Capex

  Highlights China should fare a global recession better than most G20 economies, given its large domestic market and powerful policy response. China is likely to frontload a large portion of its multi-year infrastructure investment projects to this year. We project a near 10% increase in infrastructure investments in 2020. While at the moment we do not have high conviction in the absolute trend in Chinese stock prices, we think Chinese equities will still passively outperform global benchmarks in a global recession. Feature Chart 1A Black Monday Triggered By A "Perfect Storm" A Black Monday Triggered By A "Perfect Storm" A Black Monday Triggered By A "Perfect Storm" Investors are now pricing in a global recession, triggered by a worsening COVID-19 epidemic outside of China and a full-blown price war in the oil market. Global stocks tumbled by 7% on Monday March 9 while the US 10-year Treasury yield dropped to a record low (Chart 1).  This extreme volatility reflects investors’ inability to predict how the epidemic will evolve or how long the oil price war will persist. If growth in the US and other major economies turns negative, then China’s disrupted supply side in Q1 will be met with weaker global demand in Q2 and even Q3. While our visibility is limited on the predominantly medically- or politically-oriented crisis, what we have conviction in forecasting at this point is that the Chinese economy will weather the storm better than most G20 economies. China’s policy response and the recovery in domestic demand will more than offset weaknesses from external demand. Thus Chinese stocks will likely outperform global benchmarks in the next 3 months and over a 6-12 month span, even though the absolute trend in both Chinese and global stock prices remains unclear over both these time horizons. A One-Two Punch In a recessionary scenario affecting the entire global economy, China would receive a one-two punch through shocks to both supply and demand tied to the COVID-19 outbreak and shrinking global demand. However, while a global recession would impact China’s export growth, it would not have the kind of bearing on China’s aggregate economy as it did in either 2008/2009 or 2015/2016. The reason is that the Chinese economy is less reliant on exports than it was in 2015 and considerably less than in 2008 (Chart 2). Domestic demand is now dominant, accounting for more than 80% of China’s economy, meaning that the country is less vulnerable to reductions in global demand. Chart 2The Chinese Economy Is Much Less Reliant On Exports The Chinese Economy Is Much Less Reliant On Exports The Chinese Economy Is Much Less Reliant On Exports Chart 3Global Economy Showing Reflation Signs Before COVID-19 Global Economy Showing Reflation Signs Before COVID-19 Global Economy Showing Reflation Signs Before COVID-19 Our current assessment is that the shocks from the virus epidemic and oil price rout on global demand will be brief.Global manufacturing and trade were on a path to recovery prior to the crisis (Chart 3). China’s external and domestic demand rebounded sharply in December and likely have improved even further until late January when the COVID-19 outbreak took hold in China (Chart 4). Even though China’s trade figures in the first two months of 2020 were distorted by COVID-19 (Chart 5),1 a budding recovery in both China’s domestic and global demand before the outbreak suggests the epidemic should disrupt rather than completely derail the global economy. Moreover, a rebound in trade following the crisis will likely be powerful, as the short-term disruption in business activities will lead to a sizable buildup in manufacturing orders. A rebound in trade following the crisis will likely be powerful. Chart 4Chinese Exports Likely To Have Improved Further Until COVID-19 Hit Chinese Exports Likely To Have Improved Further Until COVID-19 Hit Chinese Exports Likely To Have Improved Further Until COVID-19 Hit Chart 5Chinese Demand Likely To Pick Up Sharply In Q2 Chinese Demand Likely To Pick Up Sharply In Q2 Chinese Demand Likely To Pick Up Sharply In Q2   Bottom Line: China’s export growth will moderate if the virus outbreak prolongs and substantively weakens the global economy. However, the demand shock should have a relatively minor impact on China’s aggregate economy and the subsequent recovery should be robust. Infrastructure Investment Comes To Rescue, Again Chart 6Substantial Acceleration In Infrastructure Investment Likely In 2020 Substantial Acceleration In Infrastructure Investment Likely In 2020 Substantial Acceleration In Infrastructure Investment Likely In 2020 Infrastructure investment in China will likely ramp up significantly in 2020, which will mitigate the influence on the domestic economy from both COVID-19 and slowing global growth. The message from the March 4th Politburo Standing Committee2 chaired by President Xi Jinping further supports our view, that Chinese policymakers are committed to a major increase in infrastructure investment in 2020. Our baseline projection suggests a near 10% increase in infrastructure investment growth in 2020 (Chart 6). Local governments’ infrastructure investment plans for the next several years amount to about 34 trillion yuan.3 While local government budget and bond issuance will be approved at the annual National People’s Congress, which is delayed due to the epidemic, we have high conviction that a significant portion of the planned spending will be frontloaded this year. A significant portion of the multi-year infrastructure projects will likely be moved up to this year. In the first two months, local governments have frontloaded 1.2 trillion yuan worth of bonds, including nearly 1 trillion yuan of special-purpose bonds (SPBs). The consensus forecasts a total of 3-3.5 trillion yuan of SPBs to be issued in 2020, a 30% jump from 2019. Given tightened restrictions on the use of SPBs, we expect that 50% of the bonds will be invested in infrastructure projects, up from about 25% from 2019. This should contribute to about 10-15% of infrastructure spending in 2020. We are likely to also see significant additional funding channels to support infrastructure spending this year: Debt-swap program: With the aggressive easing by the PBoC in recent weeks, there is a high probability that another round of debt-swap program will materialize this year – a form of fiscal stimulus similar to the debt-to-bond swap program that the Chinese government initiated during the 2015-2016 cycle (Chart 7).  As we pointed out in our report dated July 24, 2019, the Chinese authorities were formulating another round of local government off-balance-sheet debt swaps, which we estimated would be about 3-4 trillion.4 What was absent back then was a concerted effort from the PBoC to equip commercial banks with the required liquidity and further lower policy rate (Chart 8). Both monetary and policy conditions are now ripe for such a program to be rolled out. Chart 7Money Supply Likely To Pick Up Strongly At The Onset Of Substantial Stimulus Money Supply Likely To Pick Up Strongly At The Onset Of Substantial Stimulus Money Supply Likely To Pick Up Strongly At The Onset Of Substantial Stimulus Chart 8Monetary Conditions Are Ripe For Major Money Base Expansion Monetary Conditions Are Ripe For Major Money Base Expansion Monetary Conditions Are Ripe For Major Money Base Expansion   Construction bond issuance: Borrowing through local government financing vehicles (LGFV) has climbed since the second half of last year. This follows two years of tightened regulations on local government borrowing. Net issuance of urban construction investment bonds (UCIB) reached 1.2 trillion in 2019, nearly doubling the amount from a year earlier. A total of 457 billion yuan in UCB has already been issued in the first two months of 2020, which indicates that the authorities are further relaxing LGFV borrowing.  We think that net UCIB issuance could reach 1.5 trillion this year, a 25% increase compared with last year. Chart 9More Room To Widen Government Budget Deficit More Room To Widen Government Budget Deficit More Room To Widen Government Budget Deficit Government budget:  Funding from the central and local governments budgets accounts for about 15% of overall infrastructure financing. We think that the government budget deficit will likely expand by about 2% of GDP in 2020. As Chart 9 shows, this figure is a conservative estimate compared with the 3%+ widening in the budget deficit during the 2008 and 2015 easing cycles. Bottom Line: Fiscal efforts to support the economy will significantly escalate this year. Monetary conditions and policy directions have already paved the way for a 2015-2016 style credit expansion. We expect infrastructure investment to rise to about 10% in 2020 compared with 2019. Will The RMB Join The Devaluation Club? The RMB appreciated by more than 1% against the USD in the past week, fanned by the expectation that China will have a faster recovery than other countries. The latest round of interest rate cuts by central banks around the world also pushed yield-seeking investors to RMB assets (Chart 10). Still, it is highly unlikely that the PBoC will allow the RMB to continue to appreciate at this rate. When other economies are in a competitive currency devaluation cycle, a strong RMB will generate deflationary headwinds for China’s economy and will partially offset the PBoC’s easing efforts (Chart 11). Chart 10Too Much Too Fast? Too Much Too Fast? Too Much Too Fast? Chart 11A Strong RMB Will Choke Off PBoC's Easing Efforts A Strong RMB Will Choke Off PBoC's Easing Efforts A Strong RMB Will Choke Off PBoC's Easing Efforts If the upward pressure in the RMB persists, then Chinese policymakers will be more inclined to expand the money base. Chart 12PBoC Likely To Rapidly Expand Its Balance Sheet Again PBoC Likely To Rapidly Expand Its Balance Sheet Again PBoC Likely To Rapidly Expand Its Balance Sheet Again We do not expect the PBoC to follow the US Federal Reserve and chase its policy rate even lower.  However, if the upward pressure in the RMB persists, then Chinese policymakers will be more inclined to expand the money base. This further raises the probability that local government debt-swap programs will develop this year (Chart 12). The government may allow financial institutions to extend or swap maturing local government off-balance sheet debt with bank loans that carry lower interest rates and longer maturities. Or, it will simply move the debt to the PBoC’s balance sheet. Bottom Line: If upward pressure in the RMB endures, the PBoC will likely expand its balance sheet and make more room to buy local government debt, but it is unlikely to aggressively cut interest rates. Investment Conclusions Chart 13Chinese Stocks Will Likely Continue To Outperform, Even In A Global Recession Chinese Stocks Will Likely Continue To Outperform, Even In A Global Recession Chinese Stocks Will Likely Continue To Outperform, Even In A Global Recession Our recent change in view5 concerning the willingness of Chinese authorities to “stimulate the economy at all costs” meant that Chinese stocks were likely to outperform the global benchmarks in a rising equity market.  In a global recessionary, which is now a fait accompli, Chinese leadership’s willingness to stimulate the economy will only intensify. China’s large domestic economy also makes the country less vulnerable to a global demand shock. At this point in time we do not have high conviction in the absolute trend in either Chinese or global stock prices, as their near-term performance is predominantly driven by a medically- and politically-oriented crisis. However, as we expect the Chinese economy to outperform in a global recession, our overweight call on Chinese equities remains intact on both a 3-month and 12-month horizon, in relative terms (Chart 13).   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    China had postponed January’s data release and instead, has combined the first two months of the year. 2   “We should select investment projects; strengthen policy support for land use, energy use, and capital; and accelerate the construction of major projects and infrastructure that have been clearly identified in the national plan.” http://cpc.people.com.cn/n1/2020/0305/c64094-31617516.html?mc_cid=2a979… 3   https://m.21jingji.com/article/20200306/504edc15217322ab37337da2ca35a49e.html?[id]=20200306/nw.D44010021sjjjbd_20200306_9-01.json  4   Please see China Investment Strategy Weekly Report "     Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?," dated July 24, 2019, available at cis.bcaresearch.com 5   Please see China Investment Strategy Weekly Report "China: Back To Its Old Economic Playbook?," dated February 26, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Demand for construction machinery in China will contract by 10-15% over the next 12-18 months. Diminishing replacement demand, deteriorating property construction activity and only a moderate acceleration in infrastructure investment will weigh on construction machinery sales in China. We recommend avoiding or underweighting global construction machinery stocks. Feature China is the largest manufacturer and consumer of construction machinery in the world. The country accounts for about 30% of global construction machinery demand in unit terms. Construction machinery includes heavy-duty vehicles performing earthwork operations or other hefty construction tasks. In this report, our coverage of construction machinery refers to the seven most-used construction machines in the world – excavators, loaders, cranes, road rollers, bulldozers, ball-graders and spreaders. Between 2016 and 2019, machinery sales surged by  close to 170%. However, unlike during the 2009-2011 boom, sales were not  widespread across all types of machinery. Sales of these machines are often used by investors and strategists as a microcosm to detect the potency of an economy’s business cycle. An increase in machine sales is usually interpreted as a sign of an acceleration in real estate construction and/or infrastructure spending. Chart I-1Excavators In China: Robust Sales Vs. Diminishing Working Hours Excavators In China: Robust Sales Vs. Diminishing Working Hours Excavators In China: Robust Sales Vs. Diminishing Working Hours Are machinery sales a good measure of construction activity in both the real estate and infrastructure development? Not really. In this report we make the point that sales of construction machinery do not always reflect construction activity in the mainland. Specifically, Chart I-1 demonstrates that sales of excavators in China have differed from Komatsu’s Komtrax index for China. The latter is the average hours of operation per excavator. What explains this gap between resilient excavator sales and diminishing hours of excavator usage? This divergence has been due to the fact that robust excavator sales numbers have been supported by replacement demand as well as a changing product mix (a rising share of smaller and cheaper excavators bought by small entrepreneurs). China’s machinery imports have also been crowded out by a growing roster of domestically made models (import substitution). Boom-Bust Machinery Cycles Chart I-2Chinese Construction Machinery Demand Is Likely To Shrink Chinese Construction Machinery Demand Is Likely To Shrink Chinese Construction Machinery Demand Is Likely To Shrink Chinese sales1 of construction machinery (thereafter, machinery) skyrocketed between 2009 and 2011, when China drastically boosted its infrastructure spending and property construction surged. The 2009-2011 boom was followed by a bust: Between 2012 and 2015, total machinery sales dropped by nearly 70%, (Chart I-2). That bust was succeeded by another boom: between 2016 and 2019, machinery sales surged by close to 170%. However, unlike during the 2009-2011 boom, sales were not widespread across all types of machinery: only excavator and crane sales boomed (Chart I-3). The other five categories – loaders, road rollers, bulldozers, ball-graders and spreaders – experienced a relatively muted sales recovery; their 2019 unit sales were well below their respective 2011 highs (Chart I-4). Chart I-3The 2016-2019 Boom: Only Sales Excavators And Cranes Hit A New High... The 2016-2019 Boom: Only Sales Excavators And Cranes Hit A New High... The 2016-2019 Boom: Only Sales Excavators And Cranes Hit A New High... Going forward, we expect sales of construction machinery in China to experience a 10-15% downturn over the next 12-18 months (Chart I-2 on page 2). The basis for such a contraction is diminishing replacement demand, deteriorating property construction and only a moderate acceleration in infrastructure investment growth. Chart I-4...While Many Others Had A Relatively Muted Sales Recovery ...While Many Others Had A Relatively Muted Sales Recovery ...While Many Others Had A Relatively Muted Sales Recovery   Understanding Construction Machinery Demand China’s property construction and infrastructure development have been the main drivers behind construction machinery demand. Chart I-5 shows construction machinery sales in China are highly correlated with building floor space started. Meanwhile, Chart I-6 reveals that infrastructure investment distinctively led construction machinery sales between 2007 and 2013, but that relationship has broken down since 2014. Chart I-5Main Drivers For Construction Machinery Demand In China: Property Construction... Main Drivers For Construction Machinery Demand In China: Property Construction... Main Drivers For Construction Machinery Demand In China: Property Construction... Chart I-6...And Infrastructure Spending ...And Infrastructure Spending ...And Infrastructure Spending   Crucially, in the past three years, property and infrastructure development alone have not been enough to explain the surge in construction machinery sales. In particular, between 2018 and 2019, growth of both building floor areas started and infrastructure investment were weak, yet construction machinery sales still surged by an astonishing 50%. Crucially, in the past three years, property and infrastructure development alone have not been enough to explain the surge in construction machinery sales. Specific developments in the excavator market were behind this surge. Excavators are the largest component of China’s construction machinery market, with a 52% market share (Chart I-7). The decoupling of excavator sales from property construction and infrastructure investment has been due to non-macro forces such as: Replacement demand: Given the average lifespan of an excavator is about eight years, the excavators bought in 2009-2011 were likely replaced during 2017-2019. Meanwhile, strengthening environmental regulations on emissions of heavy construction machinery also accelerated the pace of replacement. According to the China Construction Machinery Association, replacement demand accounted for about 60% of all excavator sales last year. Price drop: The significant reduction in excavator prices, ranging from 15%-30% since the middle of 2018, spurred more purchases. Prices of excavators imported into China have also dropped about 30% in the past 18 months (Chart I-8). The fundamental reason behind excavator producers cutting prices was weak demand amid lingering excess capacity. Chart I-7The Breakdown Of China’s Construction Machinery Sales Chinese Construction Machinery Demand: Going Downhill Chinese Construction Machinery Demand: Going Downhill Chart I-8A Sizeable Drop In Prices Of Imported Excavators A Sizeable Drop In Prices Of Imported Excavators A Sizeable Drop In Prices Of Imported Excavators   Cranes are the only other construction machinery whose sales reached an all-time high last year. Similar to excavators, replacement demand has been the main factor behind sales. Excluding excavators and cranes, machinery sales have been lackluster, as illustrated in Chart I-4 on page 3. Bottom Line: Property construction and infrastructure development alone do not explain the strong growth in construction machinery sales between 2017 and 2019. Considerable replacement demand prompted by a sizable reduction in excavator prices also facilitated sales in China. A Downbeat Cyclical Demand Outlook Chart I-9Chinese Property Construction Is Very Weak Chinese Property Construction Is Very Weak Chinese Property Construction Is Very Weak We remain downbeat on Chinese construction machinery demand going forward. Chinese sales of construction machinery will likely contract 10-15% over the next 12-18 months (Chart I-2 on page 2). First, the Chinese property market remains vulnerable to the downside in 2020. A comprehensive measure of Chinese property construction activity – the “building construction” dataset2 – shows that “building construction” floor area started, under construction and completed are all either stagnant or in contraction (Chart I-9). Real estate is still facing considerable headwinds. The COVID-19 outbreak will reduce household income growth and hence weigh on home purchases in the months to come. In the meantime, structural impediments such as poor housing affordability, slowing rural-to-urban migration, demographic changes and the promotion of the housing rental market will also curtail housing demand. Further, the drop in sales will shrink developers’ cash flow, curbing their already feeble financial position to undertake new construction or complete already started projects. Second, the growth rate of China’s infrastructure investment will likely rebound only moderately from its current nominal 3% pace (Chart I-6 on page 4). Even though the central government is likely to implement more fiscal stimulus due to the current coronavirus outbreak, the infrastructure investment growth rate will still be well below the double digits it registered for most of the past decade. Local government special bond quotas are currently a moving target. No doubt, if economic conditions continue to deteriorate, the central government will continue to increase quotas. However, there are several critical points about the importance of special bond issuance that are worth emphasizing: Special bonds accounted for 14% of total infrastructure investment in 2019. Special bond issuance amounted to 7% of combined local government and government-managed funds expenditures last year. Aggregate infrastructure spending was equal to 30% of fixed asset investment excluding the value of land, and 18% of nominal GDP in 2019. It is roughly equal to property construction. Therefore, modest acceleration in infrastructure spending will likely be offset by shrinking property construction. On the whole, barring irrigation-style fiscal and credit stimulus – which has been repeatedly rejected by Beijing – infrastructure spending is unlikely to surge to the extent it did in 2009-‘10, 2013 and 2016-‘17. It is critical to realize that infrastructure spending during those episodes was funded not by Beijing-approved debt but via bank and shadow-banking credit that was beyond Beijing's control. Chart I-10Excavator Sales Are Likely To Fall Excavator Sales Are Likely To Fall Excavator Sales Are Likely To Fall Third, two specific factors below may result in a considerable reduction in excavator sales. Replacement demand will crater starting in 2020. Excavator sales in 2012 were 35% below their 2011 peak. Given the average eight-year replacement cycle, demand for excavators in 2020 and 2021 will be significantly below 2019 levels (Chart I-10). The price war in the excavator sector will continue, but it will fail to lift overall excavator demand. There are signposts that there is an oversupply of excavators in operation. Last year, excavator drivers (individual entrepreneurs) accounted for a large share of purchases, with the bulk of them opting for small-sized machines – the latter contributed about 70% of the total excavator sales growth. The surge in small service providers amid stagnant construction activity has intensified competition and hence depressed income among these individual owners. This will discourage new demand in the coming one to two years. A risk to this view is that replacement demand could be supported to some extent by increasingly stringent environmental rules. This year, the government will accelerate the scrapping process of off-road heavy vehicles below National III emission standards. Bottom Line: Chinese sales of construction machinery will likely experience a 10-15% downturn over the next 12-18 months, with the largest category – excavator sales – falling by 20% or more. Rising Competitiveness Of Chinese Machinery Producers China’s machinery producers have significantly enhanced their competitiveness. This has led to import substitution. For instance, sales of domestic-brand excavators accounted for 65% of total Chinese excavator sales, a considerable rise from 43% in 2014 and only 26% in 2009. Chinese sales of construction machinery will likely  experience a 10-15% downturn over  the next 12-18 months,  with the largest category  – excavator  sales – falling by  20% or  more. The increasing competitiveness of domestic producers has resulted in not only shrinking imports but also rising exports of construction machinery. As a result, Chinese construction machinery net exports have been on the rise (Chart I-11). In fact, excavators, loaders, cranes, and spreaders have all shown increasing net exports in both volume and value terms (Chart I-12). Chart I-11Chinese Construction Machinery: Flat Exports, Less Imports Chinese Construction Machinery: Flat Exports, Less Imports Chinese Construction Machinery: Flat Exports, Less Imports Chart I-12Increasing Net Exports Of Chinese Construction Machinery Increasing Net Exports Of Chinese Construction Machinery Increasing Net Exports Of Chinese Construction Machinery   We expect this trend to continue in the coming years. The ongoing Belt and Road Initiative (BRI) will facilitate construction machinery exports to BRI recipient countries. For example, on January 12, Chinese construction machinery manufacturer Zoomlion delivered its first batch of an order of 100 excavators to Ghana as part of a BRI agreement. Total BRI investment with Chinese financing will fall moderately in 2020, as the Chinese government will be applying greater scrutiny and tighter oversight over lending for BRI projects. However, we believe this moderate decline in BRI investment will not affect the country’s construction machinery exports by much. Chinese construction machinery companies are highly focused on technology improvements and 5G applications for their products. This will continue to increase the competitiveness of Chinese construction machinery producers. For example, last May, the 5G-based unmanned mining truck made its debut in China’s Bayan Obo mining region. Autonomous vehicles are more efficient and cheaper to maintain. The Bayan Obo mining area plans to purchase more unmanned mining trucks and transform existing traditional vehicles, with plans to make over 65% of its future fleet of mining cars autonomous. Technology improvements and 5G application will further enhance Chinese construction machinery producers’ productivity, making their products more competitive in the global marketplace. Bottom Line: China’s construction machinery net exports will continue to rise, implying a rising market share for mainland producers. This is a bad sign for foreign producers. Investment Implications Global construction machinery stock prices correlate closely with China’s domestic machinery sales (Chart I-13). This confirms the importance of the mainland, which accounts for 30% of global construction machinery demand. There are 30 stocks in the MSCI global construction machinery stock index, including Caterpillar, Komatsu, Paccar, Cummins and Volvo B.  China’s construction machinery  net exports  will continue to rise, implying a rising market share for  mainland producers. This is a bad sign for  foreign producers. Global machinery producers will likely suffer from both shrinking demand in China and a loss of market share to mainland producers. In fact, both Caterpillar and Komatsu excavator sales are already in contraction, even though mainland excavator sales did not contract in 2019 (Chart I-14). Chart I-13Global Construction Machinery Stocks: Closely Correlate With Chinese Demand Global Construction Machinery Stocks: Closely Correlate With Chinese Demand Global Construction Machinery Stocks: Closely Correlate With Chinese Demand Chart I-14Caterpillar And Komatsu Sales: Shrinking Caterpillar And Komatsu Sales: Shrinking Caterpillar And Komatsu Sales: Shrinking   However, a caveat is in order: both Caterpillar and Komatsu have manufacturing factories in China, ranking the third and seventh place in terms of domestic excavator sales, respectively. Hence, domestic producers also include some multinationals that have established operations on the mainland. A point on equity valuations is also in order: Chart I-15 demonstrates the cyclically adjusted P/E ratio for Caterpillar. This stock is not yet cheap. As its sales contract, the stock price will fall further. Chart I-15Cyclically-Adjusted P/E Ratio For Caterpillar: Not Cheap Cyclically-Adjusted P/E Ratio For Caterpillar: Not Cheap Cyclically-Adjusted P/E Ratio For Caterpillar: Not Cheap Chart I-16Global Machinery Stocks Are At Risk Global Machinery Stocks Are At Risk Global Machinery Stocks Are At Risk Overall, trailing EPS of both global construction machinery companies and mainland producers listed on the A-share market are beginning to contract (Chart I-16). This entails that their share prices are at risk.   On the whole, we recommend avoiding or underweighting global machinery stocks. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com     Footnotes 1 Please note that all the Chinese construction machinery sales data used in this report are compiled by China Construction Machinery Association. Based on the Association’s definition, its sales data Include exports and domestic sales of domestically produced machineries, but exclude imports. However, exports are small so this sales data can be used as a proxy of domestic demand. 2 This measure includes not only “commodity buildings” but also buildings built by non-real estate developers.

Highlights The coronavirus is a wild card that may have a significant impact on the global economy, … : The COVID-19 outbreak is unfolding in real time, half a world away, and its ultimate course is uncertain. For now, our China strategists think the worst-case scenarios are unlikely, but we will not remain constructive if the virus outlook materially worsens. … but as long as there is not a significantly negative exogenous event, the US economy will be just fine, … : From a domestic perspective, the US expansion is in very good shape. Easy monetary conditions will support a range of activities, and a potent labor market will give increasing numbers of households the confidence and wherewithal to ramp up consumption. … and if there’s no recession, there will not be a bear market: Recessions and equity bear markets coincide, with stocks typically peaking six months ahead of the onset of a recession. If the next recession doesn’t come before late 2021/early 2022, the bull market should remain intact at least through the end of this year. What We Do US Investment Strategy’s stated mission is to analyze the US economy and its future direction for the purpose of helping clients make asset-allocation and portfolio-management decisions. As important as the economic backdrop is, however, we never forget that we are investment strategists, not economic forecasters. We don’t belabor the state of every facet of the economy because neither we nor our clients care about 10- to 20-basis-point wiggles in real GDP growth in themselves. They do want us to keep them apprised of the general trend, though, and we are always trying to assess it. Ultimately, macro analysis benefits investors by providing them with timely recognition of the approach or emergence of an inflection point in the cycles that matter most for financial assets. We view investment strategy as the practical application of the study of cycles, and we are continuously monitoring the business cycle, the credit cycle, the monetary policy cycle and the squishy and only sporadically relevant sentiment cycle. This week, we turn our attention to the business cycle, and the ongoing viability of the expansion, which is already the longest on record at 128 months and counting. If it remains intact, risk assets are likely to continue to generate returns in excess of returns on Treasuries and cash. The Message From Our Simple Recession Indicator We have previously described our simple recession indicator.1 It has just three components, and all three of them have to be sounding the alarm to conclude that a recession is imminent. Our first input is the slope of the yield curve, measured by the difference between the yield on the 10-year Treasury bond and the 3-month T-bill.2 The yield curve inverts when the 3-month bill yield exceeds the 10-year bond yield, and a recession has followed all but one yield curve inversion over the last 50 years (Chart 1). The yield curve inverted from May through September last year, and the coronavirus outbreak (COVID-19) has driven it to invert again, but the unprecedentedly negative term premium (Chart 2) has made the curve much more prone to set off a false alarm. Chart 1An Inverted Curve May Not Be What It Used To Be ... An Inverted Curve May Not Be What It Used To Be ... An Inverted Curve May Not Be What It Used To Be ... Chart 2... When A Negative Term Premium Is Holding Down Long Yields ... When A Negative Term Premium Is Holding Down Long Yields ... When A Negative Term Premium Is Holding Down Long Yields The indicator’s second input is the year-over-year change in the leading economic index (“LEI”). When the LEI contracts on a year-over-year basis, a recession typically ensues. As with the inverted yield curve, year-over-year contractions in the LEI have successfully called all of the recessions in the last 50 years with just one false positive (Chart 3). The LEI bounced off the zero line thanks to January’s strong reading, and the year-ago comparisons are much easier than they were last year, but we are mindful that it is flirting with sending a recession warning. Chart 3Leading Indicators Are Wobbly, ... Leading Indicators Are Wobbly, ... Leading Indicators Are Wobbly, ... It takes more than tight monetary conditions to make a recession, but you can't have one without them. To confirm the signal from the yield curve and the LEI and make it more robust, we also consider the monetary policy backdrop. Over the nearly 60 years for which BCA’s model calculates an equilibrium rate, every recession has occurred when the fed funds rate has exceeded our estimate of equilibrium (Chart 4). Tight monetary policy isn’t a sufficient condition for a recession – expansions continued for six more years despite tight policy in the mid-‘80s and mid-'90s – but it is a necessary one. Our indicator will not definitively signal an approaching recession until monetary conditions turn restrictive. Chart 4... But The Fed Is Nowhere Near Inducing A Recession ... But The Fed Is Nowhere Near Inducing A Recession ... But The Fed Is Nowhere Near Inducing A Recession Bottom Line: In our view, the yield curve and the LEI both represent yellow lights, though the LEI has a greater likelihood of turning red, especially in the wake of COVID-19. Monetary policy is unambiguously green, however, and we will not conclude that a recession is imminent until the Fed deliberately attempts to rein in the economy. Bolstering Theory With Observation A potential shortcoming of our recession indicator is its reliance on a theoretical concept. The equilibrium (or natural) rate of interest cannot be directly observed, so our judgment of whether monetary policy is easy or tight turns on an estimate. To bolster our assessment of whether or not the expansion can continue, we have been tracking the drivers of the main components of US output. Going back to the GDP equation from Introductory Macroeconomics, GDP = C + I + G + (X - M), we look at the forces supporting Consumption (C), Investment (I) and Government Spending (G). (Because the US is a comparatively closed economy in which trade plays a minor role, we ignore net exports (X-M).) Consumption is by far the largest component, accounting for two-thirds of overall output, while investment and government spending each contribute a sixth. As critical as consumption is for the US economy, it is not the whole story; smaller but considerably more volatile investment is capable of plunging the economy into a recession on its own. The Near-Term Outlook For Consumption Chart 5Labor Market Slack Has Been Absorbed Labor Market Slack Has Been Absorbed Labor Market Slack Has Been Absorbed Consumption depends on household income, the condition of household balance sheets, and households’ willingness to spend. The labor market remains extremely tight, with the unemployment rate at a 50-year low, and “hidden” unemployment dwindling as the supply of discouraged (Chart 5, top panel) and involuntary part-time workers (Chart 5, bottom panel) has withered. The prime-age employment-to-population ratio trails only the peak reached during the dot-com era (Chart 6), which bodes well for household income. The historical correlation between the prime-age non-employment-to-population ratio and wage gains has been quite robust, and compensation growth has plenty of room to run before it catches up with the best-fit line (Chart 7). Chart 6Prime-Age Employment Has Surged, ... Prime-Age Employment Has Surged, ... Prime-Age Employment Has Surged, ... Chart 7... And Wages Will Eventually Follow Suit Back To Basics Back To Basics Chart 8No Pressing Need To Save, Or Pay Down Debt No Pressing Need To Save, Or Pay Down Debt No Pressing Need To Save, Or Pay Down Debt Households can use additional income to increase savings or pay down debt instead of spending it, but it doesn’t look like they will. The savings rate is already quite elevated, having returned to its mid-‘90s levels (Chart 8, top panel); households have already run debt down to its post-dot-com bust levels (Chart 8, middle panel); and debt service is less demanding than it has been at any point in the last 40 years (Chart 8, bottom panel). The health of household balance sheets, and the recent pickup in the expectations component of the consumer confidence surveys, suggest that households have the ability and the willingness to keep consumption growing at or above trend.   Household balance sheets are healthy enough to support spending income gains; there's even room to borrow to augment them.           The Near-Term Outlook For Investment Table 1GDP Equation Recession Probabilities Back To Basics Back To Basics Chart 9A Budding Turnaround A Budding Turnaround A Budding Turnaround We previously identified investment as the individual component most likely to decline enough to zero out trend growth from the other two components (Table 1), and it was a drag in 2019, declining in each of the last three quarters to end the year more than 3% below its peak. We expect it will hold up better this year, however, as the capital spending intentions components of the NFIB survey of smaller businesses (Chart 9, top panel) and the regional Fed manufacturing surveys (Chart 9, bottom panel) have both pulled out of declines. The trade tensions with China weighed heavily on business confidence in 2019, but the signing of the Phase 1 trade agreement lifted that cloud, and we expect that capex will revive in line with confidence once COVID-19 has been subdued. Government Spending In An Election Year Chart 10State And Local Revenues Are Well Supported State And Local Revenues Are Well Supported State And Local Revenues Are Well Supported Heading into the most hotly contested election in many years, we confidently assert that federal spending is not going to go away. Regardless of party affiliation, everyone in Congress sees the appeal of distributing pork to their constituents. Spending by state and local governments, which accounts for 60% of aggregate government spending, should also hold up well, as a robust labor market will support state income tax (Chart 10, top panel) and sales tax (Chart 10, middle panel) receipts. Healthy trailing home price gains will support property tax assessments, keeping municipal coffers full (Chart 10, bottom panel). Coronavirus Uncertainties The coronavirus epidemic (COVID-19) is unfolding in real time, generating daily updates on new infections, deaths and recoveries. Any opinion we offer on the economy’s future is conditioned on the virus' ongoing course. If it takes a sharp turn for the worse, with more severe consequences than we had previously expected, it is likely that we will downgrade our outlook. For now, we are operating under the projection that the virus will cause China’s first quarter output to contract sharply enough to zero out global growth in the first quarter. Our base-case scenario, following from the work of our China Investment Strategy service, is fairly benign from there. For now, we are expecting that the worst of the effects will be confined to the first quarter, and that the Chinese economy and the global economy will bounce back vigorously in the second quarter and beyond, powered by pent-up demand that will go unfilled until the outbreak begins to recede. Our China strategists continue to be heartened by Chinese officials' aggressive (albeit belated) measures to stem the outbreak, revealed in the apparent slowing of the rate of new infections in Hubei province, the epicenter of the outbreak (Chart 11, top panel), and in the rest of China (Chart 11, bottom panel). They also expect a determined policy response to offset the drag from the epidemic (Charts 12 and 13), as officials pursue the imperative of meeting their goal to double the size of the economy between 2010 and 2020. Chart 11Stringent Quarantine Measures May Be Gaining Traction Back To Basics Back To Basics Chart 12The PBOC Is Doing Its Part, ... The PBOC Is Doing Its Part, ... The PBOC Is Doing Its Part, ... Chart 13... By Easing Monetary Conditions ... By Easing Monetary Conditions ... By Easing Monetary Conditions If the economy is expanding, investors' bar for de-risking should be high. Bottom Line: Our China strategists’ COVID-19 view remains fairly optimistic, though it is subject to unfolding developments. Our US view is contingent on BCA’s evolving COVID-19 views. Investment Implications As we noted at the outset, we are not interested in the economy for the economy’s sake; we are only interested in its impact on financial markets. The key business-cycle takeaway for markets is that bear markets and recessions typically coincide, as it is difficult to get a 20% decline at the index level without a meaningful decline in earnings, and earnings only decline meaningfully during recessions. No recession means no bear market, and it also means no meaningful pickup in loan delinquencies and defaults. The bottom line is that it is premature to de-risk while the expansion remains intact. We reiterate our recommendation that investors should remain at least equal weight equities in balanced portfolios, and at least equal weight spread product within fixed income allocations, though we may turn more cautious as we learn more about the progression of COVID-19.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the August 13, 2018 US Investment Strategy Special Report, "How Much Longer Can The Bull Market Last?" available at usis.bcaresearch.com. 2 We use the 3-month/10-year segment instead of the more common 2-year/10-year because the 3-month bill is a cleaner proxy for short rates than the 2-year note, which incorporates estimates of the Fed’s future actions.

Highlights Bulk commodity markets – chiefly iron ore and steel – could see sharp rallies once Chinese authorities give the all-clear on COVID-19 (the WHO’s official name for the coronavirus). These markets rallied sharply Tuesday, as President Xi vowed China would achieve its growth targets this year, which, all else equal, likely will require additional monetary and fiscal stimulus. China accounts for ~ 70% of the global trade in iron ore, and ~ 50% of global steel supply and demand. COVID-19-induced losses have hit Chinese demand for steel hard, forcing blast furnaces to sharply reduce output. However, this partly is being countered by transitory weather- and COVID-19-related disruptions that are reducing iron ore exports from Brazil and delaying Australian shipments. Iron ore inventories could be drawn hard in 2Q and 2H20 to meet demand as steelmakers rebuild stocks and construction and infrastructure projects restart (Chart of the Week). The Chinese Communist Party celebrates its 100th anniversary next year. To offset the COVID-19-induced drag on domestic growth this year, which could take GDP growth below 5%, and a weak GDP performance next year additional stimulus is an all-but-foregone conclusion. Feature When policymakers really want to jumpstart GDP growth, their playbook typically turns to the real economy via policies that encourage construction, infrastructure development and manufacturing. There is a compelling case a strong rally in iron ore and steel will accompany the containment of COVID-19, reversing the 14% and 4% declines in both since the start of the year (Chart 2). Chief among the drivers of the rally will be the increase in fiscal and monetary stimulus required to restore Chinese GDP growth disrupted by the COVID-19 outbreak, which could reduce annual growth closer to 5% than the ~ 6% rate policymakers were targeting. Chart of the WeekLow Iron Ore Stocks Setting Up A Rally Low Iron Ore Stocks Setting Up A Rally Low Iron Ore Stocks Setting Up A Rally Chart 2Policy Stimulus Will Reverse Declines In Iron Ore And Steel Prices Policy Stimulus Will Reverse Declines In Iron Ore And Steel Prices Policy Stimulus Will Reverse Declines In Iron Ore And Steel Prices There are a number of reasons for expecting this. 2020 marks the terminus of the decade-long policy evolution that was supposed to end with the realization of the “Chinese Dream.” Chief among the goals that were to be realized by the end of this year – which will usher in the 100th anniversary of the founding of the Chinese Communist Party in 2021 – are a doubling of per capita income and of GDP.1 The Communist Party in China has numerous policy levers it can pull to respond to worse-than-expected growth and economic shocks. These policies consume a lot of bulk commodities and base metals. When policymakers really want to jump-start GDP growth, their playbook typically turns to the real economy via policies that encourage construction, infrastructure development and manufacturing. This was clearly seen following the Global Financial Crisis (GFC) in 2008-09 (Chart 3). Even before the COVID-19 outbreak, policymakers made it clear they wanted to stabilize growth following the Sino-US trade war at the conclusion of the Central Economic Work Conference (CEWC) in December. Nominal wages and per capita income growth had been falling since 3Q18, imperilling one of the principal goals of the “Chinese Dream.” Chart 3Policy Stimulus Will Lift GDP And Iron Ore And Steel Prices Policy Stimulus Will Lift GDP And Iron Ore And Steel Prices Policy Stimulus Will Lift GDP And Iron Ore And Steel Prices Policymakers will aim for annualized quarterly growth of ~ 6.5% in 2Q- 4Q20 if their goal is simply to achieve 6% p.a. growth this year. Following that CEWC meeting, our colleagues at BCA’s China Investment Strategy (CIS) anticipated policymakers would announce growth targets at the National People’s Congress (NPC) meeting next month in the range of 5.8 and 6.2% p.a. growth, noting, “the Chinese economy needs to increase by 6% in 2020 to double its size from the 2010 level in real terms.”2 The growth rate required to put the economy on track to deliver on the “Chinese Dream” is now much higher following the COVID-19 outbreak, which could shave ~1% or more off China’s growth this year alone. This suggests policymakers will aim for annualized quarterly growth of ~ 6.5% in 2Q-4Q20 if their goal is simply to achieve 6% p.a. growth this year. This predisposes us to expect significant monetary and fiscal stimulus this year after the all-clear is sounded and the economy can return to its day-to-day activities. In addition – and by no means least of the concerns driving policymakers’ decisions – the 100th anniversary of the founding of the CCP will be celebrated next year, something policymakers at all levels have been looking forward to showcase the success of their revolution. A Boon For Bulks As monetary policy eases, the construction growth trajectory should pick up smartly. China accounts for ~ 70% of the global trade in iron ore. It is expected to import ~ 1.1 billion MT this year and next, based on estimates published by the Australian government’s Department of Industry, Innovation and Science in its December 2019 quarterly assessment (Chart 4). China will account for ~ 50% of global steel supply and demand, or roughly 900mm MT/yr in 2020 and 2021. The COVID-19 outbreak reduced utilization rates at the close to 250 steel mills monitored by Mysteel Global in China to 78%, a drop of 2.3pp.3 Platts estimates refined steel production could fall by 43mm MT by the end of February.4 Most of China’s steel output goes into commercial and residential construction (~ 35%), infrastructure (~20%), machinery (~ 20%), and automobile production (~ 7%), based on S&P Global Platts estimates.5 Residential construction began to recover last year, and residential housing inventories were declining relative to sales (Chart 5). In our view, once the COVID-19 infection rate falls outside Hubei Province – the epicenter of the outbreak – markets will begin pricing in a revival of commercial and residential construction in China. As monetary policy eases, the construction growth trajectory should pick up smartly (Chart 6). Chart 4China Dominates Iron Ore, Steel Markets Iron Ore, Steel Poised For Rally Iron Ore, Steel Poised For Rally   Chart 5Resumption Of Construction Will Lift Demand For Bulks Resumption Of Construction Will Lift Demand For Bulks Resumption Of Construction Will Lift Demand For Bulks Chart 6Easier Money And Credit Policy Will Revive Construction Easier Money And Credit Policy Will Revive Construction Easier Money And Credit Policy Will Revive Construction Infrastructure spending already was on track to increase prior to the COVID-19 outbreak, based on our CIS colleagues’ reading of the CEWC statement issued in December, which “suggests fiscal support to the economy will mainly focus on infrastructure, and listed transportation, urban and rural development, and the 5G networks to be the government’s main investment projects next year.”6 This fiscal push will be supported by additional spending at the local government level, and by the issuance of special-purpose bonds by these governments with proceeds earmarked for infrastructure development (Chart 7). “A bigger fiscal push by the central government, coupled with a frontloading of 2020 local government special-purpose bond issuance, will likely boost infrastructure spending to around 10% in the first two quarters, doubling the growth in the first eleven months of 2019,” according to our CIS colleagues. Chart 7Pump Priming Will Boost Infrastructure Spending Pump Priming Will Boost Infrastructure Spending Pump Priming Will Boost Infrastructure Spending Bottom Line: Infrastructure fixed asset investment will be supported by easier credit and fiscal policy in China. Whether it rises at double-digit growth rates remains to be seen, however. Expect Chinese Consumers To Come Out Spending Infrastructure fixed asset investment will be supported by easier credit and fiscal policy in China. Prior to the outbreak of COVID-19, consumer confidence was running high (Chart 8), and employment prospects have bottomed and turned higher, although they still indicate contraction. (Chart 9). This boded well for consumer-spending expectations, particularly for autos (Chart 10). Chart 8Consumer Confidence Was High Prior to COVID-19 Outbreak ... Consumer Confidence Was High Prior to COVID-19 Outbreak ... Consumer Confidence Was High Prior to COVID-19 Outbreak ... Chart 9... And Job Prospects Were Improving ... ... And Job Prospects Were Improving ... ... And Job Prospects Were Improving ... At ~ 7%, China’s automobile production remains a marginal contributor to overall steel consumption. Nonetheless, a meaningful pickup in automobile production following the depressed growth rate of the past 15 months would move steel demand upward. China’s share of world auto sales is ~30% (Chart 11). Chart 10... Thus Lifting Prospects For Chinese Auto Sales ... Thus Lifting Prospects For Chinese Auto Sales ... Thus Lifting Prospects For Chinese Auto Sales   Chart 11Policy Stimulus Will Revive Chinese Auto Sector Policy Stimulus Will Revive Chinese Auto Sector Policy Stimulus Will Revive Chinese Auto Sector Accommodative monetary and fiscal policies in China point toward higher growth for the auto sector. However, it is important to note the revival in auto production needs to be driven by consumer demand – if it is led simply by restocking, the rebound will not be sustainable. The recovery we are expecting will support steel and metal consumption at the margin, but the outlook for infrastructure and construction remains key due to their higher weight in total steel consumption. Bottom Line: Auto consumption and production were recovering in late 2019; however, the strength of the recovery did not match previous stimulus programs (2009 and 2016). The recovery we are expecting this year will support steel and metal consumption at the margin, but the outlook for infrastructure and construction remains key due to their higher weight in total steel consumption. If these other sectors remain constructive for metal demand (or at least are not contracting or slowing drastically), the boost from the auto sector will meaningfully contribute to higher iron ore and steel prices.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com     Commodities Round-Up Energy: Overweight Oil prices halted their decline and rose 1% on Tuesday as the number of daily confirmed cases of the Wuhan coronavirus decelerated in China. As of Tuesday, the daily growth in cases dropped to 5%, down from 6% the previous day. Investors will closely monitor this number for any sign of a durable slowdown in daily confirmed cases. Separately, the US Energy Information Administration revised down its global demand growth estimates for 2020 to 1.0mm b/d from 1.3mm b/d last month, reflecting the effects of the coronavirus and warmer-than-expected January temperatures in the northern hemisphere. We will be updating our global oil balances next week. Base Metals: Neutral Iron ore prices fell 14% since the COVID-2019 outbreak in January. Investors are assessing how the iron ore market will balance weaker demand expectations in China amid lower supply – largely a result of falling Brazilian ore exports. Brazil’s total iron ore exports fell ~19% y/y in January due to heavy rainfall and lower production at Brazilian miner Vale. The company’s output never fully recovered from the 2019 dam incident and remains a risk to iron ore supply in 1Q20. Vale lowered its March sales guidance by 2mm MT. Low Chinese port inventories raise prices’ vulnerability to supply disruptions (Chart 12). Precious Metals: Neutral Gold remains well bid despite a strong US dollar, fueled by safe-haven demand. The yellow metal’s price fell slightly on Tuesday as investors’ concerns over the coronavirus eased. Based on our fair-value model, prices averaged $55/oz above our estimate in January. Investors – i.e. global ETF holders and net speculative positions reported by the US CFTC – have been important contributors to the latest gold rally. Investors’ total holding of gold reached a record high 113mm oz last week. Nonetheless, we believe there is still opportunity for this group to further support prices: the share of gold allocation vs. world equity-market capitalization is still low at 0.24%, vs. its peak of 0.42% in 2012 (Chart 13). Ags/Softs:  Underweight March wheat futures were down 1.8% at Tuesday’s close, settling at the lowest level of the year after the USDA called for ‘stable supplies’ of the grain for the 2019/2020 U.S. marketing year. For corn, ending stocks were unchanged relative to the January projection, while world production was revised slightly upwards. March corn futures finished 2¢ lower at $3.7975/bu. The USDA also estimated higher soybean exports on the back of increased sales to China. However, soybean price gains were limited by higher production and ending stocks abroad. Chart 12Low Iron Ore Inventory Raises Exposure To Supply Disruptions Low Iron Ore Inventory Raises Exposure To Supply Disruptions Low Iron Ore Inventory Raises Exposure To Supply Disruptions Chart 13A Higher Share Of Gold Holdings Could Support Prices Further A Higher Share Of Gold Holdings Could Support Prices Further A Higher Share Of Gold Holdings Could Support Prices Further   Footnotes 1     The “Chinese Dream” is a phrase coined by President Xi Jinping, following the 18th Party Congress of the Chinese Communist Party in 2012, when the overarching goal of transforming China into a “moderately well-off society” was memorialized in writing. These goals were crystalized in terms of progress expected in per capita income and GDP, both of which were to be doubled in the decade ending this year. Please see Why 2020 Is a Make-or-Break Year for China published by thediplomat.com February 13, 2015. 2     Please see A Year-End Tactical Upgrade, published by BCA Research’s China Investment Strategy December 18, 2019, for an in-depth analysis of policy guidance coming out of the Economic Work Conference last December. It is available at cis.bcaresearch.com. 3    Please see WEEKLY: China’s blast furnace capacity use drops to 78% published by Mysteel Global February 10, 2020. 4    Please see China steel consumption to plunge by up to 43 mil mt in February due to coronavirus published February 6, 2020, by S&P Global Platts. 5    Please see China Macro & Metals: Steel output falls, but property creates bright spots published by S&P Global Platts December 6, 2019. 6    Please see footnote 2 above. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Iron Ore, Steel Poised For Rally Iron Ore, Steel Poised For Rally Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Iron Ore, Steel Poised For Rally Iron Ore, Steel Poised For Rally

Dear Clients, Please note that this week we are re-publishing a Special Report written by our Emerging Market Strategy team and published on January 7, 2020. The report, authored by Ellen JingYuan He, is an extension of the Special Report published in September 2017 and examines the progress made in China’s “Belt and Road Initiative (BRI)” since its implementation in 2013.  This Special Report concludes that going forward, the Chinese government will likely shift to a stricter regulatory stance in BRI project financing. The shift will lead to a modest pullback in realized BRI investment in 2020. However, given the small size of BRI investments relative to China’s total capital spending, the recovery in Chinese capital goods imports still hinges on the domestic property and infrastructure spending cycle.  I trust you will find this report insightful. In addition, we are closing our long USD/CNH trade, initiated in May 2019 as a currency hedge for our cyclical overweight in Chinese stocks and corporate bonds (denominated in USD terms). As we mentioned in last week’s China Macro and Market Review, upon the signing of the Phase One trade deal on January 15, we expect further modest strengthening in the Chinese currency as China’s economy continues to improve. Therefore, the currency hedge is no longer needed and we recommend that investors favor Chinese stocks and bonds versus the global benchmark in unhedged terms.  Best regards, Jing Sima, China Investment Strategist   Highlights The Chinese government will be applying more scrutiny and tighter oversight over lending for ‘Belt and Road’ Initiative (BRI) projects going forward. As a result, total BRI investment with Chinese financing will fall moderately – by 5% to US$135 billion in 2020 from US$142 billion in 2019. BRI investment is too small relative to mainland capital spending. Hence, the global outlook for capital goods and industrial commodities will be driven by Chinese capex, not BRI. BRI Overview Chart I-1Chinese BRI Investment: Likely To Decline In 2020 Chinese BRI Investment: Likely To Decline In 2020 Chinese BRI Investment: Likely To Decline In 2020 China has been promoting and implementing its strategic ‘Belt and Road’ Initiative (BRI) since late 2013. The country has so far signed about 200 BRI cooperation documents with 137 countries and 30 international organizations. The government’s strong push has resulted in a surge in Chinese BRI investment, albeit with a major downturn in 2018 (Chart I-1). BRI projects center on infrastructure development such as transportation (railways, highways, subways and bridges), energy (power plants and pipelines) and telecommunications infrastructure in recipient countries covered by the BRI program. Chart I-2 demonstrates the geographical reach of the BRI as well as transportation linkages/routes being built and funded by it. We discussed the BRI in great detail in a special report published in September 2017. Chart I-2The Belt And Road Program China’s Belt And Road Initiative: Entering A Cooling-Down Phase China’s Belt And Road Initiative: Entering A Cooling-Down Phase The cumulative size of the signed contracts with BRI-recipient countries over the past six years is about US$700 billion, of which US$460 billion has already been completed. However, the value of newly signed contracts in a year does not equal the actual project investment that occurred in that year, as these contracts generally take several years to be implemented and completed. In this report, “BRI investment” encompasses realized investments for BRI projects, which we derive from the official data of “BRI newly signed contracts.” Based on our calculations, Chinese BRI investment reached about US$142 billion in 2019, equaling about 2% of nominal gross fixed capital formation (GFCF) in China. The latter in 2019 was about US$6 trillion. Yet, BRI is much larger than multilateral funding for the developing world. For example, current annual financing disbursements from the World Bank are only about US$50 billion. Looking into 2020, due to a number of considerations, the Chinese government’s attitude towards BRI project financing will continue to shift from aggressive to a stricter and more-cautious stance. Looking into 2020, due to a number of considerations, the Chinese government’s attitude towards BRI project financing will continue to shift from aggressive to a stricter and more-cautious stance. Consequently, we expect a 10% decline in the total value of annual newly signed contracts in 2020, slightly less than the 13% decline in 2018. In addition, we also expect the average implementation period for BRI projects to be slightly longer this year than last year. Based on these expectations, our projection is that realized Chinese BRI investment in 2020 will likely fall moderately – by 5% to US$135 billion this year from US$142 billion in 2019 (Chart I-1 and Table I-1). Table I-1Projection Of Chinese BRI Project Investment In 2020 China’s Belt And Road Initiative: Entering A Cooling-Down Phase China’s Belt And Road Initiative: Entering A Cooling-Down Phase BRI Investments: More Scrutiny Ahead The Chinese authorities are constantly recalibrating their BRI implementation strategy. The lessons learned over the past six years as well as shifting domestic macro and global geopolitical landscapes all suggest even more scrutiny ahead. First, the Chinese government has learned hard lessons that easy large lending/financing can result in unanticipated negative consequences. In the past six years, the Chinese government has actively promoted the BRI by providing considerable amounts of financing to BRI projects. The main objectives of the BRI have been: (1) to export China’s excess capacity in heavy industries and construction to other countries; and (2) to build transportation and communication networks to facilitate trade between China and other regions. Although the projects have indeed improved infrastructure and connectivity and boosted both current and potential growth rates in the recipient countries, there have been numerous cases of debt restructuring demand by borrowers as well as growing criticism on China’s BRI as “debt trap diplomacy.” The argument is that China makes loans and uses the debt as leverage to secure land or strategic infrastructure in the recipient countries – in addition to the Middle Kingdom promoting its own geopolitical interests. History will eventually reveal whether BRI constituted “debt trap diplomacy.” As of now, China has either renegotiated or written off debt for some debt-strapped BRI- recipient countries rather than seize their assets. Among all BRI projects spreading over 60 countries in the past six years, there has been only one asset seizure case in Sri Lanka. Crucially, increasingly more BRI-recipient countries are now demanding to renegotiate the terms of their loans and financing, asking China for more favorable concessions, debt forgiveness and write-offs. The reasons run the gamut: from BRI projects not generating enough cash flow to service debt to simple requests among recipient countries for better financing terms. These demands are reducing the value of China’s claims on both BRI projects and recipient countries, and curtailing its willingness to finance more BRI projects. In general, China has learned again that substantially augmenting investments in a single stroke – whether on the mainland or in other countries – produces capital misallocation. The latter results in unviable debtors and bad assets on balance sheets of financiers. Second, many BRI investment projects have suffered delays or cancellations due to changes in the recipient countries’ governments. Reducing both unanticipated negative consequences and unexpected delays/ cancellations requires more scrutiny and tighter oversight on BRI projects by the Chinese government, which is on the way. In April 2019, Chinese President Xi Jinping called for high-quality, sustainability and transparency in implementing BRI projects, as well as a zero-tolerance policy towards corruption. He also stressed that China would only support open cooperation and clean governance when pursuing BRI projects. China’s Ministry of Finance last year released a new document titled, The Debt Sustainability Framework for Participating Countries of the Belt and Road Initiative, in order to identify debt stress among recipient countries and prevent defaults. China, in April, rejected the Kenyan government’s request of US$3.7 billion in new loans for the third phase of its standard gauge railway (SGR) line amid concerns about the country’s finances. In Zimbabwe, the Export-Import Bank of China backed out of providing financing for a giant solar project due to the government’s legacy debts. To be sure, like any lender, the risks and costs fall to Chinese banks and financing providers in the event of a default. Therefore, increasing scrutiny of such projects is in the best interests of China as a whole. That said, the BRI is a signature initiative of President Xi and still has many positives for China. Specifically, it helps the country export its excess capacity, increase its trade with the rest of the world and expand the country’s geopolitical influence. Therefore, any slowdown in the BRI will be marginal. China will tweak and may reduce the pace of BRI investment moderately, but it will not halt it outright. Like any lender, the risks and costs fall to Chinese banks and financing providers in the event of a default. Therefore, increasing scrutiny of such projects is in the best interests of China as a whole. Bottom Line: There will be increasing scrutiny of BRI projects by the Chinese government. Consequently, it will become incrementally more difficult for BRI countries to obtain financing from China in 2020. Nevertheless, the pace of BRI will slow somewhat but not plunge, given the program’s strategic benefits for China. BRI Financing: Switching From Dollar- To Yuan-Denominated Chinese banks have been the major BRI funding providers. Table I-2 shows Chinese policy banks and large state-owned commercial banks accounted for about 51% and 41% of BRI funding in the past five years, respectively. Table I-2China's BRI Funding Sources During 2014-2018 China’s Belt And Road Initiative: Entering A Cooling-Down Phase China’s Belt And Road Initiative: Entering A Cooling-Down Phase Debt and equity financing are the two major types of BRI funding, with the former playing the dominant role in the form of bank loans and BRI-specialized bond issuance. While the majority of BRI financing to date – about 83% of the total, according to our estimates – has been denominated in foreign currency (mainly in US dollars), there has been a noticeable rise in loans and bond issuance denominated in yuan. In May 2017, President Xi encouraged domestic financial institutions to promote overseas RMB-denominated financing for BRI projects. In the past two and a half years, about 17% of BRI financing has been in yuan. Before May 2017, such yuan-denominated loans for BRI projects were insignificant. Yuan-denominated BRI loans: The two Chinese policy banks have provided more than RMB 380 billion (equivalent to US$55 billion) in BRI-specialized loans in RMB terms over the past two and half years. Offshore yuan-denominated BRI-related bond issuance by Chinese banks and companies: There has been an increasing amount of BRI-specialized bond issuance in RMB terms offshore over the past several years as well. Onshore yuan-denominated BRI-related bond issuance by governments and organizations/companies of recipient countries: Since 2018, foreign private companies and government agencies have been allowed to issue RMB-denominated BRI bonds onshore in China. There are three reasons why the Chinese authorities will continue to encourage more yuan-denominated financing for BRI projects. Chart I-3China: Few FX Reserves Compared With RMB Money Supply China: Few FX Reserves Compared With RMB Money Supply China: Few FX Reserves Compared With RMB Money Supply First, balance-of-payment constraints make RMB funding for BRI more desirable. US dollar financing for BRI initiatives inevitably creates demand for the People’s Bank of China’s increasingly precious foreign-exchange resources. The main risk to China’s balance of payments is the 177 trillion of local currency deposits of households and enterprises. The PBoC’s US$3 trillion in foreign exchange reserves accounts for only 12% of Chinese total deposits (Chart I-3). Chinese households and private enterprises prefer to hold a higher proportion of their assets in foreign currencies than they do now. This will continue to generate capital outflows, and risks depleting the nation’s foreign currency reserves. Given potential capital outflows from the domestic private sector, China will be careful in expanding state-sponsored capital outflows, including US dollar-denominated BRI financing. Therefore, increasing RMB-denominated funding will reduce US dollar outflows and diminish pressure on China’s foreign exchange reserves. Second, providing BRI financing in yuan promotes RMB internationalization, which is a major long-term objective of China. When a borrower (whether Chinese or foreign entity) with a BRI project obtains yuan-denominated financing, it is encouraged to also pay its suppliers in yuan. As a result, more global trade is settled in renminbi, promoting its internationalization. This is especially convenient when the borrower buys goods and services from China, as they can easily pay in yuan. In cases where a borrower has to buy services and equipment from other countries and is required to pay in US dollars, the renminbis will go into foreign exchange markets. On margin, this will drive the yuan’s value versus the US dollar lower. Provided China has excess capacity in many raw materials and industrial goods, there is a lot of scope to expand RMB financing for BRI projects, with limited downward pressure on the yuan’s exchange rate. In short, RMB-denominated funding will be used to buy Chinese goods. Chart I-4Low Odds Of Acceleration In Bank Financing In 2020 Low Odds Of Acceleration In Bank Financing In 2020 Low Odds Of Acceleration In Bank Financing In 2020 Finally, in any country, banks originate local-currency denominated loans “out of thin air,” – i.e., bank balance sheet expansion is not constrained by national savings. We have written about this extensively in numerous past reports. Theoretically, there is no hard limit on much in yuan-denominated loans Chinese commercial banks can originate, nor how many yuan-denominated bonds they can buy. What constrains commercial banks from expanding their assets infinitely is banking regulation, liquidity constraints (their excess reserves at the central bank rather than deposits), worries about asset impairment and a lack of loan demand among borrowers. Among these, the most pertinent that could cap the amount of BRI financing originated by Chinese banks is macro-prudential bank regulation that is being implemented by regulators in a piecemeal way to cap leverage among enterprises, households, local governments and banks themselves. Chart I-4 illustrates that banks’ asset growth is on par with nominal GDP, and has recently rolled over. The Chinese authorities target bank assets, bank broad credit and broad money growth at the level of potential nominal GDP growth. This entails low odds of acceleration in bank financing in general and BRI projects in particular. Meanwhile, the need for BRI debt restructuring and provisioning will also lead mainland commercial banks to become slightly more cautious in BRI financing. Bottom Line: Both RMB- and US dollar- denominated financing for BRI projects will marginally diminish in 2020. Macro Implications Chart I-5Deep Contraction In Chinese Property Construction... Deep Contraction In Chinese Property Construction... Deep Contraction In Chinese Property Construction... Implications For Commodities And Capital Goods The size of BRI investments in 2019 – US$142 billion – accounts for only about 2% of China’s nominal GFCF. Hence, BRI investment is too small relative to mainland capital spending. This is why we often do not incorporate BRI when analyzing China’s capital spending cycle. In 2020, we are still negative on China’s property construction activity due to weak real estate demand and increasing difficulty for indebted property developers to secure financing (Chart I-5). There will likely be a moderate growth rebound in Chinese infrastructure investment. However, it will not be able to offset the negative impact on commodities and capital goods from weaker BRI investment and mainland contracting property construction. All in all, the recovery in Chinese capital goods imports will be moderate (Chart I-6). Notably, prices of steel, industrial metals and other raw materials do not signal widespread and robust recovery as of now (Chart I-7). Chart I-6...And In Chinese Capital Goods Imports ...And In Chinese Capital Goods Imports ...And In Chinese Capital Goods Imports Chart I-7Commodity Prices Do Not Signal Widespread And Robust Recovery Commodity Prices Do Not Signal Widespread And Robust Recovery Commodity Prices Do Not Signal Widespread And Robust Recovery     Impact On Chinese Exports Chinese exports to BRI countries have done much better than its shipments elsewhere (Chart I-8). For example, Chinese exports to ASEAN countries showed a strong 10.4% year-on-year growth in 2019, versus a 1% contraction in overall exports. The ASEAN countries that received significant amounts of BRI investments posted double-digit growth in imports from China. There are two primary reasons behind the stronger growth in Chinese exports to BRI-recipient countries. 1. As most of China’s BRI investment has focused on infrastructure projects, it has significantly increased recipient countries’ imports of capital goods and raw materials. Chart I-9 shows that Chinese exports of digging and excavating machines have gone vertical. Chart I-8Strong Growth In Chinese Exports To BRI Countries Strong Growth In Chinese Exports To BRI Countries Strong Growth In Chinese Exports To BRI Countries Chart I-9Surging Chinese Exports Of Digging And Excavating Machines Surging Chinese Exports Of Digging And Excavating Machines Surging Chinese Exports Of Digging And Excavating Machines   2. Considerable BRI investment has propelled recipient countries’ income growth. Chart I-10 reveals a positive correlation between capital spending as a share of GDP and real GDP growth across 33 BRI-receiving developing economies during the BRI implementation period of 2014-2018. Hence, BRI investments have considerable impact on both potential and current growth of recipient countries. Chart I-10Strong Capital Spending Tend To Facilitate Real Economic Growth China’s Belt And Road Initiative: Entering A Cooling-Down Phase China’s Belt And Road Initiative: Entering A Cooling-Down Phase Chart I-11BRI Helped Boost Chinese Consumer Goods Exports BRI helped Boost Chinese Consumer Goods Exports BRI helped Boost Chinese Consumer Goods Exports Robust income growth has boosted demand for household goods (Chart I-11). China has a very strong competitive advantage in consumer goods production, especially in low-price segments that are popular in developing economies. Despite a slight drop in overall BRI investment, we still expect solid growth (albeit less than in 2019) in Chinese exports to BRI countries in 2020. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations

Highlights The Chinese government will be applying more scrutiny and tighter oversight over lending for ‘Belt and Road’ Initiative (BRI) projects going forward. As a result, total BRI investment with Chinese financing will fall moderately – by 5% to US$135 billion in 2020 from US$142 billion in 2019. BRI investment is too small relative to mainland capital spending. Hence, the global outlook for capital goods and industrial commodities will be driven by Chinese capex, not BRI. BRI Overview Chart I-1Chinese BRI Investment: Likely To Decline In 2020 Chinese BRI Investment: Likely To Decline In 2020 Chinese BRI Investment: Likely To Decline In 2020 China has been promoting and implementing its strategic ‘Belt and Road’ Initiative (BRI) since late 2013. The country has so far signed about 200 BRI cooperation documents with 137 countries and 30 international organizations. The government’s strong push has resulted in a surge in Chinese BRI investment, albeit with a major downturn in 2018 (Chart I-1). BRI projects center on infrastructure development such as transportation (railways, highways, subways and bridges), energy (power plants and pipelines) and telecommunications infrastructure in recipient countries covered by the BRI program. Chart I-2 demonstrates the geographical reach of the BRI as well as transportation linkages/routes being built and funded by it. We discussed the BRI in great detail in a special report published in September 2017. Chart I-2The Belt And Road Program China’s Belt And Road Initiative: Entering A Cooling-Down Phase China’s Belt And Road Initiative: Entering A Cooling-Down Phase The cumulative size of the signed contracts with BRI-recipient countries over the past six years is about US$700 billion, of which US$460 billion has already been completed. However, the value of newly signed contracts in a year does not equal the actual project investment that occurred in that year, as these contracts generally take several years to be implemented and completed. In this report, “BRI investment” encompasses realized investments for BRI projects, which we derive from the official data of “BRI newly signed contracts.” Based on our calculations, Chinese BRI investment reached about US$142 billion in 2019, equaling about 2% of nominal gross fixed capital formation (GFCF) in China. The latter in 2019 was about US$6 trillion. Yet, BRI is much larger than multilateral funding for the developing world. For example, current annual financing disbursements from the World Bank are only about US$50 billion. Looking into 2020, due to a number of considerations, the Chinese government’s attitude towards BRI project financing will continue to shift from aggressive to a stricter and more-cautious stance. Looking into 2020, due to a number of considerations, the Chinese government’s attitude towards BRI project financing will continue to shift from aggressive to a stricter and more-cautious stance. Consequently, we expect a 10% decline in the total value of annual newly signed contracts in 2020, slightly less than the 13% decline in 2018. In addition, we also expect the average implementation period for BRI projects to be slightly longer this year than last year. Based on these expectations, our projection is that realized Chinese BRI investment in 2020 will likely fall moderately – by 5% to US$135 billion this year from US$142 billion in 2019 (Chart I-1 and Table I-1). Table I-1Projection Of Chinese BRI Project Investment In 2020 China’s Belt And Road Initiative: Entering A Cooling-Down Phase China’s Belt And Road Initiative: Entering A Cooling-Down Phase BRI Investments: More Scrutiny Ahead The Chinese authorities are constantly recalibrating their BRI implementation strategy. The lessons learned over the past six years as well as shifting domestic macro and global geopolitical landscapes all suggest even more scrutiny ahead. First, the Chinese government has learned hard lessons that easy large lending/financing can result in unanticipated negative consequences. In the past six years, the Chinese government has actively promoted the BRI by providing considerable amounts of financing to BRI projects. The main objectives of the BRI have been: (1) to export China’s excess capacity in heavy industries and construction to other countries; and (2) to build transportation and communication networks to facilitate trade between China and other regions. Although the projects have indeed improved infrastructure and connectivity and boosted both current and potential growth rates in the recipient countries, there have been numerous cases of debt restructuring demand by borrowers as well as growing criticism on China’s BRI as “debt trap diplomacy.” The argument is that China makes loans and uses the debt as leverage to secure land or strategic infrastructure in the recipient countries – in addition to the Middle Kingdom promoting its own geopolitical interests. History will eventually reveal whether BRI constituted “debt trap diplomacy.” As of now, China has either renegotiated or written off debt for some debt-strapped BRI- recipient countries rather than seize their assets. Among all BRI projects spreading over 60 countries in the past six years, there has been only one asset seizure case in Sri Lanka. Crucially, increasingly more BRI-recipient countries are now demanding to renegotiate the terms of their loans and financing, asking China for more favorable concessions, debt forgiveness and write-offs. The reasons run the gamut: from BRI projects not generating enough cash flow to service debt to simple requests among recipient countries for better financing terms. These demands are reducing the value of China’s claims on both BRI projects and recipient countries, and curtailing its willingness to finance more BRI projects. In general, China has learned again that substantially augmenting investments in a single stroke – whether on the mainland or in other countries – produces capital misallocation. The latter results in unviable debtors and bad assets on balance sheets of financiers. Second, many BRI investment projects have suffered delays or cancellations due to changes in the recipient countries’ governments. Reducing both unanticipated negative consequences and unexpected delays/ cancellations requires more scrutiny and tighter oversight on BRI projects by the Chinese government, which is on the way. In April 2019, Chinese President Xi Jinping called for high-quality, sustainability and transparency in implementing BRI projects, as well as a zero-tolerance policy towards corruption. He also stressed that China would only support open cooperation and clean governance when pursuing BRI projects. China’s Ministry of Finance last year released a new document titled, The Debt Sustainability Framework for Participating Countries of the Belt and Road Initiative, in order to identify debt stress among recipient countries and prevent defaults. China, in April, rejected the Kenyan government’s request of US$3.7 billion in new loans for the third phase of its standard gauge railway (SGR) line amid concerns about the country’s finances. In Zimbabwe, the Export-Import Bank of China backed out of providing financing for a giant solar project due to the government’s legacy debts. To be sure, like any lender, the risks and costs fall to Chinese banks and financing providers in the event of a default. Therefore, increasing scrutiny of such projects is in the best interests of China as a whole. That said, the BRI is a signature initiative of President Xi and still has many positives for China. Specifically, it helps the country export its excess capacity, increase its trade with the rest of the world and expand the country’s geopolitical influence. Therefore, any slowdown in the BRI will be marginal. China will tweak and may reduce the pace of BRI investment moderately, but it will not halt it outright. Like any lender, the risks and costs fall to Chinese banks and financing providers in the event of a default. Therefore, increasing scrutiny of such projects is in the best interests of China as a whole. Bottom Line: There will be increasing scrutiny of BRI projects by the Chinese government. Consequently, it will become incrementally more difficult for BRI countries to obtain financing from China in 2020. Nevertheless, the pace of BRI will slow somewhat but not plunge, given the program’s strategic benefits for China. BRI Financing: Switching From Dollar- To Yuan-Denominated Chinese banks have been the major BRI funding providers. Table I-2 shows Chinese policy banks and large state-owned commercial banks accounted for about 51% and 41% of BRI funding in the past five years, respectively. Table I-2China's BRI Funding Sources During 2014-2018 China’s Belt And Road Initiative: Entering A Cooling-Down Phase China’s Belt And Road Initiative: Entering A Cooling-Down Phase Debt and equity financing are the two major types of BRI funding, with the former playing the dominant role in the form of bank loans and BRI-specialized bond issuance. While the majority of BRI financing to date – about 83% of the total, according to our estimates – has been denominated in foreign currency (mainly in US dollars), there has been a noticeable rise in loans and bond issuance denominated in yuan. In May 2017, President Xi encouraged domestic financial institutions to promote overseas RMB-denominated financing for BRI projects. In the past two and a half years, about 17% of BRI financing has been in yuan. Before May 2017, such yuan-denominated loans for BRI projects were insignificant. Yuan-denominated BRI loans: The two Chinese policy banks have provided more than RMB 380 billion (equivalent to US$55 billion) in BRI-specialized loans in RMB terms over the past two and half years. Offshore yuan-denominated BRI-related bond issuance by Chinese banks and companies: There has been an increasing amount of BRI-specialized bond issuance in RMB terms offshore over the past several years as well. Onshore yuan-denominated BRI-related bond issuance by governments and organizations/companies of recipient countries: Since 2018, foreign private companies and government agencies have been allowed to issue RMB-denominated BRI bonds onshore in China. There are three reasons why the Chinese authorities will continue to encourage more yuan-denominated financing for BRI projects. Chart I-3China: Few FX Reserves Compared With RMB Money Supply China: Few FX Reserves Compared With RMB Money Supply China: Few FX Reserves Compared With RMB Money Supply First, balance-of-payment constraints make RMB funding for BRI more desirable. US dollar financing for BRI initiatives inevitably creates demand for the People’s Bank of China’s increasingly precious foreign-exchange resources. The main risk to China’s balance of payments is the 177 trillion of local currency deposits of households and enterprises. The PBoC’s US$3 trillion in foreign exchange reserves accounts for only 12% of Chinese total deposits (Chart I-3). Chinese households and private enterprises prefer to hold a higher proportion of their assets in foreign currencies than they do now. This will continue to generate capital outflows, and risks depleting the nation’s foreign currency reserves. Given potential capital outflows from the domestic private sector, China will be careful in expanding state-sponsored capital outflows, including US dollar-denominated BRI financing. Therefore, increasing RMB-denominated funding will reduce US dollar outflows and diminish pressure on China’s foreign exchange reserves. Second, providing BRI financing in yuan promotes RMB internationalization, which is a major long-term objective of China. When a borrower (whether Chinese or foreign entity) with a BRI project obtains yuan-denominated financing, it is encouraged to also pay its suppliers in yuan. As a result, more global trade is settled in renminbi, promoting its internationalization. This is especially convenient when the borrower buys goods and services from China, as they can easily pay in yuan. In cases where a borrower has to buy services and equipment from other countries and is required to pay in US dollars, the renminbis will go into foreign exchange markets. On margin, this will drive the yuan’s value versus the US dollar lower. Provided China has excess capacity in many raw materials and industrial goods, there is a lot of scope to expand RMB financing for BRI projects, with limited downward pressure on the yuan’s exchange rate. In short, RMB-denominated funding will be used to buy Chinese goods. Chart I-4Low Odds Of Acceleration In Bank Financing In 2020 Low Odds Of Acceleration In Bank Financing In 2020 Low Odds Of Acceleration In Bank Financing In 2020 Finally, in any country, banks originate local-currency denominated loans “out of thin air,” – i.e., bank balance sheet expansion is not constrained by national savings. We have written about this extensively in numerous past reports. Theoretically, there is no hard limit on much in yuan-denominated loans Chinese commercial banks can originate, nor how many yuan-denominated bonds they can buy. What constrains commercial banks from expanding their assets infinitely is banking regulation, liquidity constraints (their excess reserves at the central bank rather than deposits), worries about asset impairment and a lack of loan demand among borrowers. Among these, the most pertinent that could cap the amount of BRI financing originated by Chinese banks is macro-prudential bank regulation that is being implemented by regulators in a piecemeal way to cap leverage among enterprises, households, local governments and banks themselves. Chart I-4 illustrates that banks’ asset growth is on par with nominal GDP, and has recently rolled over. The Chinese authorities target bank assets, bank broad credit and broad money growth at the level of potential nominal GDP growth. This entails low odds of acceleration in bank financing in general and BRI projects in particular. Meanwhile, the need for BRI debt restructuring and provisioning will also lead mainland commercial banks to become slightly more cautious in BRI financing. Bottom Line: Both RMB- and US dollar- denominated financing for BRI projects will marginally diminish in 2020. Macro Implications Chart I-5Deep Contraction In Chinese Property Construction... Deep Contraction In Chinese Property Construction... Deep Contraction In Chinese Property Construction... Implications For Commodities And Capital Goods The size of BRI investments in 2019 – US$142 billion – accounts for only about 2% of China’s nominal GFCF. Hence, BRI investment is too small relative to mainland capital spending. This is why we often do not incorporate BRI when analyzing China’s capital spending cycle. In 2020, we are still negative on China’s property construction activity due to weak real estate demand and increasing difficulty for indebted property developers to secure financing (Chart I-5). There will likely be a moderate growth rebound in Chinese infrastructure investment. However, it will not be able to offset the negative impact on commodities and capital goods from weaker BRI investment and mainland contracting property construction. All in all, the recovery in Chinese capital goods imports will be moderate (Chart I-6). Notably, prices of steel, industrial metals and other raw materials do not signal widespread and robust recovery as of now (Chart I-7). Chart I-6...And In Chinese Capital Goods Imports ...And In Chinese Capital Goods Imports ...And In Chinese Capital Goods Imports Chart I-7Commodity Prices Do Not Signal Widespread And Robust Recovery Commodity Prices Do Not Signal Widespread And Robust Recovery Commodity Prices Do Not Signal Widespread And Robust Recovery     Impact On Chinese Exports Chinese exports to BRI countries have done much better than its shipments elsewhere (Chart I-8). For example, Chinese exports to ASEAN countries showed a strong 10.4% year-on-year growth in 2019, versus a 1% contraction in overall exports. The ASEAN countries that received significant amounts of BRI investments posted double-digit growth in imports from China. There are two primary reasons behind the stronger growth in Chinese exports to BRI-recipient countries. 1. As most of China’s BRI investment has focused on infrastructure projects, it has significantly increased recipient countries’ imports of capital goods and raw materials. Chart I-9 shows that Chinese exports of digging and excavating machines have gone vertical. Chart I-8Strong Growth In Chinese Exports To BRI Countries Strong Growth In Chinese Exports To BRI Countries Strong Growth In Chinese Exports To BRI Countries Chart I-9Surging Chinese Exports Of Digging And Excavating Machines Surging Chinese Exports Of Digging And Excavating Machines Surging Chinese Exports Of Digging And Excavating Machines   2. Considerable BRI investment has propelled recipient countries’ income growth. Chart I-10 reveals a positive correlation between capital spending as a share of GDP and real GDP growth across 33 BRI-receiving developing economies during the BRI implementation period of 2014-2018. Hence, BRI investments have considerable impact on both potential and current growth of recipient countries. Chart I-10Strong Capital Spending Tend To Facilitate Real Economic Growth China’s Belt And Road Initiative: Entering A Cooling-Down Phase China’s Belt And Road Initiative: Entering A Cooling-Down Phase Chart I-11BRI Helped Boost Chinese Consumer Goods Exports BRI helped Boost Chinese Consumer Goods Exports BRI helped Boost Chinese Consumer Goods Exports Robust income growth has boosted demand for household goods (Chart I-11). China has a very strong competitive advantage in consumer goods production, especially in low-price segments that are popular in developing economies. Despite a slight drop in overall BRI investment, we still expect solid growth (albeit less than in 2019) in Chinese exports to BRI countries in 2020. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Footnotes

Highlights Monetary policy settings should continue to sustain the expansion,… : Tight monetary policy is a precondition for a recession. Although the line separating tight from easy is a matter of judgment, current Fed policy is squarely accommodative.  … and the building blocks of GDP confirm that recession is not an imminent threat: A robust labor market and fortified household balance sheets should continue to support consumption; the fixed investment outlook is okay as long as trade tensions don’t wreck business confidence; and the fiscal taps are likely to remain open throughout 2020. Housing will not get in the way of the economy or the markets: Mortgage rates have fallen since we examined housing dynamics in a two-part Special Report this time last year, and residential investment will increasingly reflect it. We project that the beginning of the next recession is about two years away, and that the equity and credit bull markets still have room to run: We are not perma-bulls, but there’s no evidence that the long bull run is about to end. Feature We view the study of key cycles – the business cycle, the credit cycle, the monetary policy cycle and the sentiment cycle – as an essential element of investment strategy. The monetary policy cycle has been especially critical throughout the long expansion and bull market because it has held sway over the business cycle and the credit cycle since the crisis. We have also found that it exerts a powerful influence on equity returns: for six decades, stocks have done very well when policy is easy, but they have failed to generate positive real total returns when it’s tight. There is far more to investment returns than monetary policy, but a simple strategy of embracing risk during easy-policy phases of the fed funds rate cycle and limiting exposure to it when policy is tight has been a big winner over time. Although the fed funds rate cycle has been an especially valuable input in our process, it relies on an estimate. The equilibrium, or neutral, fed funds rate cannot be directly observed. We can only infer when the target fed funds rate crosses above or below it by observing actual economic performance. We continually review real-time data to gauge whether our equilibrium estimate is in the ballpark. As a formal check on that estimate, we regularly examine the building blocks of GDP for insight into where the business cycle is going. We update our review of the GDP equation in this report, and conclude that the expansion should remain on track over the next six to twelve months. We also provide an update on housing a year after our dedicated Special Reports on the topic, finding that it is unlikely to derail the expansion. The GDP Equation – Consumption As we all learned in Introductory Macroeconomics, GDP is the sum of consumption (C), investment (I), government spending (G) and net exports (X-M). As net exports are insubstantial in the comparatively closed US economy, US GDP growth reduces to the weighted sum of growth in consumption, investment and government spending, with consumption accounting for two-thirds of growth and investment and government spending accounting for one-sixth each. GDP = C + I + G Month-to-month moves in real retail sales and personal consumption expenditures (PCE) are volatile, but both series have recovered from their late-2018 softness to get back to their mean for this cycle, somewhat below the means of the previous two expansions (Chart 1). The activity supports our constructive take at the time of our initial review of the GDP equation in April,1 but the choppy series do not provide much insight into the consumption outlook. Looking forward involves examining households’ income prospects and balance sheets to project the money that will be coming in, and consumers’ ability and willingness to spend it. Chart 1Consumption Has Been Holding Up Well Consumption Has Been Holding Up Well Consumption Has Been Holding Up Well Labor market conditions drive household income, and they remain quite tight. The number of unfilled job openings continues to exceed the number of unemployed workers (Chart 2), indicating that demand for employees remains strong. An elevated quits rate indicates that employers are competing fiercely to meet that demand, even to the point of poaching employees from one another (Chart 3). Our payrolls model projects that employment growth will stay close to its pace of the last several years (Chart 4, top panel), as small businesses have ambitious hiring plans (Chart 4, second panel), temporary employment is still growing (Chart 4, third panel), and the 26-week moving average of initial unemployment claims is only slowly beginning to rise (Chart 4, bottom panel). Chart 2With More Jobs Than Workers, ... With More Jobs Than Workers, ... With More Jobs Than Workers, ... Chart 3... Employees Can Seek Out Greener Pastures ... Employees Can Seek Out Greener Pastures ... Employees Can Seek Out Greener Pastures Chart 4Payrolls Will Keep Expanding Payrolls Will Keep Expanding Payrolls Will Keep Expanding Wages are already growing around 3% year-over-year, and the tight labor-market backdrop should promote further gains. With employers forced to bid up wages to attract a shrinking pool of available workers, we expect that wage growth will peak somewhere above 3.5% before the cycle ends. Humans’ ability to see into the future does not extend beyond six to twelve months, but we are confident that more households will be working by the middle of 2020 than are working now, and that they’ll be earning more, in real terms. Households don't have to spend their income gains, but they're in a comfortable position to do so after several years of building up savings and working down debt. Households won’t necessarily spend all of their income gains. They may choose to direct them to paying down debt or increasing savings. Their balance sheets suggest they don’t have a need to do so, however, as the savings rate is back to early ‘90s levels above 8% (Chart 5, top panel), nearly all the debt as a share of GDP that they took on in the last expansion has been worked off (Chart 5, middle panel), and their aggregate debt service burden is lower now than it has been at any point in the last 40 years (Chart 5, bottom panel). Not only do households face little pressure to save their coming income gains, they have plenty of capacity to borrow to augment them. Chart 5Household Finances Are Solid Household Finances Are Solid Household Finances Are Solid The GDP Equation – Investment And Government Spending Investment accounts for just a sixth of GDP, but its volatility gives it a greater likelihood of tipping the economy into a recession than either consumption or government spending (Chart 6). Per the surveys we use to anticipate capital expenditures, the change since April is mixed. Small business capital spending plans as reported in the NFIB survey have ticked up and remain elevated (Chart 7, top panel), while capex intentions from the regional Fed manufacturing surveys have continued to slip and are only around their historical mean (Chart 7, bottom panel). We expect that the trade negotiations will exert a powerful near-term pull on corporate capex; if the US and China reach some sort of accord, capex should pick up, but if tensions worsen, corporate confidence will decline and capex may outright contract. Our base case calls for a modest détente around a Phase 1 agreement, so we do not expect that investment will break down, but it is the most vulnerable component of GDP and we are watching it closely. Chart 6Investment Is The Swing Factor Investment Is The Swing Factor Investment Is The Swing Factor Chart 7The Capex Outlook Is Only Okay, ... The Capex Outlook Is Only Okay, ... The Capex Outlook Is Only Okay, ... Government spending, on the other hand, doesn’t merit a whole lot of attention right now. It is a stable series that accounts for a modest share of GDP and for most of the postwar era, it was reliably countercyclical, shrinking when times were good and expanding when times were bad (Chart 8). The gaping divergence between the federal deficit and economic performance bodes ill for Treasuries and the dollar over the long term, but it shows that there’s no appetite for reining in federal spending ahead of the most hotly contested election campaign in recent memory. State and local spending accounts for about 60% of all government spending, and the strong labor market will boost state receipts, which come from income and sales taxes, while steady home price appreciation will support property tax receipts (Chart 9), keeping municipal coffers full. The longer-term implications of the debauched federal budget are unpleasant, but government profligacy will help sustain the expansion through the end of next year. Chart 8... But The Fiscal Party Rages On ... But The Fiscal Party Rages On ... But The Fiscal Party Rages On Chart 9Home Price Gains Will Fill Local Government Coffers Home Price Gains Will Fill Local Government Coffers Home Price Gains Will Fill Local Government Coffers Housing Residential investment finally broke out of a six-quarter string of detracting from GDP growth last quarter, though its drag in the first half of the year was modest. Residential investment may not exert the sway over the economy that it did earlier in the postwar era when the suburbs were being created from scratch, but its interest rate sensitivity makes it a good proxy for the effect of monetary policy on the economy. Housing has picked up as mortgage rates have fallen, and rates’ lagged effect suggests that more gains are in store (Chart 10). A high level of affordability should keep the momentum going (Chart 11), and new household formations continue to outstrip housing starts (Chart 12, top panel), at a time when inventories (Chart 12, middle panel) and vacancies (Chart 12, bottom panel) are historically low. Chart 10The Full Effect Of Lower Rates Is Yet To Be Felt The Full Effect Of Lower Rates Is Yet To Be Felt The Full Effect Of Lower Rates Is Yet To Be Felt Chart 11Affordability Is High, ... Affordability Is High, ... Affordability Is High, ... Chart 12... And Supply Is Tight ... And Supply Is Tight ... And Supply Is Tight We continue to believe that housing poses no threat to the expansion. New home sales should pick up as builders address the undersupply of homes for first-time and first move-up buyers. The cap on itemized deductions imposed by the December 2017 revision to the federal tax code does not appear to have had a material impact on regional sales activity, and the relationship between top marginal income tax rates2 and home price appreciation since the tax act passed is weak (Chart 13). The bottom line is that residential investment is more likely to boost fixed investment over the next year than it is to detract from it. Chart 13Post-Act Home Price Appreciation Among 20-City Case-Shiller Constituents Stay The Course Stay The Course Investment Implications The underlying elements of the GDP equation support our monetary policy-driven assessment that the expansion will keep chugging along. A robustly healthy labor market will support wage gains, and household balance sheets have firmed up enough to allow consumers to spend their increased income. Surveys indicate that fixed investment does not present a major economic headwind, and positive trade developments could turn it into a tailwind. Government spending will be well supported through 2020. It would be consistent with history if this bull market didn't end until it made one more big push higher. Recessions and bear markets coincide, so the equity bull market should persist until the next recession is in sight. Spread product should also continue to outperform Treasuries and cash, especially while lenders are desperately seeking incremental carry. We reiterate our broad recommendation to overweight equities and spread product, while underweighting Treasuries, and urge investors with more conservative mandates to remain at least equal weight equities and spread product. Excesses in the real economy or the financial markets are a recession prerequisite, and it is quite possible that the excesses that precipitate the next recession will not emerge until after stocks make another significant move higher. We want to be positioned to participate in that move, which would be consistent with bull markets’ established tendency to sprint to the finish line.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the April 8, 2019 US Investment Strategy Weekly Report, “If We Were Wrong,” available at www.bcaresearch.com 2 The 2017 Act capped the amount of state and local tax payments household filers could claim as itemized deductions, severely reducing the federal government’s homeownership subsidy. Residents of states with high income tax rates lost the most from the change, but those states’ housing markets have not yet experienced disproportionately negative impacts.

Feature We spent the past two weeks visiting and exchanging views with our clients in Asia. We presented our view that the ongoing stimulus measures are beginning to bear fruit in terms of stabilizing China’s economic activity, and that we expect the economic slowdown to bottom early next year. In addition, Chinese policymakers are signaling their willingness to accelerate stimulus on both monetary and fiscal fronts, which should mitigate the downside risks and help the economy regain traction in 2020. Interestingly, our view sparked divergent responses: clients outside of China were more upbeat about the state of the Chinese economy than clients from mainland China.  While few investors we spoke to showed concerns over an imminent “hard landing” in China’s economy or systemic risk from China’s financial system, our mainland Chinese clients remain skeptical that the ongoing stimulus will be sufficient to revive the economy. They were also worried that financial regulations may be too restrictive to generate the amount of money growth needed for the economy. Another interesting observation was that while being pessimistic about the economy, our mainland Chinese investors share our assessment that Chinese domestic stocks still have some upside in the coming year. On the other hand, global investors, who are more sanguine about China’s economic recovery, prefer to wait on the sidelines before favoring Chinese investable stocks (Chart 1). Chart 1AA Tale Of Two Markets: Onshore Outperforms Global Markets... A Tale Of Two Markets: Onshore Outperforms Global Markets A Tale Of Two Markets: Onshore Outperforms Global Markets Chart 1B...While Offshore Underperforms ...While Offshore Underperforms ...While Offshore Underperforms Below we present some of the top questions that were posed by investors during our trip, along with our answers. We recap the conclusions of our view, and draw out the investment implications of the differences between the sentiments towards China’s equity markets, in the last question of the report. Q: Recent economic data suggests a weakening Chinese economy. Why do you think the economy will reach a bottom in 2020? Historically, China’s credit formation has consistently led economic activity by about three quarters (Chart 2).  Even though credit growth this year has not been as strong as in previous expansionary cycles, a turning point in the credit impulse occurred at the start of 2019. This suggests that economic activity should turn around within the next two quarters. Chart 2Expecting A Turn In Q1 2020 Expecting A Turn In Q1 2020 Expecting A Turn In Q1 2020 Chart 3Emerging Green Shoots Emerging Green Shoots Emerging Green Shoots   Furthermore, despite weakening headline economic data, some underlying components indicate promising improvements (Chart 3): Growth in infrastructure investment has ticked up modestly in the past couple months, and is set to improve further. The State Council mandated local governments to allocate the proceeds from special-purpose bond sales to infrastructure projects by the end of October. This, combined with a frontloading of next year’s local government bonds, should lend support to infrastructure spending in the coming months. After fluctuating in and out of contraction for a year, growth in auto manufacturing production picked up in August and remained positive through October. This improvement is due to less contraction in auto sales and a faster reduction in auto inventories. Moreover, electricity output surged in October, which also indicates that growth may be gaining momentum. Chart 4Trade Should Improve Into 2020 Trade Should Improve Into 2020 Trade Should Improve Into 2020 Lastly, global financial conditions have eased significantly and credit growth has picked up worldwide, which should help support global demand. Even though Sino-US trade negotiations are ongoing, our baseline view is that a “Phase One” trade deal will be inked in the next couple months. Eased trade tensions and even some rollbacks in the existing tariffs on Chinese export goods, coupled with improved global demand, should provide some tailwinds to China’s external sector (Chart 4). Q: What is your outlook on China’s economic policy for 2020? The Chinese economic growth model remains reliant on credit formation and capital investment. Therefore, the sustainability of an economic recovery depends on whether Chinese policymakers are willing to keep the stimulus wheel turning. Chart 5A Sign Of A Policy Shift A Sign Of A Policy Shift A Sign Of A Policy Shift For investors favoring China-related assets, the good news is that there has been an increasing urgency in policymakers’ tone to support economic growth since September. Capex growth from state-owned enterprises (SOEs) has increasingly outpaced the private sector, which is significant:  A sustained rotation in the pace of SOE vis-à-vis private sector capex marked a turning point in the 2015-2016 cycle, when Chinese policymakers’ imperative to supporting growth outweighed their desire to continue with structural reforms (Chart 5).  We do not expect a 2016-style drastic rise in SOE capex growth next year, because the current economic slowdown is not as severe or prolonged as in 2015. Nonetheless, the rotation in capex growth is an important signal that Chinese policymakers may be more willing to stimulate the economy by again allowing the state sector to upstage the private sector. In the meantime, we expect that some pro-growth “policy adjustments” will be deployed in 2020: Chart 6Infrastructure Investment Likely To Rise Infrastructure Investment Likely To Rise Infrastructure Investment Likely To Rise Monetary policy will incrementally ease, with one to two 10-15bps loan prime rate (LPR) cuts in the next 3-6 months. At the same time, China’s central bank (PBoC) will keep bank liquidity ample and commercial banks’ funding costs relatively low, by continuing frequent liquidity injections to stabilize the interbank rate. A further cut in the reserve requirement ratio (RRR) is also highly likely. Keeping banks well capitalized will partially mitigate the pressure commercial banks face from falling profit margins and rising credit defaults. Accommodative monetary conditions will also support more stimulus on the fiscal front. We expect that the National People’s Congress in March 2020 will approve higher quotas on the issuing of local government bonds. Chinese state-owned commercial banks will continue to be the main buyers for local government bonds.  A portion of 2020 local government special-purpose bond issuance will be frontloaded to the remainder of 2019 and into the first months of next year. Relaxed capital requirements will likely boost local governments’ infrastructure project funding and expenditures. Our model suggests infrastructure spending should pick up from the current 3.3% year-on-year, to close to 7.5% in the second and third quarters next year (Chart 6). There are subtle signs that the government is starting to relax restrictions on the real estate sector. Land sales by local governments have increased since mid-2019, and the trend will continue into 2020 (Chart 7).  Income from land sales accounts for 70% of local government revenues, thus allowing more land sales should help fund a larger local government spending budget next year. Declining government subsidies to shantytown renovation (namely the Pledged Supplementary Lending, or PSL) have recently abated and will likely continue to improve (Chart 8). Chart 7Some Improvement To Come In The Real Estate Sector Some Improvement To Come In The Real Estate Sector Some Improvement To Come In The Real Estate Sector Chart 8Government Subsidies Will Continue Government Subsidies Will Continue Government Subsidies Will Continue   December’s Central Economic Work Conference (CEWC) will set policy priorities for the following year. We think Chinese policymakers will make economic growth a top priority for 2020. Credit growth swelled in the first quarter of 2019 following the December 2018 CEWC, and we expect a surge in early 2020 as well.Due to the unusually high credit growth in January this year and the seasonal factor next year (Chinese New Year will fall in January 2020), the surge in credit growth, on a year-over-year basis, will more likely be muted until towards the end of the first quarter and into the second quarter. Investors should overweight Chinese investable stocks in the next 6-12 months, but need to watch for more positive signs to upgrade tactical stance. Beyond the second quarter, however, the outlook gets cloudier as tension from the US election heats up and President Trump may change his trade negotiation strategies with China.1 This may have implications on China’s domestic policies. But for now, our baseline view is that Chinese policymakers will incrementally accelerate the pace of economic stimulus throughout next year. Q:  Monetary policy has been accommodative for more than a year, but capex this year has fallen below market expectations compared with past cycles. How will further stimulus help to revive investment and economic growth next year? In short, our answer is this: interest rate cuts alone will not be enough to boost economic growth in China. Capex, and growth more generally, will only revive through synchronized policy support from the Chinese authorities. In a previous report2 we discussed that the lack of response to monetary easing has been due to a less effective monetary policy transmission mechanism, a reactive and reluctant central bank, and a debt-loaded corporate sector. More importantly, the “half-measured” stimulus has been preferred by Chinese authorities in this cycle, as they prioritized financial de-risking over growth and have significantly tightened financial regulations since 2016. Given the expected policy pivot to a more pro-growth stance in the coming year, the following underlines our conviction that capex should pick up in 2020.  Modern Money Theory (MMT), with Chinese characteristics:3 local governments will ramp up debt again, and this quasi-fiscal stimulus will be a key support to the economy in 2020. During the 2015-2016 cycle, aggressive interest cuts did not result in a significant uptick in credit growth. Bank lending was not the core driver for economic recovery in 2016. The economy only bottomed following an unprecedented issuance of local government bonds after mid-2015 (Chart 9).  Chinese authorities will keep a “back door” open: even though overall tight financial regulations will remain intact, we expect the PBoC to allow a more moderate contraction in shadow banking (Chart 10). This will provide smaller banks and enterprises access to tap into bank credit. Importantly, this means the government will acquiesce to local governments in providing extra funding through shadow banking. We already see local government financing vehicles (LGFV) making a comeback in recent months. Chart 9A Chinese Version Of MMT A Chinese Version Of MMT A Chinese Version Of MMT Chart 10The "Back Door" May Open Wider The "Back Door" May Open Wider The "Back Door" May Open Wider     Small- and medium-sized enterprises (SMEs) will benefit from lowered financing costs through the new LPR system. As we pointed out in our previous report,4 the new LPR regime is not intended as much to expand bank credit as to help struggling SMEs survive economic hardships. This, along with tax cuts, should provide SMEs some relief from capital constraints. Q. CPI has been rising sharply and is above the government’s inflation target of 3%. Will inflation prevent the PBoC from maintaining an easy monetary policy? Chart 11PBoC Likely To Capitulate To Producer Deflation PBoC Likely To Capitulate To Producer Deflation PBoC Likely To Capitulate To Producer Deflation No. We think deflationary pressure in the industrial sector (measured by producer prices) poses a bigger threat to the economy, and that PBoC is more likely to loosen monetary policy than to tighten (Chart 11). Chart 12 shows that the recent surge in headline consumer prices has almost been entirely driven by soaring pork prices. There is compelling evidence from historical data that, unless core consumer price inflation also rises, climbing food prices alone will have a limited impact on PBoC policy (Chart 13). We think this approach is justified, as the necessity of “core feedthrough” is also what most central banks in the developed world look for when confronted with a detrimental supply shock. Chart 12Rising Pork Prices Have Driven Up Headline Inflation... Rising Pork Prices Have Driven Up Headline Inflation... Rising Pork Prices Have Driven Up Headline Inflation... Chart 13...But Won't Be Driving Up Interest Rates ...But Won't Be Driving Up Interest Rates ...But Won't Be Driving Up Interest Rates Chart 14A Wild Year For The RMB A Wild Year For The RMB A Wild Year For The RMB Core CPI has been trending downwards since February 2018, and there is no evidence to suggest that food prices will drive up core CPI inflation (Chart 13, bottom panel).  This, in combination with deflating producer prices, means that the probability of tighter monetary policy over the coming 6-9 months is extremely low. In fact, we expect, with high conviction, that the PBOC will guide the LPR lower in the coming months. Q: What is your view on the RMB for 2020? The RMB depreciated by 5% against the US dollar from its peak in February this year, mostly driven by market expectations of US tariffs imposed on Chinese export goods. Interest rate differentials, short-term capital flows, and economic fundamentals all have played much smaller roles in the RMB’s value changes (Chart 14). The depreciation in the CNY/USD this year has pushed the RMB close to two sigma below its long-term trend (Chart 15). As we expect a “Phase One” trade deal to be signed and trade tensions abating at least in the near term, the RMB will face upward pressure through the first half of 2020. The appreciation will also be supported by, although to a lesser extent, China’s improved domestic economy, rising demand for RMB-denominated assets, and a weakening US dollar (Chart 16). According to our model, the USD/CNY exchange rate can return to a 6.8-7.0 range, if a significant portion of the existing tariffs is rolled back (Chart 17).  This range seems to be within the “fair value” of the RMB, justifiable by the current China-US interest rate differential (Chart 14, bottom panel). Chart 15Has The RMB Gone Too Far? Has The RMB Gone Too Far? Has The RMB Gone Too Far? Chart 16Demand For RMB Assets On The Rise, Despite The Trade War Demand For RMB Assets On The Rise, Despite The Trade War Demand For RMB Assets On The Rise, Despite The Trade War However, it would not be in the PBoC’s best interests to let the RMB appreciate too rapidly, because an appreciating Chinese currency would act as a deflationary force on China’s export and manufacturing sectors.  The large differential in the China-US interest rates would allow PBoC to cut interest and/or RRR rates, to ease upward pressure on the RMB.   Chart 17Tariff Rollbacks Will Push Up RMB Tariff Rollbacks Will Push Up RMB Tariff Rollbacks Will Push Up RMB   Q: How should equity investors position themselves towards China over the coming year? We are bullish on Chinese investable stocks in the next 6 to 12 months, based on our view that the Chinese economy will bottom in the first quarter next year, policy will be incrementally more supportive, and a “Phase One” trade deal will be signed soon. In the very near term, however, we think downside risks to Chinese equities are not trivial. We remain a neutral tactical stance, but will continue to watch for the following signs before upgrading our tactical call from neutral to overweight.5 Chart 18A (top panel) shows that cyclical stocks remain very depressed relative to defensives, underscoring investors’ lack of confidence in the Chinese economy and trade negotiations. A breakout in cyclicals versus defensives would signify a major improvement in investor sentiment towards Chinese economic growth. An uptick in the relative performance of industrials and consumer staples (Chart 18A, bottom panel). The negative sensitivity of industrials and positive sensitivity of consumer staples to monetary policy suggests that the relative performance between the two sectors may be a reflationary barometer for China’s economy. The relative performance trend remains off its recent low, which suggests that China’s existing policy stance has not yet turned more reflationary. A technical breakdown in the relative performance of healthcare and utility stocks (Chart 18B) would also be a bullish sign. Investable health care and utilities stocks have historically led China’s economic activity, core inflation and stock prices by 1-3 months. A technical breakdown in the relative performance of these sectors would signify that market participants anticipate a bottom in China’s economy. As we mentioned at the outset, we observed an interesting divergence in sentiment among our domestic versus global investors. This divergence is reflected in both the onshore and offshore stock markets; year to date, onshore A shares have outperformed global benchmarks by 5.6% (Chart 1, on page 1 of the report). Chart 18AWaiting For A Telltale Sign... Waiting For A Telltale Sign... Waiting For A Telltale Sign... Chart 18B...Before A Tactical Upgrade ...Before A Tactical Upgrade ...Before A Tactical Upgrade However, all of the outperformance in A shares occurred before end April, when the trade talks broke down and domestic credit expansion significantly slowed from the first quarter. Since May, the relative performance of A shares in US dollar terms has been mostly flat, reflecting the fact the markets were not expecting a significant stimulus forthcoming.  Chinese investable stocks, on the other hand, have been trading heavily on the day-to-day news surrounding the trade negotiations and have significantly underperformed both domestic A shares and global benchmarks. Therefore, our base case view of a trade truce coupled with an improved Chinese economy and more supportive policy near year, warrant a cyclical overweight stance favoring Chinese investable stocks over their domestic peers. Earnings from both onshore and offshore markets will benefit from a modest improvement in economic activity, but we think the investable market will benefit more from the trade truce and more upside growth potential. Stay tuned.   Jing Sima China Strategist jings@bcaresearch.com Footnotes 1Please see Geopolitical Strategy Special Report, "Is China Afraid Of The Big Bad Warren?" dated October 25, 2019, available at gps.bcaresearch.com 2Please see China Investment Strategy Weekly Report, " Threading A Stimulus Needle (Part 1): A Reluctant PBoC," dated July 10 2019, available at cis.bcaresearch.com 3We call it a “MMT” because China’s state-owned commercial banks own approximately 80% of local government bonds. The commercial banks are essentially backed by China’s central bank, which has a fiat currency system and can make independent monetary policy decisions. 4Please see China Investment Strategy Weekly Report, "Mild Deflation Means Timid Easing," dated October 9, 2019, available at cis.bcaresearch.com 5Please see China Investment Strategy Special Report, "A Guide To Chinese Investable Equity Sector Performance," dated October 30, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Global: Global growth momentum is bottoming out, leading indicators are improving, inflation is subdued, and central bankers are biased to maintain accommodative monetary policies. This is a bullish “sweet spot” for financial markets, suggesting further upside for global risk assets like equities and corporate credit, especially relative to government bonds. US: The overall US economy is weathering the storm from the global manufacturing slump, which is showing signs of bottoming out.  Stay below-benchmark on US Treasury duration, with an initial yield target of 2.25% for the benchmark 10-year. Canada: The Bank of Canada is hinting that “insurance” rate cuts may be needed, but with the Canadian economy and inflation both remaining resilient, the central bank is more likely to keep rates steady until global growth improves.  Stay neutral on Canadian government bonds, for now, but prepare to move to underweight in early 2020. Feature After knocking on the door several times in recent weeks, global equity markets are finally enjoying a true breakout.  In the U.S., the S&P 500 is setting new all-time highs on a daily basis, while equities in Europe and emerging markets (EM) are also registering solid gains. There is no conflicting signal from global corporate credit markets where spreads remain stable, or from the volatility space with measures like the US VIX index hovering near the 2019 lows. Chart Of The WeekThings Are Looking Up Things Are Looking Up Things Are Looking Up Despite this positive price action, many remain skeptical that this “risk rally” is sustainable.  Just last week, a headline in the Financial Times declared that the “U.S. stock market’s new highs baffles investors”. We find that reluctance to accept the equity market strength to be even more baffling, as the current macro backdrop is a perfect “sweet spot” for risk assets to do well.  Global economic momentum is bottoming out, with improving leading indicators suggesting better days lie ahead for growth.  A majority of central banks worldwide have eased monetary policy over the past several months, providing a more supportive liquidity backdrop for financial markets.  The world’s most important central bank, the Federal Reserve, has delivered a cumulative -75bps of rate cuts since July, helping to cool off the US dollar, which is now flat on a year-over-year basis in trade-weighted terms (Chart Of The Week).  A softening dollar is also often a signal that global growth is improving, as it indicates a shift in capital flows into more economically-sensitive non-U.S. markets like Europe and EM.  Thus, a weaker greenback combined with better global growth prospects should help lift global bond yields by raising depressed inflation expectations (middle panel).  The “sweet spot” of accelerating growth and easy money will support the continued outperformance of global equities and credit over government bonds, in an environment of gently rising bond yields. Yet with policymakers worldwide still playing the stimulus game, fearful of persistent negative impacts on growth from the U.S.-China trade dispute and other political uncertainties, it will take a large and sustained increase in inflation expectations before there is any shift to a more hawkish global policy bias.  This is critical for bond markets, as a much bigger move higher in global bond yields would require not just a pricing out of rate cut expectations, but the pricing in of future rate hikes. Such a repricing will not occur before there is clear evidence that global growth, broadly speaking, is accelerating for a sustained period and not just stabilizing in a few countries. The earliest we can envision such a hawkish shift for global monetary policy would be late in 2020, led by the Fed signaling a removal of some of the “insurance” rate cuts of 2019.  Until that happens, the “sweet spot” of accelerating growth and easy money will support the continued outperformance of global equities and credit over government bonds, in an environment of gently rising bond yields. The Art Of Analyzing Economic Data At Turning Points Typically, at turning points in the global growth cycle, there are always data available to support the arguments of both optimists and pessimists. That is certainly the case today, where so-called “hard” economic data that is reported with a lag (i.e. exports, durable goods orders) remains weak, but leading indicators are starting to improve. For example, the global manufacturing PMI data for October released last week shows the following (Chart 2): strong pickup in China, with the Caixin manufacturing PMI now up to 51.7; slight improvement in the US ISM manufacturing index, which rose from 47.8 to 48.3 in the month but remains below the 50 boom/bust line; bounce in the U.K. Markit manufacturing PMI index, rising from 48.3 to 49.6; the slightest of increases in the overall euro area Markit manufacturing PMI, from 45.7 to 45.9, still below the 50 line but showing marginal improvement in the critical German PMI; Continued weakness in the Japanese Markit manufacturing PMI, which fell to 48.4. The relative message from the PMIs fits with the signals sent from the OECD leading economic indicators (LEI) for those same countries, with the China LEI strengthening the most and the LEIs in Europe and Japan still struggling. The US is a mixed bag, with the ISM ticking up but the LEI languishing. There is, however, a sign of optimism in the export sub-index of the ISM manufacturing data. That measure surged nine points in October from 41.0 to 50.4, signaling a potential bottoming of the overall ISM index within the next three months (Chart 3).  While the ISM exports index is volatile, the modest improvement seen in the export order series from the China manufacturing PMI over the past few months (bottom panel) suggests that there may be a more significant improvement in global trade activity brewing – as signaled by the improvement in our global LEI index. Another possible explanation for the reduction in U.S. capital spending is slowing growth in corporate profits, which is related to a number of factors beyond the impact of tariffs and the trade war. Chart 2Global PMIs Are A Mixed Bag Global PMIs Are A Mixed Bag Global PMIs Are A Mixed Bag Chart 3Momentum Turning For The Trade Warriors? Momentum Turning For The Trade Warriors? Momentum Turning For The Trade Warriors? Bottom Line: Global growth momentum is bottoming out, leading indicators are improving, inflation is subdued, and central bankers are biased to maintain accommodative monetary policies. This is a bullish “sweet spot” for financial markets, suggesting further upside for global risk assets like equities and corporate credit, especially relative to government bonds. US Capital Spending Slowdown:  Only A Cautious Pause Chart 4Rising Uncertainty? Or Just Slowing Profit Growth? Rising Uncertainty? Or Just Slowing Profit Growth? Rising Uncertainty? Or Just Slowing Profit Growth? For growth pessimists in the US, a modest boost to “soft” data like the ISM does not allay their concerns about a broadening US economic slowdown. The trade war with China and the global manufacturing recession have had a clear negative impact on business confidence when looking at measures like the Conference Board CEO survey.  At the same time, US capital spending has contracted in real terms during the 2nd and 3rd quarter of 2019.  A logical inference would be to say that uncertainty over the trade war has led to a reduction in capex. Another possible explanation for the reduction in U.S. capital spending is slowing growth in corporate profits, which is related to a number of factors beyond the impact of tariffs and the trade war. Like the fading impact of the 2018 U.S. corporate tax cuts (that helped trigger a surge in after-tax earnings growth) and the squeeze on profit margins from higher labor costs. On a year-over-year basis, US profit growth has slowed from nearly 25% in 2018 to 1.8% in the 3rd quarter (a projection based on the 76% of S&P 500 companies that have already reported).  The real non-residential investment spending category from the US GDP accounts has slowed alongside profits, from 6.8% to 1.3% on a year-over-year basis (Chart 4). At the same time, annual growth in US non-farm payrolls has slowed only modestly from 1.91% to 1.4%, with average hourly earnings growth falling from a 2019 peak of 3.4% to 3.0% in October. Given the tightness of the US labor market, with firms continuing to report difficulties in finding quality labor, it should come as no surprise that employment and wages have not slowed as much as capital spending, despite the sharp downturn in profit growth.  Businesses that see their earnings getting squeezed will seek to protect profits by cutting back on investment and hiring activity. With a tight labor market, however, cutting capital spending is an easier and less costly decision than laying off workers, as it may be even harder to re-hire those employees if the economy starts to improve once again. With the US Treasury curve no longer inverted, after -75bps of Fed rate cuts and with longer-dated Treasury yields starting to increase, the US economy is stepping back from the recessionary abyss that worried investors during the summer. That can also be seen when breaking down the US non-residential investment data into its broad sub-components (Chart 5).  On a contribution-to-growth basis, the only part of US investment spending that is outright contracting year-over-year is Structures. There is still modest positive annual growth in Equipment investment, although that did contract on a quarter-on-quarter basis in Q3/2019. The Intellectual Property Products category (which includes Software, in addition to Research & Development) continues to expand at a steady pace. Chart 5Slowing US Capex Focused On Structures How Sweet It Is How Sweet It Is Chart 6The Fed Has Dis-Inverted The UST Curve The Fed Has Dis-Inverted The UST Curve The Fed Has Dis-Inverted The UST Curve So similar to signals from global PMIs and LEIs, the U.S. capital spending and employment data are sending a mixed message about U.S. growth. Yes, capital spending has slowed but the bulk of the deceleration has come in the component where canceling or delaying investment plans is easiest – buildings and construction. It is not necessarily an indication that a deeper economic downturn is unfolding. Similar cutbacks in Structures investment, without a broader decline in overall capital spending, occurred in 2013 and 2015/16.  During the past two U.S. recessions in 2001 and 2008, however, all categories of capital spending contracted. If we look at the breakdown of the contribution to US investment spending today, the backdrop looks more like those non-recessionary years. With the US Treasury curve no longer inverted, after -75bps of Fed rate cuts and with longer-dated Treasury yields starting to increase, the US economy is stepping back from the recessionary abyss that worried investors during the summer (Chart 6).  The trade détente between the US and China will help boost depressed business confidence, especially with global growth already showing signs of bottoming out. This, along with a softer US dollar and some easing of wage pressures, will help put a floor underneath US corporate profit growth. Treasury yields have more upside from here, as markets are still priced for -25bps of Fed rate cuts over the next year that is unlikely to happen if the US economy rebounds, as we expect.  Bottom Line:  The overall US economy is weathering the storm from the global manufacturing slump, which is showing signs of bottoming out.  Stay below-benchmark on US Treasury duration, with an initial yield target of 2.25% for the benchmark 10-year. The Bank Of Canada’s Newfound Caution Is Unwarranted Chart 7Canada Is A High-Beta Bond Market Canada Is A High-Beta Bond Market Canada Is A High-Beta Bond Market The Bank of Canada (BoC) has been one of the few central banks to resist the shift towards easier global monetary policy in 2019.  This has resulted in Canadian government bonds trading at relatively wide yield spreads to other countries in the developed world, even as global growth has slowed in 2019 (Chart 7).  With global growth now set to improve over the next 6-12 months, Canada’s historic status as a “high yield beta” bond market during periods of rising global yields suggests that Canadian government bonds should underperform in 2020. However, in the press conference following last week’s policy meeting, BoC Governor Stephen Poloz noted that the BoC was “mindful that the resilience of Canada’s economy will be increasingly tested as trade conflicts and uncertainty persist.” Poloz even revealed that an “insurance” rate cut was discussed at the policy meeting, although the BoC Governing Council decided against it.  This is similar language to that parroted by the more dovish global central bankers over the past several months, raising the risk that Canada could be a lower-beta bond market if the Canadian economy falters. That outcome seems unlikely, given the indications of improving growth momentum, occurring alongside tight labor markets and stable inflation: The RBC/Markit Canadian manufacturing PMI has climbed from a trough of 49 in May to 51 in October, indicating that real GDP growth accelerated in Q3 (Chart 8, top panel); The BoC’s Autumn 2019 Business Outlook Survey (BoS) showed that an increasing share of firms are reporting labor shortages, coinciding with a sharp pickup in the annual growth rate of average weekly earnings to just over 4% (middle panel); Core inflation measures remain right at the midpoint of the BoC’s 1-3% target range, although breakeven inflation rates from Canadian Real Return Bonds remain closer to the bottom end of that range (bottom panel); After a long period of adjustment, house prices and housing activity are showing some signs of recovery in response to easier financial conditions, rising household incomes and improved affordability (Chart 9); Chart 8Resilience In Canadian Growth & Inflation Resilience In Canadian Growth & Inflation Resilience In Canadian Growth & Inflation Chart 9Canadian Housing Showing Improvement Canadian Housing Showing Improvement Canadian Housing Showing Improvement Canadian investment spending is set to pick up, as the Autumn 2019 BoS reported a modest improvement in overall business sentiment and an increase in capital spending plans with a growing number of firms facing capacity pressures (Chart 10). Our bias is to downgrade Canadian government bonds to underweight heading into 2020, as we expect a return to their typical high-beta status during a period of accelerating global growth and rising bond yields. Chart 10Signs Of Life For Canadian Capex? Signs Of Life For Canadian Capex? Signs Of Life For Canadian Capex? Looking forward, reduced U.S.-China trade tensions should provide a boost to Canadian capex. Firms that had previously held off in the past few months due to the slowdown in the economy, caused partially by worries over global trade, will start to invest again. The BoC’s updated forecasts in the latest Monetary Policy Report released last week showed that the central bank expects Canadian exports to resume their expansion in 2020 – despite Governor Poloz’s stated concerns over global growth. Oil and gas exports are expected to improve as pipeline and rail capacity gradually expand, while consumer goods excluding automobiles should remain strong. Improvement in Chinese economic activity would provide a meaningful lift to Canadian exports, as Chinese imports from Canada are still contracting at a double-digit rate (Chart 11).  More importantly, Canadian exports to the country’s largest trade partner, the US, have already stabilized and should accelerate as the US economy gains momentum in the next 6-12 months. As Governor Poloz mentioned during the press conference, the BoC's decisions are not going to be directly influenced by political events such as Prime Minister Justin Trudeau’s recent re-election. Yet the odds of Canadian fiscal stimulus have shot up after Trudeau could only secure a minority government in the Canadian Parliament. Any fiscal stimulus is starting from a healthier place with the budget deficit currently at only -1% of GDP and the net government debt-to-GDP ratio falling towards a low 40% level (Chart 12).  Expected fiscal stimulus will provide an incremental boost to Canadian growth in 2020. Chart 11The Global Trade Slump Has Hurt Canada The Global Trade Slump Has Hurt Canada The Global Trade Slump Has Hurt Canada Chart 12Canada Can Afford A Fiscal Stimulus Canada Can Afford A Fiscal Stimulus Canada Can Afford A Fiscal Stimulus Net-net, the Canadian economy appears to be in good shape, with momentum starting to improve.  Inflation remains close to the BoC target, with rising pressures stemming from a tight labor market. This is not a backdrop that would be conducive to an “insurance” rate cut in December or even in early 2020.  Only -18bps of rate cuts over the next twelve months are discounted in the Canadian Overnight Index Swap (OIS) curve. Yet there is only a 16% chance of a -25bp cut expected at the December 2019 meeting, according to Bloomberg.  In other words, the markets are not taking the threat of a BoC rate cut seriously – a view that we agree with. Chart 13Stay Neutral On Canadian Government Bonds Stay Neutral On Canadian Government Bonds Stay Neutral On Canadian Government Bonds We suspect that Governor Poloz’s comments about a potential BoC policy ease were more designed to take some steam out of the strengthening Canadian dollar (Chart 13), which was threatening a major breakout going into last week’s BoC meeting.  We would be surprised if a rate cut was delivered at the December 2019 BoC meeting, but the dovish message sent last week does raise the possibility that the BoC could shock us. For now, we are choosing to stick with our neutral recommendation on Canadian government bonds, but we will re-evaluate after the December 4 BoC meeting. Our bias is to downgrade Canadian government bonds to underweight heading into 2020, as we expect a return to their typical high-beta status during a period of accelerating global growth and rising bond yields. Bottom Line: The Bank of Canada is hinting that “insurance” rate cuts may be needed, but with the Canadian economy and inflation both remaining resilient, the central bank is more likely to keep rates steady until global growth improves.  Stay neutral on Canadian government bonds, for now, but prepare to move to underweight in early 2020. A Brief Follow Up To Our US MBS Versus IG Corporates Recommendation Chart 14Spread Targets Reached - Downgrade US IG To Neutral Spread Targets Reached - Downgrade US IG To Neutral Spread Targets Reached - Downgrade US IG To Neutral In last week’s report, we made the case for raising allocations to US Agency MBS while reducing exposure to higher-quality US investment grade (IG) corporate credit.1 We implemented the trade in our model bond portfolio, lowering our recommended allocation to US IG and increasing the weighting to US Agency MBS.  We now see a case for shifting to a formal strategic recommendation, upgrading US Agency MBS to overweight (a ranking of 4 out of 5 in the tables on page 14) and downgrading US IG to neutral (3 out of 5).  The rationale for the shift is based on valuation. Our colleagues at BCA Research US Bond Strategy calculate spread targets for each credit tier within US IG (Aaa, Aa, A and Baa). The targets are determined using a methodology that ranks the option-adjusted spread (OAS) of the Bloomberg Barclays index for each credit tier relative to its history, while controlling for the “phase” of the economic cycle as determined by the slope of the US Treasury yield curve.2 The latest rally in IG has driven the OAS for all tiers below those targets, with the Baa tier looking less expensive than the others (Chart 14).  As a result, we now advise only a neutral allocation to US IG corporates, with a preference for the Baa credit tier. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1Please see BCA Research Global Fixed Income Strategy Weekly Report, “Big Mo(mentum) Is Turning Positive”, dated Oct 29, 2019, available at gfis.bcaresearch.com 2For details on how those spread targets are determined, please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index How Sweet It Is How Sweet It Is Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Today we are also publishing a Special Report titled Chinese Auto Demand: Time For A Recovery? Highlights India is the third-largest world consumer of crude oil. Hence, fluctuations in its oil consumption is a non-negligible factor behind global oil prices. India’s petroleum demand growth is slowing cyclically due to the domestic demand slump and a dramatic drop in vehicle sales. This, combined with China’s ongoing slowdown in petroleum product demand, will have a non-trivial impact on oil prices in the next six months. From a structural perspective, India’s long-term demand growth for petroleum is decelerating as well. Feature India’s petroleum products consumption growth is slowing. Chart 1India Is The World's Third Largest Crude Oil Consumer India Is The World's Third Largest Crude Oil Consumer India Is The World's Third Largest Crude Oil Consumer India is the world’s third-largest consumer of crude oil, guzzling 5% of global consumption (Chart 1). Hence, fluctuations in India’s crude oil/petroleum consumption is a non-negligible factor affecting global oil prices. India’s petroleum products consumption growth is slowing. This comes on top of China’s ongoing petroleum demand deceleration. Together, the two countries account for 19% of the world’s oil intake. Therefore, deceleration in their oil consumption growth will have a considerable impact on the outlook for global oil demand growth. A Pronounced Cyclical Oil Demand Slump Indian petroleum consumption growth has decelerated significantly on the back of slumps in Indian domestic spending and economic activity (Chart 2). Please click on this link for an in-depth analysis on the domestic demand slump in India. Chart 2Indian Petroleum Consumption Growth Has Been Dwindling Indian Petroleum Consumption Growth Has Been Dwindling Indian Petroleum Consumption Growth Has Been Dwindling Specifically, vehicle purchases and industrial sectors have been hit hard. These sectors are critical for Indian petroleum consumption, since transportation demand accounts for 50% and industrial activity for around 25% of total petroleum consumption (Chart 3). Indian vehicle sales have been in freefall. Chart 3Transportation & Industry Guzzle The Most Fuel In India bca.ems_sr_2019_10_17_001_c3 bca.ems_sr_2019_10_17_001_c3 Chart 4Indian Vehicle Sales Are In Deep Contraction Indian Vehicle Sales Are In Deep Contraction Indian Vehicle Sales Are In Deep Contraction Indian vehicle sales have been in freefall. Chart 4 shows passenger car sales are shrinking at 30% and sales of two and three-wheeler units are contracting at 20% from a year ago. Moreover, commercial vehicles and tractor unit sales are falling at annual rates of 35% and 10%, respectively. Chart 5 illustrates that the number of registered vehicles is expanding at a lower rate than before – i.e., its second derivative has turned negative. This signals a further growth slowdown in gasoline and diesel consumption. We use the second derivative in this analysis because registered vehicles are a stock variable. However, we are trying to explain changes in petroleum consumption which is a flow variable. Therefore, the second derivative of a stock variable (the number of registered cars on the road) explains the first derivative of a flow variable (the growth rate of oil consumption). Looking ahead, vehicle sales will remain in the doldrums because of a lack of financing. In particular, the impulse on auto loans issued by commercial banks is negative (Chart 6). Chart 5Slowing Growth Of Vehicles On The Road = Weaker Pace Of Fuel Consumption Slowing Growth Of Vehicles On The Road = Weaker Pace Of Fuel Consumption Slowing Growth Of Vehicles On The Road = Weaker Pace Of Fuel Consumption Chart 6Indian Banks: Negative Vehicle Loan Impulse Indian Banks: Negative Vehicle Loan Impulse Indian Banks: Negative Vehicle Loan Impulse More worrisome is the ongoing turmoil in India’s non-bank finance sector (NBFCs), which has also significantly hit auto sales. In the past, the NBFC sector played a major role in funding Indian auto purchases. For instance, according to the ICRA, an independent rating agency in India, NBFCs have helped fund the purchases of 65% of two-wheelers, 30% of passenger cars and around 55% of commercial vehicles – both new and used. Given these non-bank finance companies are currently facing formidable funding and liquidity pressures amid rising NPLs (Chart 7), they are being forced to shrink their balance sheets. This is damaging to auto sales. Please click here for an in-depth analysis on the Indian banking and non-bank finance sectors. Chart 7Major Asset-Liability Mismatches Among Indian Non-Bank Finance Sector Major Asset-Liability Mismatches Among Indian Non-Bank Finance Sector Major Asset-Liability Mismatches Among Indian Non-Bank Finance Sector Chart 8India's Capex Has Been Weak India's Capex Has Been Weak India's Capex Has Been Weak Turning to the industrial sector, overall Indian capital spending has been weak. India’s real gross fixed capital formation has rolled over, the number of capex projects underway is nosediving and both capital goods imports and production are contracting by 7% and 12% on an annual basis (Chart 8). Falling industrial activity has taken a toll on the consumption growth of petroleum products with industrial applications, such as bitumen, naphtha and petroleum coke, etc. The growth rate in demand for these products is dropping — a significant development since they account for 25% of overall petroleum consumption in India.1  Bottom Line: India’s petroleum consumption growth has been slowing drastically from a cyclical perspective. And Moderating Structural Oil Demand Growth It appears there are structural factors at play that will also reduce India’s long-term demand for petroleum. On top of the cyclical demand slowdown, it appears there are structural factors at play that will also reduce India’s long-term demand for petroleum: Chart 9Impressive Efficiency Gains In India's Vehicle Fleet Impressive Efficiency Gains In India's Vehicle Fleet Impressive Efficiency Gains In India's Vehicle Fleet The fuel efficiency of India’s vehicle fleet is markedly improving (Chart 9). Additionally, since 2015-16 the Indian government has been proactively pursuing new emission/fuel efficiency standards. For instance, emissions standards for new passenger vehicles will fall to 4.2 L/100 KM by 2023 down from its current level of 4.6 L/100 KM. This will lead to a 7% reduction in auto fuel consumption. While this is not a large reduction, the government has the scope to implement even stricter standards since Indian car makers are easily meeting these targets. Finally, the Indian government has been aggressively promoting electric vehicles (EVs) as an alternative to traditional autos. It has made the advancement of this sector a priority. Ownership of EVs is currently negligible in India. However, the government is pushing for EVs to make up 30% of vehicle sales by 2030. In addition, it has been providing incentives such as sales tax cuts and subsidies to the sector. Finally, Mahindra and Tata Motors are already establishing a lead in the EV industry and are developing new EV models in collaboration with foreign automakers.  Bottom Line: The pace of India’s structural demand for petroleum will also be downshifting. Oil Inventory Not A Critical Factor Chart 10China: Oil Inventory Drives Oil Imports China: Oil Inventory Drives Oil Imports China: Oil Inventory Drives Oil Imports Inventory accumulation and destocking can play an important role in oil price fluctuations. For example, inventory accumulation plays a key role in driving Chinese crude oil imports (Chart 10). There is a dearth of data on Indian oil inventories to make a strong inference about its de- and re-stocking cycles. However, we have the following observations: India has the capacity to store 5.33 million tons worth of strategic oil reserves - equivalent to around 10 days of its crude oil consumption. It is not clear whether or not these reserves are at full capacity. However, even if we assume they are only 50% full and the government decides to fill its reserves all at once, this would require the importation of an additional 2.67 million tons of oil, equivalent to only 1.2% of Indian crude oil imports and 0.05% of global crude oil demand. This is a negligible amount, and is unlikely to have any impact on global oil prices. Furthermore, while the Indian government is planning to expand its storage capacity by an extra 6.5 million tons, this will only take place in the next six to eight years. Thus, it will not meaningfully affect oil imports in the medium term. Chart 11India: Oil Consumption Drives Oil Imports India: Oil Consumption Drives Oil Imports India: Oil Consumption Drives Oil Imports Finally, India’s crude oil imports are strongly correlated with its petroleum final consumption (Chart 11). Therefore, it is reasonable to assume that Indian consumption – not the oil inventory cycle – is relevant for crude imports, and by extension for oil prices. Bottom Line: India’s petroleum product and crude oil inventory fluctuations are too small to influence the nation’s crude imports and hence global oil prices. Investment Conclusions From a cyclical perspective, Indian final demand for crude oil has been weakening. A major re-acceleration in economic growth and hence oil demand is not imminent. We discuss the outlook for China’s auto sales in a separate report published today. Together India and China consume 19% of world oil, and therefore a deceleration in their oil consumption growth will have a non-trivial impact on the pace of global oil demand growth. Chart 12Expansion Pace Of Vehicles On The Road Has Downshifted In India & China Expansion Pace Of Vehicles On The Road Has Downshifted In India & China Expansion Pace Of Vehicles On The Road Has Downshifted In India & China Our estimations for annual growth in cars on the road (excluding 2-wheelers) has dropped to 5.8% in India and 10.5% in China (Chart 12). This entails a slower pace of oil demand growth than in the past. Besides, if one rightly assumes petroleum consumption per car is declining for structural reasons due to technological advancements by car manufacturers and enforcement of stricter efficiency standards by governments, oil consumption growth will be considerably slower going forward relative to the past 20 years. Together India and China consume 19% of world oil, and therefore a deceleration in their oil consumption growth will have a non-trivial impact on the pace of global oil demand growth. This presents a major risk for crude prices in the next 6 months or so. Beyond the cyclical horizon, the long-term demand outlook for oil is also downbeat. Please note that this is the view of BCA’s Emerging Markets Strategy team, and differs from that of BCA’s house view, which is bullish on oil. Chart 13India’s Relative Equities Performance Benefits From Lower Oil Prices India's Relative Equities Performance Benefits From Lower Oil Prices India's Relative Equities Performance Benefits From Lower Oil Prices In turn, low oil prices are positive for the relative performance of Indian stocks versus the EM equity benchmark (Chart 13). This was among the primary reasons why we upgraded the allocation to this bourse within an EM equity portfolio to neutral from underweight on September 26, 2019. In absolute terms, the outlook for Indian share prices remains downbeat, as discussed in the same report. Finally, to express our negative view on oil prices, we are reiterating our short oil and copper / long gold position recommended on July 11, 2019. Industrial commodities such as copper and oil will continue to underperform gold prices in the medium term (the next six months). Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com   Footnotes 1      Diesel consumption will also be impacted. While the latter is mostly consumed by the transportation sector in India, diesel does have some industrial applications as well. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations