolving the Scottish question. Regardless, the Tories face stiff headwinds in the coming referendum debate and election, having been in power since 2010 and having suffered a series of major shocks (Brexit, the pandemic, inflation). Bottom Line: The US dollar is not yet peaking against pound sterling, As from a global geopolitical perspective it can go further. Investors should stay cautious about the pound in the short term. But they should prefer the pound to eastern European currencies exposed to Russian instability. Germany GeoRisk Indicator German political risk spiked around the time of the 2021 election and has since subsided, including over the course of the Ukraine war (Chart 3). However, risk will rise again now that Germany has declared that it is under “economic attack” from Russia, which is cutting natural gas in retaliation to Germany’s oil embargo. Chart 3Germany: GeoRisk Indicator This spike in strategic tensions should not be underrated. Germany is entering a new paradigm in which Russian aggression has caused a break with the past policy of Ostpolitik, or economic engagement. Germany will have to devote huge new resources to energy security and national defense and will have to guard against Russia for the foreseeable future. Domestic political risk will also rise as the economy weakens and industrial activity is rationed. Germany does not face a general election until October 26, 2025. Early elections are rare but cannot be ruled out over the next few years. The ruling coalition does not have a solid foundation. It only has a 57% majority in the Bundestag and consists of an ideological mix of parties (a “traffic light” coalition of Social Democrats, Greens, and Free Democrats). Still, Germany’s confrontation with Russia will keep the coalition in power for now. Bottom Line: From a geopolitical point of view, there is not yet a basis for the dollar to peak and roll over against the euro. That is not likely until there is a ceasefire in Ukraine and/or a new NATO-Russia understanding. France GeoRisk Indicator French political risks are lingering at fairly high levels in the wake of the general election and will only partially normalize given the likelihood of European recession and continued tensions around Russia (Chart 4). Chart 4France: GeoRisk Indicator President Emmanuel Macron was re-elected, as expected, but his Renaissance party (previously En Marche) lost its majority and Macron will struggle to win over 39 deputies to gain a majority of 289 seats in the Assembly. He will, however, be able to draw from an overall right-wing ideological majority – especially the Republicans – when it comes to legislative compromises. The election produced some surprises. The right-wing, anti-establishment National Rally of Marine Le Pen, which usually performs poorly in legislative elections, won 89 seats. The left-wing alliance (NUPES) underperformed opinion polls and has not formed a unified bloc within the Assembly. Still, the left will be a powerful force as it will command 151 seats (the sum of the left-wing anti-establishment leader Jean-Luc Mélenchon’s La France Insoumise party and the Communists, Socialists, and Greens). Macron’s key reform – raising the average retirement age from 62 to 65 – will require an ad hoc majority in the Assembly. The Republicans, with 74 seats, can provide the necessary votes. But some members have already refused to side with Macron on this issue. Macron will most likely get support from the populist National Rally on immigration, including measures to make it harder to be naturalized or obtain long-term residence permits, and measures making it easier to expel migrants whose asylum applications have been refused. France will remain hawkish on immigration, but Macron will be able to rein in the populists. On energy and the environment, Macron may be able to cooperate with the Left on climate measures, but ultimately any cooperation will be constrained by the fact that Mélenchon opposes nuclear power. The Republicans and the National Rally will support Macron’s bid to shore up France’s nuclear energy sector. Popular opinion will hold up for France’s energy security in the face of Russian weaponization of natural gas. Macron and Mélenchon will clash on domestic security. Police violence has emerged as a major source of controversy since the Yellow Vest protests. Macron and the Right will protect the police establishment while the Left will favor reforms, notably the concept of “proximity police,” which would entail police officers patrolling in a small area to create stronger, more personal links between the police and the population; officers being under the control of the mayor and prefect; and ultimately most officers not carrying lethal weapons, and the ban of physically dangerous arrest techniques. Grievances over the police as well as racial inequality will likely erupt into significant social unrest in the coming years. As a second-term president without a single-party majority, Macron will increasingly focus on foreign policy. He will aim to become the premier European leader on the world stage. He will seek to revive France’s historic role as a leading diplomatic power and arbiter of Europe. He will strengthen France’s position in the EU and NATO, keep selling arms to the Middle East, and maintain a French military presence in the Sahel. Macron will favor Ukraine’s membership in the EU but also a ceasefire with Russia. He will face a difficult decision on whether to join Israeli and American military action against Iran should the latter reach nuclear breakout capacity and pursue weaponization. Bottom Line: The outperformance of French equities is stretched relative to EMU counterparts. But France will not underperform until the EU’s natural gas crisis begins to subside and a new equilibrium is established with Russia. Italy GeoRisk Indicator Italy is perhaps the weakest link in Europe both economically and strategically (Chart 5). Elections are due by June 2023 but could come earlier as the ruling coalition is showing strains. A change of government would likely compromise the EU’s attempt to maintain a unified front against Russia over the war in Ukraine. Chart 5Italy: GeoRisk Indicator Before the war Italy received 40% of its natural gas from Russia and maintained pragmatic relations with the Putin administration. Now Russia is reducing flows to Italy by 50%, forcing the country into an energy crisis at a time when expected GDP growth had already been downgraded to 2.3% this year and 1.7% in 2023. Meanwhile Italian sovereign bond spreads over German bunds have risen by 64 basis points YTD as a result of the global inflation. The national unity coalition under Prime Minister Mario Draghi came together for two purposes. First, to distribute the EU’s pandemic recovery funds across the country, which amounted to 191.5 billion euros in grants and cheap loans for Italy, 27% of the EU’s total recovery fund and 12% of Italy’s GDP. Second, to elect an establishment politician in the Italian presidency to constrain future populist governments (i.e. re-electing President Sergio Mattarella). Now about 13% of the recovery funds have been distributed in 2021, the economy is slowing, Russia is cutting off energy, and elections are looming. The coalition is no longer stable. Coalition members will jockey for better positioning and pursue their separate interests. The anti-establishment Five Star Movement has already split, with leader Luigi di Maio walking out. Five Star’s popular support has fallen to 12%. The most popular party in the country is now the right-wing, anti-establishment Brothers of Italy, who receive 23% support in polling. Matteo Salvini, leader of the League, another right-wing populist party, has seen its public support fall to 15% and will be looking for opportunities. On the whole, far-right parties command 38% of popular voting intentions, while far-left parties command 17% and centrist parties command 39%. Italy’s elections will favor anti-incumbent parties, especially if the country falls into recession. These parties will be more pragmatic toward Russia and less inclined to expand the EU’s stringent sanctions regime. Implementing a ban on Russian natural gas by 2027 will become more difficult if Italy switches. Italy will be more inclined to push for a ceasefire. A substantial move toward ceasefire will improve investor sentiment, although, again, a durable new strategic equilibrium cannot be established until the US and Russia come to an understanding regarding Finland, Sweden, and NATO enlargement. Bottom Line: Investors should steer clear of Italian government debt and equities until after the next election. Spain GeoRisk Indicator Infighting and power struggles within the People’s Party (PP) have provided temporary relief for the ruling Socialist Worker’s Party (PSOE) and Spanish Prime Minister Pedro Sanchez. However, with Alberto Nunez Feijoo elected as the new leader of PP on April 2, the People’s Party quickly recovered from its setback. It not only retook the first place in the general election polling, but also scored a landslide victory in the Andalusia regional election. Andalusia is the most populous autonomous community in Spain, contributing 17% of the seats in the lower house. The Andalusian regional election was a test run for the parties before next year’s general election. Historically, Andalusia was PSOE’s biggest stronghold, but it was ousted by the center-right People’s Party-Citizens coalition in 2018. Since then, the People’s party has consolidated their presence and popularity in Andalusia. The snap election in June, weeks after Feijoo was elected as the new national party leader, expanded PP’s seats in the regional parliament. It now has an absolute majority in the regional parliament while the Socialists suffered its worst defeat. With the sweeping victory in Andalusia, the People’s Party is well positioned for next year’s general election. In addition, the ruling Socialist Worker’s Party continues to suffer from the stagflationary economic condition. In May, Spain recorded the second highest inflation figure in more than 30 years, slightly below its March number. Furthermore, the recent deadly Melilla incident which resulted in dozens of migrants’ death, also caused some minor setbacks within Sanchez’s ruling coalition. His far-left coalition partner joined the opposition parties in condemning Sanchez for being complacent toward the Moroccan police. The pressure is on the Socialists now, and political risk will rise in the coming months, till after the election (Chart 6). Chart 6Spain: GeoRisk Indicator Bottom Line: Domestic political risk will remain elevated in this polarized country, as elections are due by December 2023 and could come sooner. Populism may return if Europe suffers a recession. Russia aims to inflict a recession on the EU which is negative for cyclical markets like Spain, but Spain benefits from Europe’s turn to liquefied natural gas and has little to fear from Russia. Investors should favor Spanish stocks relative to Italian stocks. Turkey GeoRisk Indicator Turkey faces extreme political and economic instability between now and the general election due by June 2023 (Chart 7). Chart 7Turkey: GeoRisk Indicator Almost any country would see the incumbent ruling party thrown from power under Turkey’s conditions. The ruling Justice and Development Party has been in charge since 2002, the country’s economy has suffered over that period, and today inflation is running at 73% while unemployment stands at 11%. However, President Recep Tayyip Erdoğan is doing everything he can with his recently expanded presidential powers to stay in office. He is making amends with the Gulf Arab states and seeking their economic support. He is also warming relations with Israel, as Turkey seeks to diversify away from Russian gas and Israel/Egypt are potential suppliers. He is doubling down on military distractions across the Middle East and North Africa. And he waged a high-stakes negotiation with the West over Finnish and Swedish accession to NATO. Russian aggression poses a threat to Turkish national interests. Turkey ultimately agreed to Finnish and Swedish membership after a show of Erdoğan strong hands in negotiating with the West over their membership, to show his domestic audience that he is one of the big boys ahead of the election. A risk to this view is that Erdoğan stages military operations against Greek-controlled Cyprus. This would initiate a crisis within NATO and put Finnish and Swedish accession on hold for a longer period. Bottom Line: Investors should not attempt to bottom-feed Turkish lira or stocks and should sell any rallies ahead of the election. A decisive election that removes Erdoğan from power is the best case for Turkish assets, while a decisive Erdoğan victory is second best. Worse scenarios include indecisive outcomes, a contested or stolen election, a constitutional breakdown, or a military coup. China GeoRisk Indicator China’s geopolitical risk is falling and relative equity performance is picking up now that the government has begun easing monetary, fiscal, and regulatory policy to try to secure the economic recovery (Chart 8). Chart 8China: GeoRisk Indicator Easing regulation on Big Tech has spurred a rebound in heavily sold Chinese tech shares, while the Politburo will likely signal a pro-growth turn in policy at its July economic meeting. The worst news of the country’s draconian “Covid Zero” policy is largely priced, while positive news regarding domestic vaccines, vaccine imports, or anti-viral drugs could surprise the market. However, none of these policy signals are reliable until Xi Jinping consolidates power at the twentieth national party congress sometime between September and November (likely October). Chinese stimulus could fail to pick up as much as the market hopes and policy signals could reverse or could continue to contradict themselves. After the party congress, we expect the Xi administration to intensify its efforts to stabilize the economy. The economic work conference in December will release a pro-growth communique. The March legislative session will provide more government support for the economy if needed. However, short-term measures to stabilize growth should not be mistaken for a major reacceleration, as China will continue to struggle with debt-deflation as households and corporations deleverage and the economic model transitions to a post-manufacturing model. Bottom Line: A Santa Claus rally in the fourth quarter, and/or a 2023 rally, is likely, both for offshore and onshore equities. But long-term investors, especially westerners, should steer clear of Chinese assets. China’s reversion to autocracy and confrontation with the United States will ultimately result in tariffs and sanctions and geopolitical crises and will keep risk premiums high. Taiwan GeoRisk Indicator Taiwan’s geopolitical risk has spiked as expected due to confrontation with China. Tensions will remain high through the Taiwanese midterm election on November 26, the Chinese party congress, and the US midterm (Chart 9). But China is not ready to stage a full-scale military conflict over Taiwan yet – that risk will grow over in the later 2020s and 2030s, depending on whether the US and China provide each other with adequate security assurances. Chart 9Taiwan: GeoRisk Indicator Still, Taiwan is the epicenter of global geopolitical risk. China insists that it will be unified with the mainland eventually, by force if not persuasion. China’s potential growth is weakening so it is losing the ability to absorb Taiwan through economic attraction over time. Meanwhile the Taiwanese people do not want to be absorbed – they have developed their own identity and prefer the status quo (or independence) over unification. Taiwan does not have a mutual defense treaty with the United States and yet the US and Taiwan are trying to strengthen their economic and military bonds. This situation is both threatening to China and yet not threatening enough to force China to forswear the military option. At some point China could believe it must assert control over Taiwan before the US increases its military commitment. Meanwhile China, the US, Japan, South Korea, and Europe are all adopting policies to promote semiconductor manufacturing at home, and/or outside Taiwan, so that their industries are not over-reliant on Taiwan. That means Taiwan will lose its comparative advantage over time. Bottom Line: Structurally remain underweight Taiwanese equities. Korea GeoRisk Indicator The newly elected President Yoon reaffirmed the strong military tie between Korea and the US, when he hosted President Biden in Seoul in May. Both Presidents expressed interests in expanding cooperation into new areas like semiconductors, economic security, and stability in the Indo-Pacific region. The new administration is also finding ways to improve relations with Japan, which soured in the past few years over the issue of forced labor during the Japanese occupation of Korea. A way forward is yet to be found, but a new public-private council will be launched on July 4 to seek potential solutions before the supreme court ruling in August which could further damage bilateral ties. President Yoon’s various statements throughout the NATO summit in Madrid on wanting a better relationship with Japan and to resolve historical issues showed this administration’s willingness towards a warming of the relations between the two countries, a departure from the previous administration. On the sideline of the NATO summit, Yoon also engaged with European leaders, dealing Korean defense products, semiconductors, and nuclear technologies, with a receptive European audience eager to bolster their defense, secure supply chain, and diversify energy source. North Korea ramped up its missile tests this year as it tends to do during periods of political transitions in South Korea. It is also rumored to be preparing for another nuclear test. Provocations will continue as the North is responding to the hawkish orientation of the Yoon administration. Investors should expect a rise in geopolitical risk in the peninsular, but on a relative basis, due to its strong alliance network, Korean risk will be lower compared to Taiwan (Chart 10). Korea will benefit from a rebound in China in the near term, but in the long-term, it is a secure source of semiconductors and high-tech exports, as Greater China will be mired in long-term geopolitical instability. Chart 10Korea: GeoRisk Indicator Bottom Line: Overweight South Korean equities relative to emerging markets as a play on Chinese stimulus. Overweight Korea versus Taiwan. Australia GeoRisk Indicator Australia’s Labor Party ultimately obtained a one-seat majority in the House of Representatives following the general election in May (77 seats where 76 are needed). It does not have a majority in the Senate, where it falls 13 seats short of the 39 it needs. It will rely on the Green Party (12 seats) and a few stragglers to piece together ad hoc coalitions to pass legislation. Hence Prime Minister Anthony Albanese’s domestic agenda will be heavily constrained. Pragmatic policies to boost the economy are likely but major tax hikes and energy sector overhauls are unlikely (Chart 11). Chart 11Australia: GeoRisk Indicator Fortunately for Albanese, his government is taking power in the wake of the pandemic, inflation, and Chinese slowdown, so that there is a prospect for the macroeconomic context to improve over his term in office. This could give him a tailwind. But for now he is limited. Like President Biden in the US, Albanese can attempt to reduce tensions with China after Xi Jinping consolidates power. But also like Biden, he will not have a basis for broad and durable re-engagement, since China’s regional ambitions threaten Australian national security over the long run. Global commodity supply constraints give Australia leverage over China. Bottom Line: Stay neutral on Australian currency and equities until global and Chinese growth stabilize. Brazil GeoRisk Indicator It would take a bolt of lightning to prevent former President Lula da Silva from winning re-election in Brazil’s October 2 first round election. Lula is more in line with the median voter than sitting President Jair Bolsonaro. Bolsonaro’s term has been marred with external shocks, following on a decade of recession and malaise. Polls may tighten ahead of the election but Lula is heavily favored. While ideologically to the left, Lula is a known quantity to global investors (Chart 12). However, Bolsonaro may attempt to cling to power, straining the constitutional system and various institutions. A military coup is unlikely but incidents of insubordination cannot be ruled out. Once Lula is inaugurated, a market riot may be necessary to discipline his new administration and ensure that his policies do not stray too far into left-wing populism. Chart 12Brazil: GeoRisk Indicator Brazil’s macroeconomic context is less favorable than it was when Lula first ruled. During the 2000s he rode the wave of Chinese industrialization and a global commodity boom. Today China is slipping into a balance sheet recession and the next wave of industrialization has not yet taken off. Brazil’s public debt dynamics discourage a structural overweight on Brazil within emerging markets. At least Brazil is geopolitically secure – far separated from the conflicts marring Russia, East Europe, China, and East Asia. It also has a decade of bad news behind it that is already priced. Bottom Line: Stay neutral Brazilian assets until global and Chinese growth stabilize and the crisis-prone election season is over. South Africa GeoRisk Indicator South Africa’s economy continues to face major headwinds amid persistent structural issues that have yet to be adequately addressed and resolved by policy makers. The latest bout of severe energy supply cuts by the state-run energy producer, Eskom, serve as a reminder to investors that South Africa’s economy is still dealing with a major issue of generating an uninterrupted supply of electricity. Each day that electricity supply is cut to businesses and households, the local economy stalls. Among other macroeconomic issues such as high unemployment and rising inflation, low-income households which are too the median voter, are facing increasing hardships. The political backdrop is geared toward further increases in political risk going forward (Chart 13). Chart 13South Africa: GeoRisk Indicator Fiscal reform and austerity are underway but won’t last long enough to make a material difference in government finances. The 2024 election is not that far out and the ruling political party, the ANC, will look to quell growing economic pressures to shore up voter support and reinforce its voter base. Fiscal austerity will unwind. Meanwhile, the bull market in global metal prices stands to moderate on weakening global growth, which reduces a tailwind for the rand, South African equities relative to other emerging markets, and government coffers, reducing our reasons for slight optimism on South Africa until global growth stabilizes. Bottom Line: Shift to a neutral stance on South Africa until global and Chinese growth stabilize. Canada GeoRisk Indicator Canadian political risk has spiked since the pandemic (Chart 14). Populist politics can grow over time in Canada, especially if the property sector goes bust. However, the country is geopolitically secure and benefits from proximity to the US economy. Chart 14Canada: GeoRisk Indicator Global commodity supply constraints create opportunities for Canada as governments around the world pursue fiscal programs directed at energy security, national defense, and supply chain resilience. Bottom Line: Stay neutral Canadian currency and equities. While Canada benefits from the high oil price and robust US economy, rising interest rates pose a threat to its high-debt model, while US growth faces disappointments due to Europe’s and China’s troubles. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Yushu Ma Research Analyst yushu.ma@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com Guy Russell Senior Analyst GuyR@bcaresearch.com Alice Brocheux Research Associate alice.brocheux@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Section III: Geopolitical Calendar
In this <i>Strategy Outlook</i>, we present the major investment themes and views we see playing out for the rest of the year and beyond.
Executive Summary Accelerating wages will make core consumer inflation sticky in the US. In addition, inflation is a lagging variable and is still well above the Fed’s target. These dynamics imply that the Fed will not make a dovish pivot imminently. Following the re-normalization of economic activity after reopening, China’s recovery will be U-shaped, rather than V-shaped. Global manufacturing and exports are heading into contraction. Contracting global trade is bullish for the trade-weighted US dollar given that it is a counter-cyclical currency. A hawkish Fed is also positive for the greenback. Hence, the US dollar will likely overshoot. EM equities are unlikely to rally/outperform on a sustainable basis until an EM profit contraction is priced in and the US dollar starts depreciating. Asian Currencies Will Depreciate Bottom Line: Absolute return investors should stay defensive for now. The global equity selloff has entered its final capitulation phase. Feature Global equity and fixed-income portfolios should maintain an underweight allocation to EM. That said, we will likely be upgrading EM versus DM later this year. EM currencies have more downside. Global and EM risk assets will likely continue selling off. Our major macro themes remain intact. Accelerating wages will make core consumer inflation sticky in the US. In addition, inflation is a lagging variable and is still well above the Fed’s target. These dynamics imply that the Fed will not make a dovish pivot imminently. Meanwhile, global growth is slowing rapidly, and global trade volumes are on the verge of contracting. US and EU demand for consumer goods (ex autos) is set to shrink. EM ex-China domestic demand will be weakening from already very low levels. Following the re-normalization of Chinese economic activity after the reopening, China’s recovery will be U-shaped, rather than V-shaped. Overall, global profits − including US and EM –will contract. Our bias is that equity markets have not fully discounted a profit contraction. The combination of shrinking corporate profits and a hawkish Fed that is focused on taming inflationary pressures is bearish for global stocks and risk assets. As long as the Fed maintains its hawkish bias and/or global trade contracts, the US trade-weighted dollar will continue to appreciate. The USD will likely overshoot in the near term. Contracting global trade is bullish for the counter-cyclical greenback. EM currencies will therefore continue to depreciate, weighing on EM bonds and stocks. Typically, EM stocks do not out outperform DM ones when the dollar is strengthening. Even though global risk assets have already sold off significantly and there is a temptation to buy, odds are high that there will be another downleg. Several markets are already breaking down below their technical support lines: The Nasdaq 100 index is slipping below its 3-year moving average which proved to be a major support in past selloffs (Chart 1, top panel). The average exchange rate of AUD, NZD and CAD (which are all cyclical commodity currencies) versus the US dollar has fallen below its 3-year moving average (Chart 1, bottom panel). In the commodity space, we have similar breakdowns. Share prices of gold mining companies, silver prices and the silver-to-gold price ratio have all clearly crossed below their 3-year moving averages (Chart 2). Chart 1Breakdowns in The Nasdaq 100 And Commodity Currencies Chart 2Precious Metal Prices Are Breaking Down Too Emerging Asian financial markets underscore that growth is relapsing and demand for raw materials is weak. The top panel of Chart 3 illustrates that Korean materials stocks have broken below their 3-year moving average. Further, in China, rebar steel, rubber, cement and plate glass prices are all falling (Chart 3, middle and bottom panels). Chart 3Bearish Signals For Raw Materials From Asia The charts below provide more evidence, supporting our macro themes and investment strategy. Investment Conclusions Absolute return investors should stay defensive for now. The global equity selloff has entered its final capitulation phase. Global equity and fixed-income portfolios should continue underweighting EM. That said, we will likely be upgrading EM versus DM later this year. The US dollar has more upside. EM/Asian FX and commodity currencies are vulnerable. We also continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN, PHP and IDR; as well as HUF vs. CZK, and KRW vs. JPY. A buying opportunity in global and EM risk assets will emerge once US Treasury yields roll over decisively, the US dollar begins its descent and China provides more stimulus. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com The US Equity Bear Market: How Advanced Is It? If this US equity selloff is part of an ongoing bull market that began in 2009, then the drop in share prices is probably over. However, if this same bull market has reached its end, then this selloff has further room to go. Our best guess is that it is the latter, i.e., we might be witnessing the end of the S&P 500 bull market that commenced in 2009. Our S&P 500 Capitulation Indicator is low, but it can drop further. Also, the S&P 500 will likely break below its 3-year moving average, which acted as a support in the 2011, 2015-16 and 2018 selloffs. Chart 4The US Equity Bear Market: How Advanced Is It? US Corporate Credit And Share Prices The US corporate credit market does not yet point to a durable bottom in US share prices. Rising corporate HY ex-energy bond yields, and the underperformance of HY ex-energy corporate credit versus IG credit, point to lower share prices for now. Chart 5US Corporate Credit And Share Prices Chart 6US Corporate Credit And Share Prices The US Inflation Genie Is Out Of The Bottle US labor demand is outstripping labor supply by a record margin since 1950. US wages have accelerated and will remain sticky in the coming months. High wage growth and weaker output entail rising unit labor costs. The latter is a key driver of core inflation. Unless the unemployment rate rises, US core inflation will not drop below 3.5-4%. In fact, median and trimmed-mean CPI have continued rising even though core CPI has rolled over. Chart 7The US Inflation Genie Is Out Of The Bottle Chart 8The US Inflation Genie Is Out Of The Bottle Chart 9The US Inflation Genie Is Out Of The Bottle Chart 10The US Inflation Genie Is Out Of The Bottle US Manufacturing Is Downshifting Rapidly Railroad carload is declining, and new orders from the US regional Feds’ manufacturing surveys are in free fall. The ISM new orders index will drop below the critical 50 line. Chart 11US Manufacturing Is Downshifting Rapidly Chart 12US Manufacturing Is Downshifting Rapidly Chart 13US Manufacturing Is Downshifting Rapidly The US Is Entering A Major Growth Slump US household demand for consumer goods ex-autos will shrink. The basis is excessive goods purchases in the last two years, falling household disposable income in real terms and a shift in preference for services versus goods. US retail inventories of consumer goods ex-autos have surged. Retailers will substantially cut back on their orders. Asian/Chinese exports are set to shrink. US consumption of gasoline is also contracting. Chart 14The US Is Entering A Major Growth Slump Chart 15The US Is Entering A Major Growth SlumpChart 16The US Is Entering A Major Growth Slump Global Manufacturing And Exports Are Heading Into Contraction The relative performance of global cyclical stocks versus defensives points to a major relapse in global manufacturing. Chinese import volumes have been contracting and EM import volumes will drop too with the deteriorating purchasing power of households across many developing economies. Chart 17Global Manufacturing And Exports Are Heading Into Contraction Chart 18Global Manufacturing And Exports Are Heading Into Contraction Chart 19Global Manufacturing And Exports Are Heading Into Contraction Contracting Asian Exports Are Negative For Asian Currencies There are already signs of contraction in Asian manufacturing/exports. Downshifting global trade typically leads to Asian currency depreciation. Chart 20Contracting Asian Exports Are Negative For Asian Currencies Chart 21Contracting Asian Exports Are Negative For Asian Currencies Chart 22Contracting Asian Exports Are Negative For Asian Currencies Chart 23Contracting Asian Exports Are Negative For Asian Currencies The USD Has More Upside, EM FX More Downside The EM ex-China currency total return index has failed to break above its technical resistance line. This entails a major downside. The underperformance of global cyclicals versus defensives points to lower Asian currencies. The US dollar (shown inverted on Chart 24) will be supported by a deceleration in global US dollar liquidity. Chart 24The USD Has More Upside, EM FX More Downside Chart 25The USD Has More Upside, EM FX More Downside Chart 26The USD Has More Upside, EM FX More Downside EM Equity Capitulation Our EM Equity Capitulation Indicator has dropped significantly but is still above its 2008, 2015-16 and 2020 lows. Given the global and EM macro backdrops, odds point to an undershoot in EM share prices. Chart 27EM Equity Capitulation EM Equity And Bond Sentiment Investor sentiment on EM stocks and EM USD bonds is downbeat. This is positive from a contrarian perspective. However, as global risk assets continue selling off and the US dollar overshoots, EM stocks and bonds might undershoot. Chart 28EM Equity And Bond Sentiment Chart 29EM Equity And Bond Sentiment EM Equity Valuations And Profits Based on our cyclically adjusted P/E ratio, EM equity valuations have improved to one standard deviation below the mean. Relative to the S&P 500, EM stock valuations are at their record low based on a similar measure. Nevertheless, EM equities are unlikely to rally/outperform on a sustainable basis until an EM profit contraction is priced in and the US dollar starts depreciating. Chart 30EM Equity Valuations And Profits Chart 31EM Equity Valuations And Profits Chart 32EM Equity Valuations And Profits Chart 33EM Equity Valuations And Profits Four Large-Cap EM Stocks The four largest EM stocks (by market value) might not be out of the woods. Alibaba is facing resistance at its 200-day moving average. Tencent, TSMC and Samsung will likely drop to their next technical support lines. Chart 34Four Large-Cap EM Stocks Chart 35Four Large-Cap EM Stocks Chart 36Four Large-Cap EM Stocks Chart 37Four Large-Cap EM Stocks Chinese And EM ex-China Stocks The rally in the Chinese onshore CSI 300 stock index will probably dwindle at its 200-day moving average. Technical supports have held up for Chinese investable TMT and non-TMT stocks. However, the recent rebound is unlikely to be sustained if the global selloff continues. Finally, EM ex-China stocks have been in a free fall. Chart 38Chinese And EM ex-China Stocks Chart 39Chinese And EM ex-China Stocks Chart 40Chinese And EM ex-China Stocks Chart 41Chinese And EM ex-China Stocks Global Cross-Asset Interlinkages Rising US TIPS yields will keep upward pressure on EM local bond yields and downward pressure on EM currencies. The mainstream EM ex-China currencies are not cheap. Without EM currencies rallying, it will be difficult for EM stocks to outperform DM ones. Chart 42Global Cross-Asset Interlinkages Chart 43Global Cross-Asset Interlinkages Chart 44Global Cross-Asset Interlinkages A Structural Breakdown In Chinese Real Estate The Chinese real estate market is experiencing a structural breakdown, as is illustrated by the collapse in share prices of Chinese property developers and their corporate bond prices. The breakdown in property developers’ financing heralds lower construction volumes with negative implications for raw material prices. Chart 45A Structural Breakdown In Chinese Real Estate Chart 46A Structural Breakdown In Chinese Real Estate Chart 47A Structural Breakdown In Chinese Real Estate Chart 48A Structural Breakdown In Chinese Real Estate Chinese Domestic Demand Has Been Absent Over The Past 12 Months Chinese imports of various commodities and goods have been contracting over the past 12 months. The resilience of commodity prices has not been due to China. As investors start pricing in the US economic downturn and the need for inflation protection wanes, commodity prices could gap down. Chart 49Chinese Domestic Demand Has Been Absent Over The Past 12 Months Chart 50Chinese Domestic Demand Has Been Absent Over The Past 12 Months Will The Pendulum Swing From Inflation To Deflation? The US equity and bond market selloffs of the past 12 months have wiped out about $12 trillion and $3.5 trillion of their respective market value, respectively. This adds up to a combined $15 trillion or about 60% of US GDP, which already exceeds the wipeouts that occurred during the March 2020 crash and all other bear markets. Such wealth destruction and a hawkish Fed could swing the pendulum from inflation to deflation. Commodity prices are currently vulnerable. Stay tuned. Chart 51Will The Pendulum Swing From Inflation To Deflation? Chart 52Will The Pendulum Swing From Inflation To Deflation? Chart 53Will The Pendulum Swing From Inflation To Deflation? Footnotes Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)
Executive Summary Long-Term Contracts Needed To Increase LNG Supply The EU will have to reverse course and execute long-term contracts with natural gas producers, LNG shippers and pipeline operators to incentivize production of supplies needed to contain energy prices. Long-term contracting will offer the EU an opportunity to address political and economic fragmentation risks via joint taxation policies. This would transform state-level risks via-a-vis energy and military security into joint-and-several obligations. The G7’s plan to cap Russian oil prices will be DOA. The most oil import-dependent EM economies – China and India – will find deeply discounted crude irresistible. Hydrocarbon producers and refiners will increase investments in carbon-capture and storage technology, to maintain their new-found advantage as secure energy sources. Additional subsidies and funding for this technology will be forthcoming. Bottom Line: The hard realities of military conflict and a lack of investment in production and refining will force governments to incentivize substantial investments in hydrocarbons – particularly natural gas and LNG infrastructure – to address global energy scarcity during a time of war. We remain long oil and gas exposures via the COMT ETF, and long equity refining and services exposures via the CRAK and IEZ ETFs. We will re-establish our producer-oriented XOP ETF position if prompt Brent futures trade down to $105/bbl in the front month. We also remain tactically long Brent and eurozone natgas futures and options. Feature The G7 last opined on liquified natural gas (LNG) supply in May, and as was the case this week, it left even casual observers uncertain as to what it is seeking to achieve: It advocated for a halt to further investments in fossil-fuel projects and, at the same time, called for higher LNG supplies to be provided for the EU states.1 The EU faces daunting energy security and supply constraints.2 A deepening energy scarcity will, we expect, push the EU into recession later this year, as natural-gas rationing is invoked to ensure there are sufficient supplies to meet human needs this winter. Natgas scarcity will force the EU to reverse course on its renewable-energy transition in the medium term and prioritize fossil-fuel investments, in our view. Long-term contracting with LNG suppliers will be required to incentivize needed investment in production and transportation to replace Russian gas imports. Such contracting is a necessity for hydrocarbon producers, given governments’ continued calls for no additional fossil-fuel investment. Quicksilver shifts in policy are a continuing source of uncertainty for investors and energy-supply firms. Over time, the EU will have to replace close to 7 Tcf/yr of Russian gas imports (Chart 1, middle panel). This will propel the EU into the ranks of the world’s largest LNG importers (Chart 2). Chart 1EU Needs To Replace ~ 7 Tcf/yr Of LNG Chart 2EU Will Become A World-Class LNG Importer Chart 3Long-Term Contracts Needed To Increase LNG Supply Given the length of contracts typically executed with LNG exporters – in excess of 20-plus years – EU governments will be compelled to allow firms and member states to sign long-term contracts for these supplies. EU governments also will be required to begin planning for and developing LNG importing infrastructure, as these supplies become available over the next 3-5 years. In the meantime, LNG prices will remain under pressure as competition heats up globally ahead of the coming winter (Chart 3). G7 Price-Cap Scheme Will Be DOA The G7’s scheme to impose a price cap on Russian oil exports will be DOA as soon as details are presented. This is because the world’s largest oil import-dependent economies – China and India – not only have long trading histories with Russia, but they also operate their own oil-transport fleets that can circumvent insurance-related obstacles imposed by the US and the UK. China and India already find discounted Russian oil irresistible, and are unlikely to acquiesce to US demands for a price cap. China imports 75% of its 15.5mm b/d of oil consumption, while India imports ~ 85% of the 5mm b/d of oil it consumes. Even if oil importers taking Russia's exports going to the EU were to sign on to a price-cap scheme, Russia could always unilaterally cut its oil and condensate production by 20-30% and force Brent prices sharply higher for remaining contract holders. This would almost surely lead to higher prices – above $140/bbl, based on our earlier estimates – and raise Russia’s net export proceeds in the process, since the G7 does not want all of Russia's oil taken off the market.3 Government Interventions Exacerbate Scarcity Governments of states with contestable elections increasingly are intervening – or attempting to do so – in global energy markets and imposing often-contradictory policies that nominally favor consumers at the expense of energy producers. This almost always is counter-productive: Price caps intended to soften the blow of higher-cost electricity and hydrocarbons discourages the necessary conservation of scarce resources. So-called windfall profits taxes discourage the investment required to address supply scarcity. Higher demand and lower supply does not lead to lower prices. Even grander schemes – e.g., the monopsony cartels floated by G7 member states like the US and EU, along with China – almost surely would reduce the profitability of developing and marketing new energy supplies, which also would exacerbate scarcity of supply by discouraging investment. These quick ad hoc fixes work at cross purposes in solving the problem of global energy scarcity. While they are in keeping with a penchant of governments to demonstrate they are addressing voters’ concerns, such policies mistake a quick response for long-term solutions. Investment Implications The EU will, in our opinion, be forced to reverse course and sign long-term LNG supply contracts to replace Russian natural gas imports. This will not derail its renewable-energy transition strategy, but it will significantly delay it. We remain long oil and gas exposures via the S&P GSCI and COMT ETF, and long equity refining and services exposures via the CRAK and IEZ ETFs. We will re-establish our producer-focused XOP ETF position if Brent trades down to $105/bbl in the front month. We also remain tactically long Brent and eurozone natgas futures and options (see p. 7 below). Housekeeping Notes We were stopped out of our long S&P GSCI position with a gain of 64%. We are getting long again at the close. We also were stopped out of our long 4Q22 $120/bbl Brent calls with a 16% return. Separately, there will be no Commodity Round-Up in this week’s publication. We are broadcasting our Commodity Round-Up today at 9 a.m. EDT. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Footnotes 1 Please see The G7 wants to dump natural gas … but not yet published by politico.com 27 May 2022. The report notes, “The G7 called for an end to international investments in fossil fuels by the end of this year and slammed private finance for continuing to back dirty energy — but left a big out for EU countries desperate to replace Russian gas. ‘We acknowledge that investment in [the liquefied natural gas] sector is necessary in response to the current crisis, in a manner consistent with our climate objectives and without creating lock-in effects,’ the ministers said.” 2 Please see One Hot Mess: EU Energy Policy, published 26 May 2022. This report delves into the EU’s post-Cold War foreign policy. For three decades, EU foreign policy largely was set by Germany, the organization's most powerful economy. Successive generations of German politicians championed the idea that the West could bring the former Soviet Union – and later Russia – into the modern world of global trade through Ostpolitik, which had, at its core, a belief in the power of trade to effect political and economic change. This policy is kaput. 3 Please see Higher Gasoline, Diesel Prices Ahead, which we published 2 June 2022. It is available at ces.bcaresearch.com. Investment Views and Themes Strategic Recommendations Tactical Trades Trades Closed in 2022
BCA Research’s China Investment Strategy service continues to recommend a neutral stance in Chinese equities within a global portfolio. China’s economic data moved up slightly in May from an extremely depressed level in April. A normalization of the supply…
Executive Summary Depressing Housing Market And Service Sector Activity May’s economic data ticked up from extremely depressed levels in April, driven by a normalization in the supply chain and a resumption in production. The service sector and housing market continued to shrink on a year-on-year (YOY) basis and sentiment among households and corporates remains lackluster. The rebound in exports growth in May will likely be unsustainable. Chinese exports are set to contract from 2021 as external demand for goods weakens. The rapidly worsening labor market dynamics reinforce households’ unwillingness to consume and hence, will hinder the recovery in household consumption. Although industrial production showed a decent rebound in May, the manufacturing production recovery might be derailed by rolling lockdowns and prolonged logistic bottlenecks. Barring major lockdowns, China’s economy will likely improve in 2H 2022 from the very low base in Q2. That said, the country’s economic recovery faces several challenges and the magnitude of the rebound will be subdued. Bottom Line: The elements for a robust and sustainable recovery in the Chinese economy are not yet in place. The recent rally in the A-share market reflects a mean-reversal to the pre-March lockdown price level, rather than the beginning of a cyclical bull market. Investors should remain cautious on Chinese equities in the next several months. Feature China’s economic data moved up slightly in May from an extremely depressed level in April. A normalization of the supply chain and a resumption of production post-lockdown in Shanghai and other cities led to a modest recovery in business activities. However, indicators from the service sector and housing market continued to shrink on a YOY basis, highlighting persistent weaknesses on the demand side. Chart 1Import Dynamics Reflect Weak Domestic Demand May’s import data also reflects sluggish domestic demand. The increase in imports value from a year ago was largely driven by the elevated prices in energy and agriculture products. China’s imports in May, in volume terms, continued to contract on a YOY basis, albeit improved from its historical low in April (Chart 1). Barring major lockdowns, China’s economy will likely improve in the second half of this year. However, the economic recovery in 2H 2022 will be very subdued due to the following challenges: Downbeat sentiment among households and enterprises; Continued real estate woes; A contraction in exports; Deteriorating labor market conditions; and Risk of rolling lockdowns and persistent logistic bottlenecks. The recent rebound in the A-share market reflects an improvement in investors’ sentiment buttressed by the easing of lockdowns and a resumption of production. In other words, the rebound in Chinese stock prices is probably a mean-reversal to pre-lockdown levels, rather than a sustainable rally (Chart 2). Our cautious view on Chinese equities is also corroborated by the divergence between falling raw industrial prices, which reflect weak China’s growth, and rising Chinese equity prices (Chart 3). Overall, we continue to recommend a neutral stance in Chinese equities within a global portfolio. Chart 2Too Early To Turn Bullish On Chinese Stocks Chart 3Falling Prices In Raw Materials Do Not Signal An Imminent Round In Demand Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Downbeat Household And Corporate Sentiment Chart 4Subdued Bank Loan Growth Has Been A Drag On Credit Expansion Although China’s credit growth improved sequentially in May after a very weak reading in April, the magnitude of May’s credit rebound is much more subdued compared with the months following the first lockdowns in early 2020 (Chart 4). In addition, May’s rebound in credit growth was mainly driven by an acceleration in local government bond issuance. The modest pickup in the credit impulse - calculated as a 12-month change in total social financing (TSF) as a percentage of nominal GDP - is much more muted when excluding local government bond issuance (Chart 5). Furthermore, as noted in our previous report, given that most of the planned local government special purpose bonds (SPBs) will be issued by the end of June, barring any increase in this year’s SPBs quota, the support from local government bond issuance to TSF growth will likely wane significantly in the second half of 2022. Meanwhile, confidence among consumers and businesses remained downbeat through May (Chart 6). The poor private-sector sentiment will continue to dampen credit demand and thus, limit the effectiveness of monetary stimulus. Chart 5The Rebound In Credit Impulse Is Much More Muted When Excluding Local Government Bond Issuance Chart 6Gloomy Sentiment Among Chinese Households And Enterprises Private-sector credit demand remains very frail. Household medium- to long-term loans are still contracting from previous month, while bank loans to corporate peers were also weak in May (Chart 7 & 8). Chart 7Depressed Household Loan Demand Chart 8Corporate Demand For Credit Remains Weak Despite Accommodative Monetary Conditions Chart 9Deterioration In Corporate Sentiment Is Also Reflected In Surveys of Business Conditions On the other hand, corporate bill financing as a portion of new bank loans, although rolled over from April’s record high, remained very elevated through May (Chart 8, bottom panel). Moreover, enterprises’ financing and investment expectations deteriorated further in May (Chart 9). Persisting Real Estate Woes The near-term outlook for China’s property market remains uninspiring. So far, easing measures in the housing sector have not been successful in reviving home sales and homebuyers’ sentiment. Residential property sales and real estate investment growth ticked up slightly in May after plummeting by 43% and 10% in April, respectively (Chart 10). However, the modest improvement in May does not mark the start of a full-fledged cyclical recovery. High-frequency data show a renewed weakening in floor space sales, particularly in tier-one and tier-two cities, during the first two weeks of June (Chart 11). Chart 10The Slight Improvement In Housing Market Indicators Does Not Signal A Cyclical Recovery Chart 11Renewed Deterioration In Home Sales In June Chart 12Real Estate Developers' Decreased Funding Will Further Dampen Housing Construction Activities Funds to real estate developers have been contracting at the fastest rate since data collection began in 1998. The lack of funding for real estate developers will further depress housing construction activities in the near term (Chart 12). Moreover, new home prices, which tend to lead housing starts, started to decrease on a YOY basis in May. This was the first price contraction since 2016. Our housing price diffusion index suggests that home price growth will continue to shrink in the next six to nine months (Chart 13). Many local cities reduced mortgage rates, by anywhere from 15 to more than 100 basis points, after the PBoC lowered mortgage rate floor and the benchmark rate (5-year LPR) in May. However, the average cost of mortgage loans remains higher than households’ income growth, making mortgage borrowing less attractive to ordinary households (Chart 14). Chart 13Housing Prices Are Set To Decline Further In 2H 2022 Chart 14Mortgage Rates Have Dropped, But Still Higher Than Income And Home Price Growth In addition, the widening gap between the average mortgage rate and the pace of housing price appreciation implies that housing has become much less appealing to residents who purchase homes as investment (Chart 14, bottom panel). In short, property purchases will remain weak given neither “to live in” nor investment demand for properties is likely to recover fast. China's Exports Are Set To Contract In 2H 2022 China’s exports rebounded in May from the April low as supply chain interruptions subsided and logistic disruptions began to ease. However, as US and European consumer spending on goods (excluding autos) declines, Chinese shipments will shrink in the months ahead. May’s improvement in suppliers’ delivery times and product inventory subindexes of China’s official Purchasing Managers’ Index (PMI) suggests that logistics were less of a drag on economic activity than in April (Chart 15). In addition, Shanghai and China’s exports freight indexes recovered significantly on a month-over-month basis (Chart 16) with the lifting of lockdown measures. Chart 15Chinese Logistics Pressures Have Eased Slightly In May... Chart 16...And Export Freight Indices Have Rebounded Chart 17Global Demand Is Dwindling Meanwhile, global demand for goods has been weakening. Korean exports volume growth, a bellwether for global trade, has been trending down since late 2021 (Chart 17). Moreover, the US and Euro Area manufacturing PMIs have been falling (Chart 17, bottom panel). Spending in developed economies is shifting from manufactured goods to services. Retail inventories in the US are well above their pre-pandemic trend, suggesting that the demand growth for Chinese goods will dwindle when US retailers start to destock their inventories (Chart 18). Falling US and Euro Area real household disposable income will also reinforce the downward trend in external demand (Chart 19). Therefore, China's exports are set to shrink in the second half of this year. Chart 18Well-Stocked Shelves In The US Bode Poorly For Chinese Export Demand Chart 19A Contraction in US and Euro Area Household Real Disposable Income Deteriorating Labor Market Conditions Will Curb Household Consumption Recovery Although improved from April’s extreme low, Chinese retail sales and service activity remained in contractionary territory in May, highlighting sluggish household demand (Chart 20). In addition, the cinema audience, which is used to gauge the impact of the pandemic on the service sector, indicates a further deterioration in the sector’s activity in June (Chart 20, bottom panel). The lackluster consumer demand is also evidenced by soft core and service consumer prices (CPI) in May (Chart 21). Chart 20Chinese Retail Sales And Service Activity Continued To Contract In May Chart 21Soft Core And Service CPIs Also Reflect Lackluster Household Demand Labor market conditions have also worsened. Although the nationwide urban survey-based unemployment rate fell moderately in May, the 31-large city surveyed unemployment rate climbed to an all-time high in the 10-year history of this survey. Moreover, employment in the service sector deteriorated to the worst level since mid-2020 (Chart 22). Furthermore, urban new job creation fell into deep shrinkage on a YOY basis, while the unemployment rate among younger workers rose to the highest point since data collection began in 2018 (Chart 23). Chart 22Labor Market Situation Is Worsening Rapidly... Chart 23...Particularly Among Younger Workers Chart 24Weak Sentiment On Future Income Contributes To Households' Unwillingness To Consume The rapidly worsening labor market dynamics and income prospects reinforce households’ downbeat sentiment (Chart 24). The latter will impede household consumption recovery in the second half of this year. Production Recovery Faces Risks Of Persistent Logistic Bottlenecks The uptick in industrial activity in May was due to a lifting of Covid-related lockdown restrictions. Although industrial production showed a decent rebound, underlying data suggest that economic fundamentals remained subdued. Chart 25Industrial Activity Improved Only Slightly In May Chart 26Construction Material Production Continues To Shrink On A YOY Basis Electricity output remained in contractionary territory through May (Chart 25). Cement and steel output continued shrinking from the same period last year (Chart 26). Moreover, their prices have been falling even though production growth has been waning, which indicates that demand in the construction sector is depressed (Chart 3, bottom panel). Consumer durable goods production also remains well below their levels from a year ago (Chart 27 & 28). Chart 27Auto And Smartphone Production Keeps Decreasing From A Year Ago... Chart 28… As Well As Production Of Home Appliances Chart 29Prolonged Logistic Bottlenecks Chinese manufacturing investment rebounded in May. However, since exports will likely shrink in the second half of this year, it will create a major headwind for manufacturing investment and output. Moreover, China’s manufacturing production will likely be challenged by persistent logistic bottlenecks in 2H 2022. Chinese road freight was still declining in the first three weeks in June from the same period last year as shown in Chart 29. The risk of renewed Covid-induced lockdowns or mobility restrictions are nontrivial since China will maintain its zero-Covid policy at least through the end of this year. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Footnotes Strategic Themes Cyclical Recommendations
Although Chinese industrial profits continued to decline in May, the magnitude of contraction narrowed slightly to 6.5% y/y from 8.5% in April. This latest release follows a series of better-than-expected economic data Although most measures are still…