China

Highlights In the wake of COVID-19, the low-probability, high-impact “Black Swan” event is as relevant as ever. Investors should already expect US terrorist incidents, a fourth Taiwan Strait crisis, and crises involving Turkey – these are no longer black swans. What if Russia had a color revolution, Japan confronted China, or Saudi Arabia collapsed? What if the US and China brokered a North Korean deal? Or a major terrorist attack caused government change in Germany? Ultimately this exercise illustrates what the market is not prepared for – a new rally in the US dollar – though some scenarios would fuel the rise of the euro and renminbi. Feature The COVID-19 pandemic reminded us all of the power of the “Black Swan” – the random, unpredictable event with massive ramifications. As historian Niall Ferguson pointed out at the BCA Conference last fall, COVID-19 was not really a black swan, as epidemiologists had predicted that a pandemic would occur and the world was not ready. Astrophysicist Martin Rees made a bet with psychologist and linguist Steven Pinker that “bioterror or bioerror will lead to one million casualties in a single event within a six month period starting no later than 31 December 2020.”1 Tellingly, countries neighboring China were the best prepared for the outbreak, having dealt with SARS and bird flu. COVID accelerated major trends building up throughout the past decade – notably the shift toward pro-active fiscal policy, which had been gaining traction in policy circles ever since the austerity debates of the early 2010s. In that sense forecasting is still necessary. If solid trends can be identified, then random shocks may simply reinforce them (Chart 1). Chart 1US Fiscal Stimulus About To Get Even Bigger In this year’s “Five Black Swans” report, we focus on geopolitical risks that are highly unlikely, not at all being discussed, and yet would have a major impact on financial markets. Domestic terrorist events in the United States in 2021 would not qualify as a black swan by this definition. A crisis in the Taiwan Strait, which we have warned about for several years, is now widely (and rightly) expected. Black Swan #1: A Color Revolution In Russia Russia is one of the losers of the US election. Not because Trump was a Russian agent – the Trump administration ended up authorizing a fairly hawkish posture toward Russia in eastern Europe – but rather because the Democratic Party threatens Russia with a strengthening of the trans-Atlantic alliance and a recovery of liberal democratic ideology. Geopolitical risk surrounding Russia is therefore elevated, as we argued last year. Both President Vladimir Putin and his government have seen their approval rating drop, a development that has often led Russia to lash out abroad (Chart 2). But our expectation of rising political risk within Russia’s sphere has been reinforced by Russia’s alleged poisoning of opposition politician Alexei Navalny and the eruption of pro-democracy protests in Belarus. Vladimir Putin is increasingly focusing on home affairs due to domestic instability worsened by the pandemic and recession. Fiscal and monetary austerity have weighed on the public. The largest protests since 2011 occurred in mid-2019 in opposition to the fixing of the Moscow municipal elections. This could be a harbinger of larger unrest around the Russian legislative elections on September 19, 2021. Nominal wage growth has collapsed and is scraping its 2015-16 lows (Chart 3). Chart 2Black Swan #1: A Color Revolution In Russia Chart 3Russia's Fiscal Austerity Meanwhile US policy toward Russia will become more confrontational. New US presidents always start with outreach to Russia, but the Democratic Party blames Russia for betraying the good faith of the Obama administration’s “diplomatic reset” from 2009-11. Russia invaded Ukraine and took Crimea in exchange for cooperating on the 2015 Iran nuclear deal. Adding in the Snowden affair, the 2016 election interference, and now the monumental SolarWinds cyberattack, the Democratic Party will want to strike back and reestablish deterrence against Russia’s asymmetrical warfare. While Biden will seek to negotiate an extension of the New START missile treaty from February 5, 2021 until 2026, he will gear up for confrontation in other areas. The US could seek to go on offense with Russia’s wonted tools: psychological warfare and cyberattacks. The Americans are not willing or able to attempt regime change in Moscow. That would be taken as an act of war among nuclear powers. But if Russia is less stable internally than it appears, then US meddling could hit a weak spot and set off a chain reaction. Even if the US is incapable of anything of the sort, Russia is still ripe for social unrest. Should the authorities mishandle it, it could metastasize. Russia has a long tradition of peasant uprisings – a descent into anarchy is not out of the question. The regime would not be devoting so much attention to suppressing domestic dissent if the conditions for it were not ripe.2 Putin’s constitutional reforms in mid-2020, which could extend his term until 2036, also speak to concerns about regime stability. A successful Russian uprising would threaten to raise serious instability in Europe and the world. When great but decadent empires are destabilized, political struggle can intensify rapidly and spill out to affect the neighbors. Bottom Line: Russian domestic political instability could produce a black swan. The ruble would tank and the US dollar would catch a bid against European currencies. Black Swan #2: A Major Terror Attack In Germany 2020 was a banner year for European solidarity. Brexit went forward but none of the European states have followed – nor would any want to follow given the political turmoil it aroused. Brussels initiated a recovery fund to combat the global pandemic that consisted of a mutual debt scheme – in what has been hailed somewhat excessively as a “Hamiltonian moment,” a move toward federalism. Germany stood at the center of this process. After opening the doors to a flood of migrants from Syria in 2015, Chancellor Angela Merkel suffered a blow to her popularity and was eventually forced to make plans for her exit. But she stuck to her core liberal policies and her fortunes have recovered (Chart 4). She is stepping down in 2021 as the longest-serving chancellor since Helmut Kohl and an influential European stateswoman. The EU member states are more integrated than ever while Germany has taken another step toward improving its international image. The public has rewarded the ruling coalition for its relatively competent handling of the global pandemic (Chart 5). Chart 4Black Swan #2: A Major Terror Attack In Germany Chart 5German People Happy With Their Government Merkel’s approval coincides with a recovery of the liberal democratic consensus in Europe after a series of challenges from anti-establishment and populist parties. Only in Italy did populists take power, and they were forced to back down from their extravagant fiscal policy demands while modifying their policy platform with regard to membership in the monetary union. Even today, as Italy’s ruling coalition comes apart at the seams, the risk of a populist backlash is lower than it was in most of the past decade. One of the main ways the European establishment neutralized the populist challenge was by tightening control over immigration and cracking down on terrorism (Charts 6 and 7). These two forces have played a large role in generating support for right wing parties, and these parties have declined in popularity as these two forces have abated. Chart 6Terrorist Attacks Have Fallen In Europe Chart 7Europeans Softening Toward Immigrants? Still, the risk posed by terrorist groups has not disappeared – and it is always possible that disaffected individuals could evade detection. French President Emmanuel Macron faced seven terrorist attacks over the past year, which partly stemmed over the commemoration of the Charlie Hebdo massacre but also points to the persistence of underground extremist networks (Chart 8).3 Chart 8French Fear Of Terrorism Has Increased Chart 9European Breakup Risk At Testing Point What would happen if a major attack occurred in Germany in 2021? Would it upset the country’s liberal consensus and fuel another surge in popular support for far-right parties like the Alternative for Germany? Only a major attack would have a lasting impact. A systemically important attack in the pivotal year of Merkel’s retirement could create more uncertainty in domestic German politics than has been seen since the 1990s and early 2000s. It is possible that an attack could strengthen the ruling coalition and the public’s desire to continue with the leadership of the Christian Democrats after Merkel. More likely, however, it would divide the conservative and right-wing parties among themselves. Merkel’s chosen successor, Defense Minister Annagret Kramp-Karrenbauer, was forced to abandon her bid for the chancellorship last year after members of her Christian Democratic Union in the state of Thuringia voted along with the anti-establishment Alternative for Germany to remove the state’s left-wing leader. The cooperation was minimal but it set off a firestorm by suggesting that Kramp-Karrenbauer was willing to work together with the far right.4 She bowed out and now the party is about to pick a new leader. The point is that if any event strengthens the far right, it would suck away votes from the Christian Democrats. The latter could also see divisions emerge with their Bavarian sister party, the Christian Social Union, which has differed on immigration in the past. Or the conservatives could alienate the median German voter by tacking too far to the right to preempt the anti-establishment vote (e.g. overreacting to the attack). Either way, German politics would be rocked. Ironically, if the coalition was seen as mishandling the response, a left-wing coalition of the Greens and the Social Democrats could be the beneficiaries. The risk of a government change – in the wake of Merkel and the pandemic – is greatly underrated, entirely aside from black swans. Nevertheless a major shock that strengthens the far right would be a black swan by forcing the question of whether the center-right is willing to cooperate with its fringe. If that occurred, then Europe would be stunned. If it did not, then the conservatives could lose the election and plunge into intra-party turmoil. The takeaway of a rightward shift on the back of any shock would be a renewed risk of fiscal hawkishness – a partial relapse from the past two years’ fiscal expansion to the more traditionally austere German posture. The takeaway of a leftward shift would be the opposite – a doubling down on that fiscal expansion. German hawkishness would increase the European breakup risk premium, while a confirmation of the new German dovishness would further suppress it (Chart 9). Bottom Line: The fiscal dovish turn is the more likely response to such a black swan in today’s climate, but a major terrorist attack could have unpredictable consequences. Black Swan #3: A US-China Deal On North Korea Critics misunderstood President Trump’s policy on North Korea. Trump’s policy – even his belligerent rhetoric – echoed that of Bill Clinton in the 1990s. The intention of the US show of force was to create an overwhelming threat that would force Pyongyang into serious negotiations toward a nuclear deal. That in turn would pave the way to economic cooperation. Trump’s efforts failed – Kim Jong Un stonewalled him in the final year and a half. Kim’s bet paid off since he avoided making major concessions and now Biden must start from scratch. Pyongyang has ramped up its threats and Kim has elevated his sister, Kim Yo Jong, to a higher standing in the party – apparently to lob attacks at South Korea full-time. Biden will put the technocrats and Korea experts in charge. Pyongyang may test nuclear weapons or launch intercontinental ballistic missiles to attract Biden’s attention. But Kim could also go straight to negotiations. Optimistically, a few years of talks could result in a phased reduction of sanctions in exchange for nuclear inspections. Kim has the incentive and the dictatorial powers to open up the economy and engage in market reforms while managing any backlash among the army. He has already prepared the ground by elevating economic policy to the level of military policy in the national program. For years he has allowed some market activity to little effect. The North must have suffered from the pandemic, as Kim publicly confessed to the failure of economic management at the latest party meeting. His country needs a vaccine for COVID. And if he intends to go the way of Vietnam, then he needs to open up the doors while a new global business cycle is beginning (Chart 10). The black swan would emerge if the Biden administration’s attempt to reboot relations with China produced a unified effort to force a resolution onto Kim. It is undeniable that Trump broke diplomatic ice by meeting with Kim directly, giving Biden the option of doing so quickly and with minimal controversy if he should so desire. Most importantly, China has enforced sanctions, if official statistics can be trusted (Chart 11). Beijing made no secret that it saw North Korea as an area of compromise to appease US anger. After all, success on the peninsula would remove the reason for the US to keep troops there. Chart 10Black Swan #3: A US-China Deal On North Korea Chart 11An Area Of US-China Cooperation Under Biden? The last point is the material point. If the North sought to open up, it would likely have to do so through talks with the US, China, South Korea, and Japan. Success would mean that US-China engagement is still effective. Bottom Line: A breakthrough on the Korean peninsula would mean that investors could begin imagining a future in which the US and China are not “destined for war” but rather capable of reviving their old cooperative approach. This has far-reaching positive implications, but most concretely the Korean won and Chinese renminbi would rally against the US dollar and Japanese yen on the historic reduction of war risk. Black Swan #4: Saudi Arabia (And Oil Prices) Collapse Saudi Arabia is an even greater loser from the US election than Russia. The Saudis came face to face with their geopolitical nightmare of US abandonment under the Obama administration, as the US gained energy independence while reaching out to Iran. The 2015 nuclear deal gave Iran a strategic boost and enabled it to resume pumping oil (Chart 12). The Saudis, like the Israelis, lobbied hard to stop the deal but failed. They threw their full support behind President Trump, who reciprocated, and now face the restoration of the Obama policy under Joe Biden. Chart 12Black Swan #4: Saudi Arabia (And Oil Prices) Collapse Chart 13Fiscal Pressure On Saudis Global investors should expect Biden to return to the nuclear deal with Iran as quickly as possible, notwithstanding Iran’s latest nuclear provocations, since the latter are designed to increase negotiating leverage. The Joint Comprehensive Plan of Action was an executive agreement that Biden could restore with the flick of his wrist, as long as Iranian President Hassan Rouhani returned to compliance. Rouhani can do so before a new president is inaugurated in August – he could secure his legacy at the cost of taking the blame for “dealing with the devil.” This would save the regime from further economic and social instability as it prepares for the all-important succession of the supreme leader in the coming years. A black swan would occur if this diplomatic situation led to a breakdown in support for Crown Prince Mohammed bin Salman (MBS). MBS, whose nickname is “reckless,” in part because his foreign policies have backfired, could attempt to derail or sabotage the US-Iran détente. If he tried and failed, the US could effectively abandon Saudi Arabia – energy self-sufficiency, public war-weariness, and Iranian détente would pave the way for the US to downgrade its commitment. This would create an existential risk for the kingdom, which depends on the US for national security. It could also be the final straw for MBS, who already faces opposition from elites who have been shoved aside and do not wish to see him ascend the throne in a few years’ time. A different trigger for the same black swan would be a collapse of the OPEC 2.0 oil cartel. The Saudis and Russians have fought two market-share wars over the past seven years. They could relapse into conflict in the face of shifting global dynamics, such as the green energy revolution, that disfavor oil. Arthur Budaghyan and Andrija Vesic, of BCA’s Emerging Markets Strategy, have argued that financial markets will start pricing in a higher probability of Saudi currency depreciation versus the US dollar in coming years. Lower-for-longer oil prices (say $40 per barrel average over next few years) would pose a dilemma to the authorities: either (1) cut fiscal spending further and tighten liquidity or (2) resort to local banks financing (money creation “out of thin air”) to sustain economic activity. The first scenario would impose severe fiscal austerity on the population (Chart 13), which is politically difficult to endure in the long run. The second scenario will lead to depleting the country’s FX reserves, robust money growth and some inflation culminating in downward pressure on the currency. The main reason for believing the devaluation will not happen is that it would topple the regime. Currency devaluation would result in unbearable inflation in a country that lacks domestic production and domestically sourced staples. But that is precisely why it is a black swan risk. After all, prolonged fiscal austerity may not be feasible either. Bottom Line: MBS controls the security forces and has consolidated power for years but that may not save him if his foreign policies led to American abandonment or a breakdown of the peg. Black Swan #5: A Sino-Japanese Crisis For the first time since 2016, we are not including US-China tensions over Taiwan in our list of black swans. A crisis in the strait is only a matter of time and the global news media is increasingly aware of it (Chart 14). It would not necessarily have to be a war or even a show of military force, though either are possible. A mere Chinese boycott or embargo of Taiwan would violate the US’s Taiwan Relations Act and trigger a US-China crisis from the get-go of the Biden administration. What is less widely recognized is that peaceful resolution of the China-Taiwan predicament is not just a concern for the United States. It is a concern for Japan and South Korea as well – whose vital supplies must travel around the island one way or another. These two nations would face constriction if mainland China reunified Taiwan by force – and therefore Beijing’s signals of increasing willingness to contemplate armed action are already reverberating among the neighbors. Japan sounded an uncharacteristically stark warning just last month. The hawkish statement from State Minister of Defense Yasuhide Nakayama is worth quoting at length: We are concerned China will expand its aggressive stance into areas other than Hong Kong. I think one of the next targets, or what everyone is worried about, is Taiwan … There’s a red line in Asia – China and Taiwan. How will Joe Biden in the White House react in any case if China crosses this red line? The United States is the leader of the democratic countries. I have a strong feeling to say: America, be strong!5 China and Japan have improved trade relations through the RCEP agreement, as Beijing looks to diversify from the United States. But China’s rise is of enormous strategic concern for Japanese policymakers. COVID-19 and the rollback of Hong Kong’s freedoms have made matters worse. The belt of sea and land around China – the “first island chain” – is the critical area from which Beijing seeks to expel American and foreign military presence. With China already having shown a willingness to clash with India and Australia simultaneously in 2020 – as it carves a sphere of influence in the absence of American pushback – it should be no surprise to see conflicts erupt in the East or South China Sea (Chart 15). Chart 14Differences In The Taiwan Strait Chart 15Black Swan #5: A Sino-Japanese Crisis In the aftermath of the last global crisis, in 2010, China and Japan clashed mightily over maritime-territorial disputes in the East China Sea. China imposed a brief embargo on exports of rare earth elements to Japan. The two clashed again the following year and tensions escalated dramatically when China rolled out an Air Defense Identification Zone (ADIZ) in 2013. Tense periods come and go and are often attended by mass anti-Japanese protests, as in 2005 and 2012. Usually these events are of passing importance, though they have the potential to escalate. What would truly be a black swan would be if Japan took the initiative to challenge China and test the Biden administration’s commitment to Japanese security. With the US internally divided and distracted, and China ascendant, Japan could grow increasingly insecure and seek to take precautions. China could see these as offensive. A new Sino-Japanese crisis could ensue that would catch investors by surprise. It is highly unlikely that Tokyo would provoke China – hence the black swan designation – but the effective absence of the Americans is a strategic liability that Tokyo may wish to resolve sooner rather than later. In this case the market reaction would be predictable – the yen would appreciate while the renminbi and Taiwanese dollar would fall. The risk-off period could be extended if the US failed to reinforce the Japanese alliance for fear of China, with the whole world watching. Bottom Line: Global investors would be blindsided if a sudden explosion of Sino-Japanese tensions prevented any US-China thaw and confirmed their worst fears about China’s economic decoupling from the West. Investment Takeaways This exercise in identifying black swans may be useful in at least one way: it exposes the vulnerability of financial markets to a sudden reversal of the US dollar’s weakening trend (Chart 16). The dollar would surge on broad Russian instability, Sino-Japanese conflict, or another exogenous geopolitical shock. This kind of dollar surprise would be much greater than a temporary counter-trend bounce, which our Foreign Exchange Strategist Chester Ntonifor fully expects. It would upset the financial community’s dollar-bearish consensus, with far-reaching ramifications for the global economy and financial markets. A rising dollar against the backdrop of a recovering global economy represents a de facto tightening of global financial conditions. Equity markets, for example, have only started to rotate away from the US and this trend would be reversed (Chart 17). Whereas further appreciation of the euro and the renminbi is not only expected but would support global reflation. Chart 16The USD Over Trump's Four Years Chart 17Global Market Cap Over Trump's Four Years There is a much plainer and straighter way to an upset of the dollar-bearish consensus. Rather than a black swan it is a “gray rhino,” the term that Michele Wucker uses for risks that are common, expected, and staring you right in the face.6 This would be the peak of China’s stimulus, which holds out the risk of a major reversal to the pro-cyclical global financial market rally in late 2021 (Chart 18). Chart 18China Impulse Will Linger In 2021, But EM Stocks Tactically Stretched It would be a colossal error if Beijing over-tightened monetary and fiscal policy in 2021 in the context of high debt, deflation, and unemployment (Chart 19). Chart 19Three Reasons China Will Avoid Over-Tightening (If It Can) Nevertheless the government’s renewed efforts to contain asset bubbles and credit excesses clearly increase the risk. Financial policy tightening is always a risky endeavor, as global policymakers routinely discover. Chart 20Book Profits But Stay Cyclically Positive On Reflation Trades We maintain that China’s major stimulus will have a lingering positive effects for the economy for most of this year and that the authorities will relax policy and regulation as needed to secure the recovery. The Central Economic Work Conference in December suggested that the Politburo still views downside economic risks as the most important. But this is a clear and present risk that will have to be monitored closely. Clearly the global reflation trend has extended to dangerous technical extremes over the past month on the realization that US fiscal stimulus will surprise to the upside. Therefore we are doing some housekeeping. We will book 31.1% profit on long cyber security, 16.7% on long US infrastructure, and 24.3% on long US materials. We will also book 9.5% gains on our long EM-ex-China equity trade, which has gone vertical (Chart 20).     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Such epidemiologists include Michael Osterholm and Lawrence Brilliant. For Pinker and Rees, see George Eaton, "Steven Pinker interview: How does a liberal optimist handle a pandemic?" The New Statesman, July 22, 2020, newstatesman.com. 2 Thomas Grove, "New Russian Security Force Will Answer To Vladimir Putin," Wall Street Journal, April 24, 2016, wsj.com. 3 Elaine Ganley, "Grisly beheading of teacher in terror attack rattles France," Associated Press, October 16, 2020, apnews.com. 4 Philip Oltermann, "German politician elected with help from far right to step down," The Guardian, February 6, 2020, theguardian.com. 5 Ju-min Park, "Japan official, calling Taiwan ‘red line,’ urges Biden to ‘be strong,’" Reuters, December 25, 2020, reuters.com. 6 See www.wucker.com.

Highlights The incidents of state-owned enterprise (SOE) bond defaults late last year reflected deteriorating corporate balance sheets and exposed local governments’ weakening fiscal positions. Both were preexisting conditions that worsened due to the pandemic. China’s policymakers have vowed to accelerate restructuring the SOE/corporate sector, but they face a dilemma between economic stability and painful reforms; the outcome will ultimately depend on policymakers’ pain thresholds. In the next 6 to 12 months, the policy tightening cycle will continue and credit growth will decelerate. Chinese stocks are already more expensive than before the start of the last policy tightening cycle. We recommend a neutral position on domestic and investable stocks for now. Feature The days of China’s unconditional bailout of state firms may be over. In the past six months, Beijing has embarked on a series of reform agendas, including restructuring and stricter regulations targeting SOEs and the broader spectrum of the corporate sector. When three SOEs defaulted on bond payments late last year, neither the central nor the local government supported those firms. Allowing market forces to allocate capital to more productive firms by driving out the less efficient companies is structurally positive for the Chinese economy.  However, the pursuit of meaningful SOE and broader corporate reforms will be a tough choice for Chinese policymakers this year while the economic recovery is underway. Ultimately, the degree and speed to reform SOEs will depend on how much near-term pain policymakers are willing to endure. We recommend a neutral position in Chinese stocks for now. We expect the financial markets to experience frequent mini-cycles in 2021 due to policy zigzags. Risks for policy miscalculations cannot be ruled out; equity prices will falter if Chinese authorities push for deeper reforms and tighter industry regulations while scaling back stimulus at the same time. Chinese stocks are already expensive and are vulnerable to authorities opting for much smaller stimulus and harsher corporate/SOE reforms. SOE Defaults: Policy Response Matters More Than Defaults Chart 1Policy Zigzags And Market Mini-Cycles A flurry of high-profile defaults by state firms late last year unnerved investors and pushed up onshore corporate bond yields. Beijing’s move to allow SOEs to fail forced investors to reprice bonds issued by state firms as much riskier propositions. Following the defaults in November, the PBoC injected unusually large interbank liquidity; the de jure policy rate dropped and Chinese stock prices rallied (Chart 1). In our view, the recent liquidity injections do not provide enough evidence that macro policy is shifting to an easier bias. Despite a retreat in the short-term interbank rate, the authorities have plowed ahead with reforms and initiated more restrictions in key industries. In the coming months, investors should expect the following: SOE reforms will tolerate more bond defaults. Bank loans and local government bonds make up nearly 80% of China’s total domestic credit, whereas corporate bonds (including SOEs and local government financing vehicles (LGFVs)) account for only 10% of the total (Chart 2). Thus, even if corporate bond defaults push up yields, Beijing may see this as a small price to pay in the near term, in exchange for a market-driven system cleansing to eliminate inefficient SOEs. This outcome will be negative for corporate bonds (Chart 3). Chart 2Corporate Bond Issuance Make Up Only A Small Portion Of Total Financing Chart 3Periods Of Financial Tightening Dampen Corporate Bond Market Chart 4Higher Funding Costs Will Discourage Corporate Borrowing Policymakers may underestimate the unintended consequences of SOE defaults on credit flow and the broader economy. The central bank was able to engineer a sharp drop in its policy rate last month, which may prompt policymakers to believe that interbank liquidity injections are efficient market-calming measures and rising corporate bond yields will not impede overall credit growth. This may be true in the short term, however, tightened policy in the name of reforms has previously pushed up both the 3-month SHIBOR and bank lending rates, leading to a significant slowing in credit growth and an eventual slowdown in economic expansion (Chart 4). Reasons for such chain reactions are twofold. First, banks become more risk averse during a tightening cycle and charge higher premiums when lending to smaller financial institutions and the private sector (Chart 4, bottom panel). Secondly, although Chinese SOEs can borrow from banks at much lower interest rates than private-sector entities (Chart 5), their heavy indebtedness makes them hyper-sensitive to even a slight uptick in financing costs. Chinese SOEs rely more on bank lending than bond issuance for financing and SOE borrowers dominate China’s bank credit to the corporate sector.1  Chart 6 shows that the rise in the weighted average lending rate in 2017 was relatively minor compared with levels that prevailed in the past decade. Nonetheless, a less than one percentage point hike in the lending rate materially slowed credit growth and the investment-driven sectors of China's economy. Chart 5SOEs Tend To Have Lower Borrowing Costs, Partially Reflecting Implicit Government Guarantees Chart 6Small Rise In Lending Rate, Large Fall In Credit Growth   Regulatory pressures will lead to de facto tightening. As outlined in our 2021 Outlook report, as part of the macroeconomic policy normalization, credit growth will likely decelerate by two to three percentage points this year from 2020. The extended Macro Prudential Assessment (MPA) System will wrap up by year-end and financial institutions will need to start slowing their asset balance sheets to meet the assessments. Moreover, last week the central government revised Measures for the Performance Evaluation of Commercial Banks. The modified version factors lending to the new-economy sectors and micro and small enterprises into the performance evaluation and salaries of the state-owned and controlled commercial banks’ management.2 The new measures will likely dampen the banks’ propensity to lend to old-economy sectors, such as real estate and traditional infrastructure. All in all, a faster-than-desired slowdown in credit growth will ensue if policymakers simultaneously allow more SOE/corporate defaults, undertake industry reforms, and implement tighter banking regulations in 2021. This is negative for both economic growth and the equity market. Bottom Line: Chinese policymakers will likely allow more SOE defaults in the coming months. In addition to an increased number of SOE defaults that is negative for the corporate bond market, sped up industry restructuring and more stringent regulations may lead to a sharp fall in credit growth and stock prices. Worsening Old Economy SOEs’ Financial Positions Chart 7SOEs Are Less Efficient Than Private Firms In Profitability And Productivity An acceleration in SOE reforms may trigger near-term risks, but a delay in restructuring China’s loss-making SOEs will have repercussions in the long term. The explicit and implicit government protections for SOEs have eroded their efficiencies compared with the private sector (Chart 7). The most significant side effect is a rapid rise in SOE leverage and diminishing profitability in some of the old economy sectors. It may be a dead end for the government to continue bailing out state firms with inefficient operations and financial losses. A Special Report we previously published  showed that among SOEs in the industrial and construction sectors, which account for half of all SOEs in China, the adjusted return on assets (ROA) versus borrowing costs has been negative since 2013 (Chart 8). This suggests that SOE investment funded by higher leverage cannot produce sufficient income to repay debt. During the last tightening cycle that started in late 2016, policymakers managed to rein in local SOE debt growth, but it reversed course in 2018 due to a collapse in domestic demand (Chart 9).  As Chart 8 illustrates, ROA among SOEs in the industrial and construction sectors has significantly deteriorated since then. Chart 8SOEs Financial Gains From Debt Are In Deep Contraction Chart 9China Was Successful In Reining In SOE Debt, But Only Briefly Bottom Line: A continued capital misallocation by perpetually leveraging SOEs and LGFVs with negative marginal operating gains will eventually lead to a self-reinforcing debt trap. In turn, that would precipitate a default en masse and necessitate a larger government bailout. Another Layer To The SOE Reform Dilemma The central government’s SOE reform agenda is further complicated by the involvement of local governments (LGs). We have several observations: First, a meaningful SOE restructuring, which would require consolidating/liquidating some of the unprofitable SOE assets, may expose the LGs’ fiscal vulnerabilities to both investors and regulators. The fiscal weakness of China’s provincial-level governments is illustrated by the bond-payment default of Yongcheng Coal, a SOE from Henan Province. Henan is economically sound with GDP growth above the national average. However, when considering the province’s direct and hidden debt, debt servicing costs, and liquidity availability, Henan is in a group of 10 provinces with the worst fiscal conditions in 2020.3 This implies that LG officials may not have been able to bail out Yongcheng even if they wanted to. Moreover, cash-strapped LGs have reportedly formed reciprocal and entrenched relationships with local SOEs. These SOEs may carry debt for LGs and in turn, free up an LG’s borrowing capacity. When these SOEs fail, the credibility of LG officials may be questioned and investigated by the central government. As such, LGs are incentivized to protect their local SOEs.  Chart 10More Defaults, More Bank Lending Secondly, removing the government’s bailout of SOE debt defaults does not negate the underlying factor eroding SOE productivity: the government’s support of local SOEs with easier access to bank loans. Banks, which heavily influence LGs, are not always vigilant about risks associated with local SOE debt. Banks provide loans at preferential rates to localities and their affiliated SOEs. In return, LGs often award banks financing opportunities for profitable infrastructure projects. In this regard, local SOE bond defaults are not necessarily detrimental to bank profits because banks can make up their losses through financing more lucrative projects. Studies show that even when some LGs have experienced large-scale SOE bond defaults, lending to these LGs from commercial banks actually increased relative to other forms of financing (Chart 10). Beijing must take bold measures to break up the long-standing relationship between LGs and SOEs in order to achieve any market-oriented reform of local SOEs. The LGs will likely strongly resist severing the connection. Lastly, given that SOEs are often deployed to support the central government’s economic, political and strategic initiatives, LGs can use those grand initiatives to help justify their local SOEs’ existence - even unprofitable ones. Bottom Line: Beijing faces a tough choice between implementing effective SOE reforms and worsening local governments’ fiscal conditions with negative implications for economic growth. While allowing more SOE bond defaults can force investors to reprice SOE credit risks, as long as the implicit government support for SOEs through bank lending still exists, allocating capital to more efficient private-sector companies will be a formidable task. Investment Conclusions Some economists argue that China’s SOE debt should be considered part of public-sector leverage because many SOE investments are affiliated with government projects. Additionally, Chinese SOEs have accumulated massive assets, which can more than offset their debt4 and make SOE bonds and debt low- risk propositions. Moreover, even though the government may allow more SOE bond defaults, if the defaults threaten China’s financial stability, then the government can move non-performing debt from LGs and SOEs to the balance sheets of the central bank or central government. There are several issues with this argument. The stock of assets in a large portion of Chinese SOEs5 has persistently failed to generate sufficient cash flow to service debt, which implies that the true value of the assets may be low and will likely be sold at below cost when liquidated. It is not useful to compare book value of assets with debt because the true value of assets is contingent on the income/cash flow that they generate. We agree that public-sector leveraging/deleveraging is fundamentally a political choice in countries with control over their own monetary policy and debt is in local currency. Theoretically, a country can monetize public and private local currency-denominated debt via a central bank or government- controlled commercial banks. In such a case, the authorities will have little control over inflation, the exchange rate, and the long-term productivity.   For now, Chinese policymakers seem to be on a path of accelerating reform, an indication that they want to avoid bailing out state firms and private-sector companies. In addition, President Xi’s “dual circulation” mantra emphasizes the importance of improving the country’s corporate efficiency and productivity. We think that consolidating some inefficient SOE sectors in the old economy fits such initiative. Our baseline view is that the SOE consolidation process will be gradual and the PBoC will provide sufficient liquidity in an effort to prevent market jitters. At the same time, the sharp turns in the policy rate in the past six months are prime examples of the periodic oscillation in China’s policymaking between maintaining economic stability and pursuing meaningful reforms. The policy swings will create mini-cycles for Chinese risk asset prices. Chinese stocks are not cheap compared with values at the start of the last policy tightening cycle (Chart 11A and 11B). We recommend a neutral position on domestic and investable equities for the time being. CHART 11AInvestable Stocks Are More Expensive Now Than Prior To The Last Tightening Cycle CHART 11BA-Shares Are Less Expensive, But Valuations Are Still Elevated   Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1Based on the OECD estimates, SOEs’ share of China’s total corporate debt escalated from 46% in 2013 to roughly 80% in 2018.  2Banks included in the new appraisal system are state-owned and state-controlled commercial lenders, and other commercial banks may also refer to the guidelines. Lenders will be evaluated yearly and the results will be factored into the annual reviews of top bank executives as salary determinants. Each of the four new categories will carry an equal weighting. The “national development goals and real economy” category has four benchmarks: serving the government’s “ecological civilization strategy” to encourage lending for green industries and companies; serving strategic emerging industries; implementing the “two increases” - inclusive lending to micro and small enterprises; and implementing the “two controls” - nonperforming loans and borrowing costs of micro and small enterprises. The category “controlling and preventing risks” includes metrics on bad loan ratios, the nonperforming loan growth rate, provision coverage, liquidity ratios and capital adequacy ratios. 3“Seeing Through the Frosted Glass: Assessing Chinese Local Governments’ Creditworthiness”, Pengyuan Rating Public Finance Report, June 2020 4Chinese SOE assets are estimated to have reached 2.3 times China’s 2019 GDP, whereas their debt is close to 130% of GDP. 5IMF estimated that about a quarter of Chinese SOEs were operating at a loss in 2017. Cyclical Investment Stance Equity Sector Recommendations

Highlights Markets largely ignored the uproar at the US Capitol on January 6 because the transfer of power was not in question. Democratic control over the Senate, after two upsets in the Georgia runoff, is the bigger signal. US fiscal policy will become more expansive yet the Federal Reserve will not start hiking rates anytime soon. This is a powerful tailwind for risk assets over the short and medium run. Politics and geopolitics affect markets through the policy setting, rather than through discrete events, which tend to have fleeting market impacts. The current setting, in the US and abroad, is negative for the US dollar. The implication is positive for emerging market stocks and value plays. Go long global stocks ex-US, long emerging markets over developed markets, and long value over growth. Cut losses on short CNY-USD. Feature Chart 1Market's Muted Response To US Turmoil Scenes of mayhem unfolded in the US Capitol on January 6 as protesters and rioters flooded the building and temporarily interrupted the joint session of Congress convened to count the Electoral College votes. Congress reconvened later and finished the tally. President-elect Joe Biden will take office at noon on January 20. Financial markets were unperturbed, with stocks up and volatility down, though safe havens did perk up a bit (Chart 1). The incident supports our thesis that the US election cycle of 2020 was a sort of “Civil War Lite” and that the country is witnessing “Peak Polarization,” with polarization likely to fall over the coming five years. The incident was the culmination of the past year of pandemic-fueled unrest and President Trump’s refusal to concede to the Electoral College verdict. Trump made a show of force by rallying his supporters, and apparently refrained from cracking down on those that overran Congress, but then he backed down and promised an orderly transfer of power. The immediate political result was to isolate him. Fewer Republicans than expected contested the electoral votes in the ensuing joint session; one Republican is openly calling for Trump to be forced into resignation via the 25th amendment procedure for those unfit to serve. The electoral votes were promptly certified. Vice President Mike Pence and other actors performed their constitutional duties. Pence reportedly gave the order to bring out the National Guard to restore order – hence it is possible that Pence and Trump’s cabinet could activate the 25th amendment, but that is unlikely unless Trump foments rebellion going forward. Vandals and criminals will be prosecuted and there could also be legal ramifications for Trump and some government officials. Do Politics And Geopolitics Affect Markets? The market’s lack of concern raises the question of whether investors need trouble themselves with politics at all. Philosopher and market guru Nassim Nicholas Taleb tweeted the following: If someone, a year ago, described January 6, 2021 (and events attending it) & asked you to guess the stock market behavior, admit you would have gotten it wrong. Just so you understand that news do not help you understand markets.1 This is a valid point. Investors should not (and do not) invest based on the daily news. Of course, many observers foresaw social unrest surrounding the 2020 election, including Professor Peter Turchin.2 Social instability was rising in the data, as we have long shown. When you combined this likelihood with the Fed’s pause on rate hikes, and a measurable rise in geopolitical tensions between the US and other countries, the implication was that gold would appreciate. So if someone had told you a year ago that the US would have a pandemic, that governments would unleash a 10.2% of global GDP fiscal stimulus, that the Fed would start average inflation targeting, that a vaccine would be produced, and that the US would have a contested election on top of it all, would you have expected gold to rise? Absolutely – and it has done so, both in keeping with the fall in real interest rates plus some safe-haven bonus, which is observable (Chart 2). Chart 2Gold Price In Excess Of Fall In Real Rates Implies Geopolitical Risk The takeaway is that policy matters for markets while politics may only matter briefly at best. Which brings us back to the implications of the Trump rebellion. What Will Be The Impact Of The Trump Rebellion? We have highlighted that this election was a controversial rather than contested election – meaning that the outcome was not in question after late November when the court cases, vote counts, and recounts were certified. This was doubly true after the Electoral College voted on December 14. The protests and riots yesterday never seriously called this result into question. Whatever Trump’s intentions, there was no military coup or imposition of martial law, as some observers feared. In fact the scandal arose from the President’s hesitation to call out the National Guard rather than his use of security forces to prevent the transfer of power, as occurs during a coup. This partially explains why the market traded on the contested election in December 2000 but not in 2020 – the result was largely settled. The Biden administration now has more political capital than otherwise, which is market-positive because it implies more proactive fiscal policy to support the economic recovery. Trump’s refusal to concede gave Democrats both seats in the Georgia Senate runoffs, yielding control of Congress. Household and business sentiment will revive with the vaccine distribution and economic recovery, while the passage of larger fiscal stimulus is highly probable. US fiscal policy will almost certainly avoid the mistake of tightening fiscal policy too soon. Taken with the Fed’s aversion to raising rates, greater fiscal stimulus will create a powerful tailwind for risk assets over the next 12 months. The primary consequence of combined fiscal and monetary dovishness is a falling dollar. The greenback is a counter-cyclical and momentum-driven currency that broadly responds inversely to global growth trends. But policy decisions are clearly legible in the global growth path and the dollar’s path over the past two decades. Japanese and European QE, Chinese devaluation, the global oil crash, Trump’s tax cuts, the US-China trade war, and COVID-19 lockdowns all drove the dollar to fresh highs – all policy decisions (Chart 3). Policy decisions also ensured the euro’s survival, marking the dollar’s bottom against the euro in 2011, and ensuring that the euro could take over from the dollar once the dollar became overbought. Today, the US’s stimulus response to COVID-19 – combined with the Fed’s strategic review and the Democratic sweep of government – marked the peak and continued drop-off in the dollar. Chart 3Euro Survival, US Peak Polarization, Set Stage For Rotation From USD To EUR Chart 4China's Yuan Says Geopolitics Matters The Chinese renminbi is heavily manipulated by the People’s Bank and is not freely exchangeable. The massive stimulus cycle that began in 2015, in reaction to financial turmoil, combined with the central bank’s decision to defend the currency marked a bottom in the yuan’s path. China’s draconian response to the pandemic this year, and massive stimulus, made China the only major country to contribute positively to global growth in 2020 and ensured a surge in the currency. The combination of US and Chinese policy decisions has clearly favored the renminbi more than would be the case from the general economic backdrop (Chart 4). Getting the policy setting right is necessary for investors. This is true even though discrete political events – including major political and geopolitical crises – have fleeting impacts on markets. What About Biden’s Trade Policy? Trump was never going to control monetary or fiscal policy – that was up to the Fed and Congress. His impact lay mostly in trade and foreign policy. Specifically his defeat reduces the risk of sweeping unilateral tariffs. It makes sense that global economic policy uncertainty has plummeted, especially relative to the United States (Chart 5). If US policy facilitates a global economic and trade recovery, then it also makes sense that global equities would rise faster than American equities, which benefited from the previous period of a strong dollar and erratic or aggressive US fiscal and trade policy. Trump’s last 14 days could see a few executive orders that rattle stocks. There is a very near-term downside risk to European and especially Chinese stocks from punitive measures, or to Emirati stocks in the event of another military exchange with Iran (Chart 6). But Trump will be disobeyed if he orders any highly disruptive actions, especially if they contravene national interests. Beyond Trump’s term we are constructive on all these bourses, though we expect politics and geopolitics to remain a headwind for Chinese equities. Chart 5Big Drop In Global Policy Uncertainty US tensions with China will escalate again soon – and in a way that negatively impacts US and Chinese companies exposed to each other. Chart 6Geopolitical Implications Of Biden's Election The cold war between these two is an unavoidable geopolitical trend as China threatens to surpass the US in economic size and improves its technological prowess. Presidents Xi and Trump were merely catalysts. But there are two policy trends that will override this rivalry for at least the first half of the year. First, global trade is recovering– as shown here by the Shanghai freight index and South Korean exports and equity prices (Chart 7). The global recovery will boost Korean stocks but geopolitical tensions will continue to brood over more expensive Taiwanese stocks due to the US-China conflict. This has motivated our longstanding long Korea / short Taiwan recommendation. Chart 7Global Economy Speaks Louder Than North Korea Chart 8China Wary Of Over-Tightening Policy Chart 9Global Stock-Bond Ratio Registers Good News Second, China’s 2020 stimulus will have lingering effects and it is wary of over-tightening monetary and fiscal policy, lest it undo its domestic economic recovery. The tenor of China’s Central Economic Work Conference in December has reinforced this view. Chart 8 illustrates the expectations of our China Investment Strategy regarding China’s credit growth and local government bond issuance. They suggest that there will not be a sharp withdrawal of fiscal or quasi-fiscal support in 2021. Stability is especially important in the lead up to the critical leadership rotation in 2022.3 This policy backdrop will be positive for global/EM equities despite the political crackdown on General Secretary Xi Jinping’s opponents will occur despite this supportive policy backdrop. The global stock-to-bond ratio has surged in clear recognition of these positive policy trends (Chart 9). Government bonds were deeply overbought and it will take several years before central banks begin tightening policy. What About Biden’s Foreign Policy? Chart 10OPEC 2.0 Cartel Continues (For Now) Iran poses a genuine geopolitical risk this year – first in the form of an oil supply risk, should conflict emerge in the Persian Gulf, Iraq, or elsewhere in the region. This would inject a risk premium into the oil price. Later the risk is the opposite as a deal with the Biden administration would create the prospect for Iran to attract foreign investment and begin pumping oil, while putting pressure on the OPEC 2.0 coalition to abandon its current, tentative, production discipline in pursuit of market share (Chart 10). Biden has the executive authority to restore the 2015 nuclear deal (Joint Comprehensive Plan of Action). He is in favor of doing so in order to (1) prevent the Middle East from generating a crisis that consumes his foreign policy; (2) execute an American grand strategy of reviving its Asia Pacific influence; (3) cement the Obama administration’s legacy. The Iranian President Hassan Rouhani also has a clear interest in returning to the deal before the country’s presidential election in June. This would salvage his legacy and support his “reformist” faction. The Supreme Leader also has a chance to pin the negative aspects of the deal on a lame duck president while benefiting from it economically as he prepares for his all-important succession. The problem is that extreme levels of distrust will require some brinkmanship early in Biden’s term. Iran is building up leverage ahead of negotiations, which will mean higher levels of uranium enrichment and demonstrating the range of its regional capabilities, including the Strait of Hormuz, and its ability to impose economic pain via oil prices. Biden will need to establish a credible threat if Iran misbehaves. Hence the geopolitical setting is positive for oil prices at the moment. Beyond Iran, there is a clear basis for policy uncertainty to decline for Europe and the UK while it remains elevated for China and Russia (Chart 11). Chart 11Relative Policy Uncertainty Favors Europe and UK Over Russia And China The US international image has suffered from the Trump era and the Biden administration’s main priorities will lie in solidifying alliances and partnerships and stabilizing the US role in the world, rather than pursuing showdown and confrontation. However, it will not be long before scrutiny returns to the authoritarian states, which have been able to focus on domestic recovery and expanding their spheres of influence amid the US’s tumultuous election year. Chart 12GeoRisk Indicators Say Risks Underrated For These Bourses The US will not seek a “diplomatic reset” with Russia, aside from renegotiating the New START treaty. The Democrats will seek to retaliate for Russia’s extensive cyberattack in 2021 as well as for election interference and psychological warfare in the United States. And while there probably will be a reset with China, it will be short-lived, as outlined above. This situation contrasts with that of the Atlantic sphere. The Biden administration is a crystal clear positive, relative to a second Trump term, for the European Union. The EU and the UK have just agreed to a trade deal, as expected, to conclude the Brexit process, which means that the US-UK “special relationship” will not be marred by disagreements over Ireland. European solidarity has also strengthened as a result of the pandemic, which highlighted the need for collective policy responses, including fiscal. Thus the geopolitical risks of the new administration are most relevant for China/Taiwan and Russia. Comparing our GeoRisk Indicators, which are market-based, with the relative equity performance of these bourses, Taiwanese stocks are the most vulnerable because markets are increasingly pricing the geopolitical risk yet the relative stock performance is toppy (Chart 12). The limited recovery in Russian equities is also at risk for the same reason. Only in China’s case has the market priced lower geopolitical risk, not least because of the positive change in US administration. We expect Biden and Xi Jinping to be friendly at first but for strategic distrust to reemerge by the second half of the year. This will be a rude awakening for Chinese stocks – or China-exposed US stocks, especially in the tech sector. Investment Takeaways Chart 13Global Policy Shifts Drive Big Investment Reversals The US is politically divided. Civil unrest and aftershocks of the controversial election will persist but markets will ignore it unless it has a systemic impact. The policy consequence is a more proactive fiscal policy, resulting in virtual fiscal-monetary coordination that is positive both for global demand and risk assets, while negative for the US dollar. The Biden administration will succeed in partially repealing the Trump tax cuts, but the impact on corporate profit margins will be discounted fairly mechanically and quickly by market participants, while the impact on economic growth will be more than offset by huge new spending. Sentiment will improve after the pandemic – and Biden has not yet shown an inclination to take an anti-business tone. The past decade has been marked by a dollar bull market and the outperformance of developed markets over emerging markets and growth stocks like technology over value stocks like financials. Cyclical sectors have traded in a range. Going forward, a secular rise in geopolitical Great Power competition is likely to persist but the macro backdrop has shifted with the decline of the dollar. Cyclical sectors are now poised to outperform while a bottom is forming in value stocks and emerging markets (Chart 13). We recommend investors go strategically long emerging markets relative to developed. We are also going long global value over growth stocks. We are not yet ready to close our gold trade given that the two supports, populist fiscal turn and great power struggle, will continue to be priced by markets in the near term. We are throwing in the towel on our short CNY-USD trade after the latest upleg in the renminbi, though our view continues to be that geopolitical fundamentals will catch yuan investors by surprise when they reassert themselves. We also recommend preferring global equities to US equities, given the above-mentioned global trends plus looming tax hikes.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 January 6, 2020, twitter.com. 2 See Turchin and Andrey Korotayev, "The 2010 Structural-Demographic Forecast for the 2010-2020 Decade: A Retrospective Assessment," PLoS ONE 15:8 (2020), journals.plos.org. 3 Not to mention that 2021 is the Communist Party’s 100th anniversary – not a time to make an unforced policy error with an already wobbly economy.

Feature Chart 1Stock Prices Are Struggling To Break Out Of Their Recent Highs Stock prices in China's onshore and offshore markets rallied into the New Year (Chart 1). Despite the strong performance in the last couple of days, as we pointed out in our 2021 Outlook Report, the biggest obstacle that Chinese stock prices face is their elevated valuations against tightening macro policy. Recent liquidity injections by the PBoC have prompted a sharp drop in the 7-day repo rate. However, slightly loosened liquidity conditions in the interbank system do not signify a shift in monetary policy, i.e. financial conditions will continue to tighten in 2021, albeit at a slower rate than in the second half of 2020. The Central Economic Work Conference (CEWC) wrapped up its December meeting with a pledge to maintain continuity, stability and sustainability in macroeconomic policy without making any “sudden turns”.  The conference release also stated that China “must use the valuable time window to focus on reform and innovation — achieving a good start for the 14th five-year plan in terms of high-quality development.” The CEWC’s messages align with our baseline view that Chinese policymakers are not yet in a deleveraging mood. The country’s macro leverage level should be kept stable in 2021 and the growth of credit creation will decelerate gradually (Chart 2, Scenario 1). The pullback in this year’s fiscal support will also be gentle: we expect newly issued special purpose bonds (SPBs) to reach 3.2-3.5 trillion in 2021, about 10% less than the 3.75 trillion issued in 2020.  This will put the 2021 SPB quota in the same range as in 2016, but higher than in 2017, 2018 or 2019 (Chart 3).   Chart 2Credit Growth Will Decelerate In 2021 Chart 3Fiscal Cliff In 2021 Unlikely A credit or fiscal cliff is unlikely this year. Instead, we expect the authorities to accelerate key reforms such as a clampdown on market monopolies and housing speculation in large cities, heavier penalties on capital market violations and a reduction in carbon emissions. In the long run, these reforms may help to rebalance China’s economic structure, but in the near term, a more stringent policy backdrop will probably hinder investors’ appetites for Chinese risk assets. In early December, we downgraded Chinese equities from overweight to neutral for the next 0-3 months, in both absolute and relative terms. We will evaluate our cyclical call on Chinese stocks in the coming weeks. Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Below is a set of market relevant charts along with our comments: The PBoC has injected large amounts of liquidity into the interbank system since mid-November, helping to sharply lower the short-term interbank repo rate. We pointed out previously that policy rates had breached their pre-pandemic levels by November while the economy had barely expanded from the end of 2019. Thus, we expected the PBoC to slow the pace of interest rate normalization in Q4. Recent liquidity injections likely were related to preventing a year-end cash crunch in the financial system, not a change in the PBoC’s planned pace of policy tightening. While the 7-day interbank repo rate is back to its June 2020 level, the 3-month SHIBOR (the de facto policy rate) has only slightly moderated. The divergence between the 7-day and the 3-month interbank rates was also apparent during the monetary tightening cycle in 2017-2018. During that cycle, the jump in the 3-month SHIBOR pushed up government bond yields and bank lending rates, while the 7-day repo rate remained stable. As shown in a previous report, the 3-month SHIBOR more tightly correlates with bond yields and is a better measure of China’s monetary policy stance.  Chart 4The Short-Term Interbank Repo Rate Dropped Sharply Since Mid-November … Chart 5… But The Declines In The 3-Month SHIBOR And Bond Yields Have Been Much Milder Chinese onshore stock prices trended sideways for most of December, even as the PBoC loosened interbank liquidity conditions in mid-November. Chinese offshore stocks have also failed to break out from highs reached in November, as tech giants such as Alibaba and Tencent have come under tough scrutiny from regulators. Chinese stocks will continue to experience a tug-of-war between tailwinds and headwinds in the next three months. The relatively well-contained domestic pandemic and improving economic growth will support investors’ sentiments towards Chinese risk assets. At the same time, stock prices will face headwinds such as elevated valuations, a more restrictive policy environment and wider corporate credit spreads. For now, the downside risks to Chinese stocks prevail.  Chart 6ADomestic Stocks Are No Longer Cheap Chart 6BElevated Valuations In Investable Stocks Tailwinds Supporting Chinese Stocks: Economic Recovery To Continue In 1H21 Chart 7China’s EPS Recovery To Continue In 1H21 China’s business cycle will remain resilient in the first half of 2021 while existing stimulus measures continue to work their way into the real economy. In the next six months, some laggards in the economic recovery, such as the service sector and household consumption, will likely pick up momentum, while the manufacturing and export sectors remain robust.  China’s export sector should maintain strong growth momentum in the first half of the year. A rising RMB exchange rate may eventually impede the price competitiveness of some labor-intensive export goods , but Chinese manufacturers will continue to fill the gap between global demand and supply before the COVID-19 vaccines are widely distributed and the global supply chains are fully recovered. Moreover, China’s global share of exports gradually rose in both 2018 and 2019 despite the Sino-US trade war. Data from Q4 show that Chinese exports have been robust beyond pandemic-related goods. As the global economy and demand growth pick up next year, Chinese exports should also benefit from the trade recovery.   Chart 8The Strength In Chinese Exports Has Expanded Beyond Pandemic-Related Goods … Chart 9… And Will Benefit From Recovering Global Demand In 2021 Chart 10The Acceleration In Completed Housing Will Support Construction In 1H21 An acceleration in completing existing projects should support the construction sector in the first half of 2021, despite a slower expansion rate in new development projects.  Floor space completed has significantly lagged floor space started and sold during the past two years, while real estate developers rushed to acquire new projects, land and down payments to expand their market share. Property developers will need to speed up the completion process of existing projects to bring leverage in line with the “three red lines” imposed since August 2020 (housing presales need to be excluded from the liability-to-asset ratio calculation). Hence, we expect the growth in real estate investment and construction activities to remain stable through the first half.    Chart 11Smaller Cities Face Less Upward Price Pressure on Housing Prices Than Big Cities Chart 12Housing Restrictions Will Be Most Stringent In Top-Tier Cities Chart 13The Laggards In The Economy Are Firming Up The laggards in the economy are firming up. Recent economic data show that growth momentum is shifting from leaders in the economic recovery, especially old-economy sectors such as infrastructure and real estate, to the coincident and lagging sectors such as manufacturing and consumer sectors. While an increase in these sectors is positive for the economy and the growth of corporate profits, it also implies that the economic recovery has entered a late phase and a peak in the business cycle is near. Therefore, the improvements do not necessarily provide enough impetus for stock prices to trend higher, and prices may be at risk from a policy overkill.   Chart 14Household Consumption Still Has Room To Improve Chart 15Sales Of Discretionary Goods Have Surged   Downside Risks To Chinese Equity Prices China’s domestic policy environment has turned less favorable for risk assets.  A new round of policy tightening is well underway as suggested by a slew of events, ranging from the recent SOE bond payment defaults to regulators suspending the Ant Group IPO and cracking down on market monopolies. Investors will likely be risk averse in the near term.   Chart 16Stringent Scrutiny On Tech Companies Hammered Their Stock Performance … Chart 17… Bringing Down Their Sector Performance   Rising corporate bond yields in China’s onshore bond market are not an impediment to increasing Chinese share prices as long as forward EPS net revisions are also climbing. Not only have onshore corporate bond yields recently risen, but forward EPS net revisions have rolled over. Such a combination does not bode well for Chinese equities.  Chart 18Red Flag For Chinese Equities The impact from stricter lending regulations in the real estate sector may start impeding home sales and new real estate investment into the second half of the year. Effective January 1, 2021, China imposed caps on bank loans to real estate developers. Loans will be capped at 40% for the largest state-owned lenders, while banks’ mortgage lending should be no more than 32.5% of their outstanding credit. The regulations are even more rigorous for smaller banks.1 The new rules highlight the authorities’ determination to curb financial risks derived from the housing market and are a step up from the existing deleveraging pressures faced by property developers. Bank loan quotas under the new rules are in line with ones used in 2020.2 However, based on our projections that overall credit growth will decelerate by at least 2 percentage points in 2021 compared with 2020, there will be a corresponding decrease in real estate sector’s borrowing from banks. Bank loans account for roughly 14% of real estate developers’ total funding sources and household mortgages accounted for 16% in 2020. When deleveraging pressures are on and financing resources are capped from both the supply and demand sides, real estate investment growth will likely peak no later than mid-2021.  Chart 19The New Rules May Exacerbate The Downward Trend In Bank Loans To The Real Estate Sector This Year Deflationary pressures may resurface in the second half, which would be a downside risk to China’s corporate profit growth. The producer prices contraction will continue to narrow and even turn mildly positive in the next six months, supported by the uptrend in the business cycle and a low base factor in 1H20. However, both consumer and producer prices may face renewed downward pressures in the second half of 2021 when the business cycle is expected to peak and the effects of stimulus gradually fade. Moreover, the RMB appreciation will add to headwinds faced by producer prices in 2021.  Chart 20While The Ongoing Economic Recovery Will Support Prices In 1H21 … Chart 21… Lower Money Growth And Higher RMB Value May Start To Hurt Prices In 2H21 Chart 22Resurfaced Deflationary Pressure Will Create Downside Risk To China’s Corporate Profit Growth In 2H21 Chart 23The Outperformance In Cyclical Stocks Versus Defensives Has Rolled Over The outperformance in cyclical stocks relative to defensives in the investable stocks recently rolled over. Historically, there is a strong link between forward earnings and stock price performance of cyclical sectors, while defensives have a low equity return beta and are market neutral. A switch in outperformance from cyclicals to defensives usually corresponds with the economy shifting from an expansionary to contractionary phase. Therefore, the recent rollover in the outperformance of cyclical stocks versus defensives may be an early sign that Chinese stock performance has lost its momentum in the current cycle. In relative terms, as breakthroughs in vaccines make the pandemic less threatening to the global economy, cyclical stocks outside of China will start to benefit from improvements in business activities. This will make Chinese risk assets relative to global ones less appealing.  Table 1China Macro Data Summary Table 2China Financial Market Performance Summary   Footnotes 1For second-tier banks, including state-owned Agricultural Development Bank of China and Exim Bank of China, and 12 joint-stock holding commercial banks, caps on loans to developers and mortgage loans are 27.5% and 20% respectively. Meanwhile, the ratios are capped at 22.5% and 17.5% respectively for smaller city and rural commercial banks, rural cooperative banks and credit cooperatives. The strictest limits apply to small village banks, which can lend only 12.5% of their portfolios to real estate developers and 7.5% to homeowners. 2Currently, outstanding loans to the real estate sector (including household mortgage loans) account for about 29% of total loans from China’s financial institutions, while the ratio of housing mortgage loans is 22%. Cyclical Investment Stance Equity Sector Recommendations