Capital Flows

In this Special Report, we evaluate future prospects for the Australian dollar and Australian government bonds. The currency remains fundamentally cheap, and positioning is very short, but the AUD will continue to underperform in the near-term due to sluggish global growth. Australian government bonds have had a nice run of outperformance over the past year, but it is now time to take profits with given the uncertainty that the RBA will deliver the rate cuts currently discounted.

Eventually South Africa will do its macro rebalancing the least painful way: via adjustments in nominal variables such as prices and currency, rather than in real variables such as jobs and incomes. That entails a much weaker rand in future.

Thai stocks and currency will weaken over the short term. And yet EM equity portfolios should overweight Thailand as tourism revivals will rejuvenate this economy.

Commodity currencies have been rather resilient, despite the broad rise in the dollar this year. In our view, we are about to experience a big rotation in commodity currency market performance at the crosses, from NZD, to CAD and finally to AUD.

A country’s external balance remains one of the key pillars of the longer-term trend for the exchange rate. In this week’s report, we look at the developments in global basic balances, and their implications for currency strategy.

Listen to a short summary of this report.     Executive Summary Higher Real Yields Have Weighed On Equity Valuations Higher Real Yields Have Weighed On Equity Valuations Higher Real Yields Have Weighed On Equity Valuations I had the pleasure of visiting clients in Saudi Arabia, Bahrain, and Abu Dhabi last week. In contrast to the rest of the world, the mood in the Middle East was very positive. While high oil prices are helping, there is also a lot of optimism about ongoing structural reforms. Petrodollar flows are increasingly being steered towards private and public equities. EM assets stand to benefit the most. Producers in the region are trying to offset lost Russian output, but realistically, they will not be able to completely fill the gap in the near term. Today’s high energy prices have largely baked in this reality, as reflected in strongly backwardated futures curves. There was no consensus about how high oil prices would need to rise to trigger a global recession, although the number $150 per barrel got bandied about a lot. Given that most Middle Eastern currencies are pegged to the dollar, there was a heavy focus on Fed policy. Market estimates of the neutral rate in the US have increased rapidly towards our highly out-of-consensus view. Nevertheless, we continue to see modest upside for bond yields over a multi-year horizon. Over a shorter-term 6-to-12-month horizon, the direction of bond yields will be guided by the evolution of inflation. While US CPI inflation rose much more than expected in May, the details of the report were somewhat less worrying, as they continue to show significant supply-side distortions. Bottom Line: Inflation should come down during the remainder of the year, allowing the Fed to breathe a sigh of relief and stocks to recover some of their losses. A further spike in oil prices is a major risk to this view.   Dear Client, Instead of our regular report next week, we will be sending you a Special Report written by Chester Ntonifor, BCA Research’s Chief Foreign Exchange Strategist, discussing the outlook for gold. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. As always, I will hold a webcast discussing the outlook the following week, on Thursday, July 7th. Best regards, Peter Berezin Chief Global Strategist Peter in Arabia I had the pleasure of visiting clients in Saudi Arabia, Bahrain, and Abu Dhabi last week. This note summarizes my impressions and provides some commentary about recent market turmoil. The Mood in the Region is Very Positive In contrast to the rest of the world, the mood in the Middle East was upbeat. Obviously, high oil prices are a major contributor (Chart 1). Across the region, stock markets are still up for the year (Chart 2). Chart 1Oil Prices Have Shot Up Oil Prices Have Shot Up Oil Prices Have Shot Up Chart 2Middle Eastern Stock Markets Are Doing Relatively Well This Year Middle Eastern Stock Markets Are Doing Relatively Well This Year Middle Eastern Stock Markets Are Doing Relatively Well This Year   That said, I also felt that investors were encouraged by ongoing structural reforms, especially in Saudi Arabia where the Vision 2030 program is being rolled out. The program seeks to diversify the Saudi economy away from its historic reliance on petroleum exports. A number of people I spoke with cited the Saudi sovereign wealth fund’s acquisition of a majority stake in Lucid, a California-based EV startup, as the sort of bold move that would have been unthinkable a few years ago. I first visited Riyadh in May 2011 where I controversially delivered a speech entitled “The Coming Commodity Bust” (oil was $120/bbl then and copper prices were near an all-time high). The city has changed immensely since then. The number of restaurants and entertainment venues has increased exponentially. The ban on women drivers was lifted only four years ago. In that short time, it has become a common-day occurrence. Capital Flows Into and Out of the Region are Reflecting a New Geopolitical Reality In addition to high oil prices and structural reforms, geopolitical considerations are propelling significant capital inflows into the region. The freezing of Russia’s foreign exchange reserves sent a shockwave across much of the world, with a number of other EM countries wondering if “they are next.” Ironically, the Middle East has emerged as a neutral player of sorts in this multipolar world, and hence a safer destination for capital flows. On the flipside, the region’s oil exporters appear to be acting more strategically in how they allocate their petrodollar earnings. Rather than simply parking the proceeds of oil sales in overseas US dollar bank accounts, they are investing them in ways that further their economic and political goals. One clear trend is that equity allocations to both overseas public and private markets are rising. Other emerging markets stand to benefit the most from this development, especially EMs who have assets that Middle Eastern countries deem important – assets tied to food security being a prime example. Assuming that the current level of oil prices is maintained, we estimate that non-US oil exports will rise to $2.5 trillion in 2022, up from $1.5 trillion in 2021 (Chart 3). About 40% of this windfall will flow to the Middle East. That is a big slug of cash, enough to influence the direction of equity markets. Chart 3Oil Exporters Reaping The Benefits Of High Oil Prices An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East Middle Eastern Energy Producers Will Boost Output, But Don’t Expect Any Miracles in the Short Term Russian oil production will likely fall by about 2 million bpd relative to pre-war levels over the next 12 months. To help offset the impact, OPEC has already raised production by 200,000 barrels and will almost certainly bump it up again following President Biden’s visit to the region in July (Chart 4). The decision to raise production to stave off a super spike in oil prices is not entirely altruistic. The region’s oil exporters know that excessively high oil prices could tip the global economy into recession, an outcome that would surely lead to much lower oil prices down the road. There was not much clarity on what that tipping point is, but the number $150 per barrel got bandied around a lot. Politics is also a factor. A further rise in oil prices could compel the US to make a deal with Iran, something the Saudis do not want to see happen. Still, there is a practical limit to how much more oil the Saudis and other Middle Eastern producers can bring to market in the near term. Today’s high energy prices have largely baked in this reality, as reflected in strongly backwardated futures curves (Chart 5). Chart 4Output Trends In The Major Oil Producers Output Trends In The Major Oil Producers Output Trends In The Major Oil Producers Chart 5Energy Prices On Both Sides Of The Atlantic An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East Data on Saudi’s excess capacity is notoriously opaque, but I got the feeling that an extra 1-to-1.5 million bpd was the most that the Kingdom could deliver. The same constraints apply to natural gas. Qatar is investing nearly $30 billion to expand its giant North Field, which should allow gas production to rise by as much as 60%. However, it will take four years to complete the project. The share of Qatari liquefied natural gas (LNG) going to Europe has actually declined this year. About 80% of Qatar’s LNG is sold to Asian buyers under long-term contracts that cannot be easily adjusted. And even if those contracts could be rewritten, this would only bring limited benefits to Europe. For example, Germany has no terminals to accept LNG imports, although it is planning to build two. While there was plenty of sympathy to Europe’s plight in the region, there was also a sense that European governments had been cruising for a bruising by doubling down on strident anti-fossil fuel rhetoric over the past decade without doing much to end their dependence on Russian oil and gas. In that context, few in the region seemed willing to bend over backwards to help Europe. In the meantime, the US remains Europe’s best hope. US LNG shipments to Europe have tripled since last year. The US is now sending nearly three quarters of its liquefied gas to Europe. This has pushed up US natural gas prices, although they still remain a fraction of what they are in Europe. Huge Focus on the Fed Chart 6Most Of The Increase In Bond Yields Has Been In The Real Component Most Of The Increase In Bond Yields Has Been In The Real Component Most Of The Increase In Bond Yields Has Been In The Real Component Most Middle Eastern currencies are pegged to the dollar, and hence the region effectively imports its monetary policy from the US. Not surprisingly, clients were very focused on the Federal Reserve. Many expressed concern about the abrupt pace of rate hikes. One of our high-conviction views is that the neutral rate of interest in the US has risen as the household deleveraging cycle has ended, fiscal policy has become structurally looser, and a growing number of baby boomers have transitioned from working (and saving) to retirement (and dissaving). The markets have rapidly priced in this view over the course of 2022. The 5-year/5-year forward Treasury yield – a proxy for the neutral rate – has increased from 1.90% at the start of the year to 3.21% at present. Most of this increase in the market’s estimate of the neutral rate has occurred in the real component. The 5-year/5-year forward TIPS yield has climbed from -0.49% to 0.84%; in contrast, the implied TIPS breakeven inflation rate has risen from only 2.24% to 2.37% (Chart 6). Implications of Higher Bond Yields on Equity Prices and the Economy Chart 7Higher Real Yields Have Weighed On Equity Valuations Higher Real Yields Have Weighed On Equity Valuations Higher Real Yields Have Weighed On Equity Valuations As both theory and practice suggest, there is a strong negative correlation between real bond yields and equity valuations. Chart 7 shows that the S&P 500 forward P/E ratio has been moving broadly in line with the 5-year/5-year forward TIPS yield. The bad news is that there is still scope for bond yields to rise over the long haul. Our fair value estimate of 3.5%-to-4% for the neutral rate is about 25-to-75 basis points above current pricing. The good news is that a high neutral rate helps insulate the economy from a near-term recession. Recessions typically occur only when monetary policy turns restrictive. A few clients cited the negative Q1 GDP reading and the near-zero Q2 growth estimate in the Atlanta Fed GDPNow model as evidence that a US recession is either close at hand or has already begun (Chart 8). Chart 8Underlying US Growth Is Expected To Be Solid In Q2 An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East We would push back against such an interpretation. In contrast to the -1.5% real GDP print, real Gross Domestic Income (GDI) rose by 2.1% in Q1. Conceptually, GDP and GDI should be equal, but since the two numbers are compiled in different ways, there can often be major statistical discrepancies. A simple average of the two suggests the US economy still grew in the first quarter. More importantly, real final sales to private domestic purchasers rose by 3.9% in Q1. This measure of economic activity – which strips out the often-noisy contributions from inventories, government expenditures, and net exports – is the best predictor of future GDP growth of any item in the national accounts (Table 1). Table 1A Good Sign: Real Final Sales To Private Domestic Purchasers Rose By 3.9% In Q1 An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East As far as Q2 is concerned, real final sales to private domestic purchasers are tracking at 2.0% according to the Atlanta Fed model – a clear deceleration from earlier this year, but still consistent with a generally healthy economy. Growth will probably slow in the third quarter, reflecting the impact of higher gasoline prices, rising interest rates, and lower asset prices. Nevertheless, the fundamental underpinnings for the economy – low household debt, $2.2 trillion in excess savings, a dire need to boost corporate capex and homebuilding, and a strong labor market – remain in place. The odds of a recession in the next 12 months are quite low. Gauging Near-Term Inflation Dynamics A higher-than-expected neutral rate of interest implies that bond yields will probably rise from current levels over the long run. Over a shorter-term 6-to-12-month horizon, however, the direction of yields will be guided by the evolution of inflation. While the core CPI surprised on the upside in May, the details of the report were somewhat less worrying, as they continue to show significant supply-side distortions. Excluding vehicles, core goods prices rose 0.3% in May, down from a Q1 average of 0.7% (Chart 9). Recent commentary from companies such as Target suggest that goods inflation will ease further. Chart 9Goods Inflation Is Moderating, While Service Price Growth Is Elevated An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East Stripping out energy-related services, services inflation slowed slightly to 0.6% in May from 0.7% in April. A deceleration in wage growth should help keep a lid on services inflation over the coming months (Chart 10). Chart 10A Deceleration In Wage Growth Should Help Keep Services Inflation Contained An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East During his press conference, Fed Chair Powell described the rise in inflation expectations in the University of Michigan survey as “quite eye-catching.” Although long-term inflation expectations remain a fraction of what they were in the early 1980s, they did rise to the highest level in 14 years in June (Chart 11). Powell also noted that the Fed’s Index of Common Inflation Expectations has been edging higher. The Fed’s focus on ensuring that inflation expectations remain well anchored is understandable. That said, there is a strong correlation between the level of gasoline prices and inflation expectations (Chart 12). If gasoline prices come down from record high levels over the coming months, inflation expectations should drop.  Chart 11Consumer Long-Term Inflation Expectations Keep Rising, But Are Still Not At Historically High Levels Consumer Long-Term Inflation Expectations Keep Rising, But Are Still Not At Historically High Levels Consumer Long-Term Inflation Expectations Keep Rising, But Are Still Not At Historically High Levels Chart 12Lower Gasoline Prices Would Help Soothe Consumer Fears Over Inflation Lower Gasoline Prices Would Help Soothe Consumer Fears Over Inflation Lower Gasoline Prices Would Help Soothe Consumer Fears Over Inflation The Fed expects core PCE inflation to fall to 4.3% on a year-over-year basis by the end of 2022. This would require month-over-month readings of about 0.35 percentage points, which is slightly above the average of the past three months (Chart 13). Our guess is that the Fed may be highballing its near-term inflation projections in order to give itself room to “underpromise and overdeliver” on the inflation front. If so, we could see inflation estimates trimmed later this year, which would provide a more soothing backdrop for risk assets. Chart 13AUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (I) US Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (I) US Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (I) Chart 13BUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (II) US Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (II) US Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (II) Concluding Thoughts on Investment Strategy According to Bank of America, fund managers cut their equity exposure to the lowest since May 2020. Optimism on global growth fell to a record low. Meanwhile, bears outnumbered bulls by 39 percentage points in this week’s AAII poll (Chart 14). If the stock market is about to crash, it will be the most anticipated crash in history. In my experience, markets rarely do what most people expect them to do. Chart 14Sentiment Towards Equities Is Pessimistic Sentiment Towards Equities Is Pessimistic Sentiment Towards Equities Is Pessimistic Chart 15Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off Chart 16US And European EPS Estimates Have Been Trending Higher This Year US And European EPS Estimates Have Been Trending Higher This Year US And European EPS Estimates Have Been Trending Higher This Year US equities are trading at 16.3-times forward earnings, with non-US stocks sporting a forward P/E ratio of 12.1 (Chart 15). Despite the decline in share prices, earnings estimates in both the US and Europe have increased since the start of the year (Chart 16). The consensus is that those estimates will fall. However, if our expectation that a recession will be averted over the next 12 months pans out, that may not happen. A sensible strategy right now is to maintain a modest overweight to stocks while being prepared to significantly raise equity exposure once clear evidence emerges that inflation has peaked. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on        LinkedIn Twitter       View Matrix An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East Special Trade Recommendations Current MacroQuant Model Scores An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East

Executive Summary Favor ASEAN And The Philippines Favor ASEAN And The Philippines Favor ASEAN And The Philippines Southeast Asia is suffering from fading macro and geopolitical tailwinds but there are still investment opportunities on a relative basis. The peace dividend, globalization dividend, and demographic dividend are all eroding and will continue to erode, though there are relative winners and losers. The Philippines and Thailand are most secure; the Philippines and Indonesia are least dependent on trade; and the Philippines and Vietnam have the highest potential GDP growth. Geopolitical risk premiums have risen for Russia, Eastern Europe, China, and will rise for the Middle East. This leaves ASEAN states as relatively attractive emerging markets. Trade Recommendation Inception Date Return LONG PHILIPPINES / EM EQUITIES 2022-05-12   LONG ASEAN / ACW EQUITIES 2022-05-12   Bottom Line: ASEAN’s geopolitical outlook is less ugly than many other emerging markets. Cyclically, go long ASEAN versus global equities and long Philippine equities versus EM. Feature Chart 1Hypo-Globalization A Headwind For Trading States Hypo-Globalization A Headwind For Trading States Hypo-Globalization A Headwind For Trading States The Philippines elected its second “strongman” leader in a row on May 9, provoking the usual round of editorials about the death of liberalism. Investors know well by now that such political narratives do as much to occlude economic reality as to clarify it. Still, there is a fundamental need to understand the changing global political order since it will ultimately impact the investment landscape. If the global order stabilizes – e.g. US-Russia and US-China relations normalize – then trade and investment may recover from recent shocks. A new era of “Re-Globalization” could ensue. Asia Pacific would be a prime beneficiary as it is full of trading economies (Chart 1). Related Report  Geopolitical StrategySecond Quarter Outlook 2022: When It Rains, It Pours By contrast, if Great Power Rivalry escalates further, then trade and investment will suffer, the current paradigm of Hypo-Globalization will continue, and East Asia’s frozen conflicts from 1945-52 will thaw and heat up. Asian states will have to shift focus from trade to security and their economies will suffer relative to previous expectations. How will Southeast Asia fare in this context? Will it fall victim to great power conflict, like Eastern Europe? Or will it keep a balance between the great powers and extract maximum benefits? Three Dividends Three dividends have underpinned Southeast Asia’s growth and prosperity in recent decades: 1.  Peace Dividend – A relative lack of war and inter-state conflict. 2.  Globalization Dividend – Advantageous maritime geography and access to major economies. 3.  Demographic Dividend – Young demographics and strong potential GDP growth. All three of these dividends are eroding, so the macro and geopolitical investment case for ASEAN has weakened relative to twenty years ago. Nevertheless in a world where Russia, China, and the Gulf Arab markets face a higher and persistent geopolitical risk premium, ASEAN still offers attractive investment opportunities, particularly if the most geopolitically insecure countries are avoided. Peace Dividend Favors The Philippines And Thailand Since the end of the US and Chinese wars with Vietnam, military conflicts in Southeast Asia have been low intensity. Lack of inter-state conflict encouraged economic prosperity and security complacency. The five major Southeast Asian nations saw military spending decline since the 1990s and only Vietnam spends more than 2% of GDP (Chart 2). Chart 2Peace Brought Prosperity Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines Unfortunately that is about to change. China has large import dependencies, an insufficient tradition of sea power, and feels hemmed in by its geography and the US alliance system. Beijing’s solution is to build and modernize its navy and prepare for potential conflict with the US, particularly over Taiwan. The result is rising tension across East Asia, including in Southeast Asia and the South China Sea. The ASEAN states fear China will walk over them, China fears they will league with the US against China, and the US tries to get them to do exactly that. Hence ASEAN’s defense spending has not kept up with its geopolitical importance and will have to rise going forward. Consider the following: Vietnam risks conflict with China. Vietnam has the most capable and experienced naval force within ASEAN due to its sporadic conflicts with China. Its equipment is supplied mainly by Russia, pitting it squarely against China’s Soviet or Soviet-inspired equipment. But Russia-China ties are tightening, especially after Russia’s divorce with Europe. While Vietnam will not reject Russia, it is increasingly partnering with the United States. The pandemic added to the Vietnamese public’s distrust of China, which is ancient but has ramped up in recent years due to clashes in the South China Sea. While Vietnam officially maintains that it will never host the US military, it is tacitly bonding with the US as a hedge against China. Yet Vietnam does not have a mutual defense treaty with the US, so it is vulnerable to Chinese military aggression over time. Indonesia distances itself from China. Rising security tensions are also forcing Indonesia to change its strategy toward China. Indonesia lacks experience in naval warfare and is not a claimant in the territorial disputes in the South China Sea. It is reluctant to take sides due to its traditionally non-aligned diplomatic status, its military culture of prioritizing internal stability (which is hard to maintain across thousands of islands), and China’s investment in its economy. However, China is encroaching on Indonesia’s exclusive economic zone and Indonesia has signaled its displeasure through diplomatic snubs and high-profile infrastructure contracts. Indonesia is trying to bulk up its naval and air capabilities, including via arms purchases from the West. Malaysia distances itself from China. Malaysia and the Philippines have the weakest naval forces and both face pressure from China’s navy and coast guard due to maritime-territorial disputes. But while the Philippines gets help from the US and its allies and partners, Malaysia has no such allies. Traditionally it was non-aligned. Instead it utilizes economic statecraft, as it has often done against more powerful countries. It recently paused Chinese economic projects in the country to conduct reviews and chose Ericsson over Huawei to build the 5G network. Ongoing maritime and energy disputes will motivate defense spending. The Philippines preserves alliance with United States. Outgoing President Rodrigo Duterte tried but failed to strengthen ties with China and Russia. Beijing continued to swarm the Philippines’ economic zone with ships and threaten its control of neighboring rocks and reefs. Ultimately Duterte renewed his country’s Visiting Forces Agreement with the US in July 2021. The newly elected President “Bong Bong” Marcos is even less likely to try to pivot away from the US. Instead the Philippines will work with the US to try to deter China. Thailand preserves alliance with United States. Thailand is the most insulated from the South China Sea disputes and often acts as mediator between China and other ASEAN states. However, Thailand is also a formal US defense ally and assisted with logistics during the Korean and Vietnamese wars. While US military aid was suspended after the 2014 military coup, non-military aid from the US continued. The State Department certified Thailand’s return to democracy in 2019, relations were normalized, and the annual Cobra Gold exercise resumed in 2020. The US’s hasty normalization shows Thailand’s importance to its regional strategy. On their own, the ASEAN states cannot counter China – they are simply outgunned (Chart 3). Hence their grand strategy of balancing Chinese trade relations with American security relations. Chart 3Outgunned By China Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines Chart 4Opinion Shifts Against China Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines In recent decades, with the US divided and distracted, they sought to entice China through commercial deals, in hopes that it would reduce its encroachments on the high seas. This strategy failed, as China’s expansion of economic and military influence in the region is driven by China’s own imperatives. Beijing’s lack of transparency about Covid-19 also sowed distrust. As a result, public opinion became more critical of China and defensive of national sovereignty (Chart 4). Southeast Asia will continue trading with China but changing public opinion, the US-China clash, and tensions in the South China Sea will inject greater geopolitical risk into this once peaceful and prosperous region. Military weakness will also lead the ASEAN states to welcome the US, EU, Japan, and Australia into the region as economic and security hedges against China. This trend risks inflaming regional tensions in the short run – and China may not be deterred over the long run, since its encroachments in the region are driven by its own needs and insecurities. Decades of under-investment in defense will result in ASEAN rearmament, which will weigh on fiscal balances and potentially economic competitiveness. Investors should not take the past three decades of peace for granted. Bottom Line: Vietnam (like Taiwan) is in a geopolitical predicament where it could provoke China’s wrath and yet lacks an American security guarantee. The Philippines and Thailand benefit from American security guarantees. Indonesia and Malaysia benefit from distance from China. All of these states will attempt to balance US and China relations – but in the future that means devoting more resources to national security, which will weigh on fiscal budgets and take away funds from human capital development. Waning Globalization Dividend Favors Indonesia And The Philippines All the ASEAN states rely heavily on both the US and China for export markets. This reliance grew as trade recovered in the wake of the global pandemic (Chart 5). Now global trade is slowing down cyclically, while US-China power struggle will weigh on the structural globalization process, penalizing the most trade-dependent ASEAN states relative to their less trade-dependent neighbors. So far US-China economic divorce is redistributing US-China trade in a way that is positive for Southeast Asia. China is rerouting exports through Vietnam, for example, while the US is shifting supply chains to other Asian states (Chart 6). The US will accelerate down this path because it cannot afford substantively to reengage with China’s economy for fear of strengthening the Russo-Chinese bloc. Chart 5Trade Rebounded But Hypo-Globalization Will Force Domestic Reliance Trade Rebounded But Hypo-Globalization Will Force Domestic Reliance Trade Rebounded But Hypo-Globalization Will Force Domestic Reliance ​​​​​ Chart 6ASEAN’s Exports To US Surge Ahead Of China’s ASEAN's Exports To US Surge Ahead Of China's ASEAN's Exports To US Surge Ahead Of China's Hence the US will become more reliant on Southeast Asian exporters. Whatever the US stops buying from China will have to be sourced from other countries, so countries that export a similar basket of goods will benefit from the switch. Comparing the types of goods that China and ASEAN export to the US, Thailand is the closest substitute for China, whereas Malaysia is the farthest (Chart 7). That is not to say that Malaysia will suffer from US-China divorce. It is already ahead of China in exporting high-tech goods to the US, which is the very reason its export profile is so different. In 2020, 58% of Malaysia’s exports to the US are high-tech versus 35% for China’s. At the same time, Southeast Asian exports to China may not grow as fast as expected – cyclically China’s economy may accelerate on the back of current stimulus efforts, but structurally China is pursuing self-sufficiency and import substitution via a range of industrial policies (“Made in China 2025,” “dual circulation,” etc). These policies aim to make Chinese industrials competitive with European, US, Japanese, and Korean industrials. But they will also make China more competitive with medium-tech and fledging high-tech exports from Southeast Asia. Thus while China will keep importing low value products and commodities, such as unrefined ores, from Southeast Asia, imports of high-tech products will be limited due to China’s preference for indigenous producers. US export controls will also interfere with ASEAN’s ability to export high-tech goods to China. (In order to retain their US trade, in the face of Chinese import substitution, ASEAN states will have to comply with US export controls at least partially.) Even the low-to-medium tech goods that China currently imports from Southeast Asia may not grow as fast in the coming years as they have in the past. The ten provinces in China with the lowest GDP per capita exported a total of $129 billion to the world in 2020, whereas China’s imports from the top five ASEAN states amounted to $154 billion USD in 2020 (Chart 8). If Beijing insists on creating a domestic market for its poor provinces’ exports, then Southeast Asian exports to China will suffer. China might do this not only for strategic sufficiency but also to avoid US and western sanctions, which could be imposed for labor, environmental, human rights, or strategic reasons. Chart 7The US Sees Thailand And Vietnam As Substitutes For China Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines ​​​​​​ Chart 8China Threatens ASEAN With Import Substitution Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines ​​​​​​ Chart 9Trade Rebound Increased Exposure To US, China Trade Rebound Increased Exposure To US, China Trade Rebound Increased Exposure To US, China China, unlike the US during the 1990s and 2000s, cannot afford to open up its doors and become a ravenous consumer and importer of all Asia’s goods. This would be a way to buy influence in the region, as the US has done in Latin America. But China still has significant domestic development left to do. This development must be done for the sake of jobs and income – otherwise the Communist Party will face sociopolitical upheaval. Malaysia, Vietnam, and Thailand are the most vulnerable to China’s dual circulation strategy because of their sizeable exports to China, which stand at 12%, 15% and 7.6% of GDP respectively (Chart 9). Even though the Southeast Asian states have formed into a common market, and have joined major new trade blocs such as the CPTPP and RCEP, they will not see unfettered liberalization within these agreements – and they will not be drawn exclusively into China’s orbit. Instead they will face a China that wishes to expand export market share while substituting away from imports. The US and India, which are not part of these new trade blocs, will still increase their trade with ASEAN, as they will seek to substitute ASEAN for China, and ASEAN will be forced to substitute them for China. Thus globalization will weaken into regionalization and will not provide as positive of a force for Southeast Asia as it did over the 1980s-2000s. Going forward, the new paradigm of Hypo-Globalization will weigh on trade-dependent countries like Malaysia, Vietnam, and Thailand relative to their neighbors. Within this cohort, Malaysia and the Philippines will benefit from selling high-tech goods to the US, while Thailand and Vietnam will benefit from selling low- and mid-tech goods. China will remain a huge and critical market for ASEAN states but its autarkic policies will drive them to pursue other markets. Those with large and growing domestic markets, like Indonesia and the Philippines, will weather hypo-globalization better than their neighbors. Vietnam, Malaysia, and Thailand are all extremely dependent on foreign trade and hence vulnerable if international trade linkages weaken. Bottom Line: Global trade is likely to slow on a cyclical basis. Structurally, Hypo-Globalization is the new paradigm and will remove a tailwind that super-charged Southeast Asian development over the past several decades. Indonesia and the Philippines stand to suffer least and benefit most. Potential Growth Dividend Favors The Philippines And Vietnam Countries that can generate endogenous growth will perform the best under hypo-globalization. Indonesia, the Philippines, and Vietnam have the largest populations within ASEAN. But we must also take into account population growth, which contributes directly to potential GDP growth. A domestic market grows through population growth and/or income growth. For example, China benefitted from its growing population but now must switch to income generation as its population growth is stagnating. In Southeast Asia, the Philippines, Malaysia, and Indonesia have the highest population growth, while Thailand has the lowest. Thai population growth is even weak compared to China. The total fertility rate reinforces this trend – it is highest in Philippines but lowest in Thailand (Chart 10). A population that is too young or too old needs significant support that diverts resources away from the most productive age group. Philippines and Indonesia have the lowest median age, while Thailand has the highest. The youth of Indonesia and Philippines will come of age in the next decade, augmenting labor force and potential GDP growth. By contrast, Vietnam and especially Thailand, like China, will be weighed down by a shrinking labor force in the coming decade (Chart 11). Chart 10Fertility Rates Robust In ASEAN Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines ​​​​​​ Chart 11Falling Support Ratio Weighs On Thailand, Vietnam Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines ​​​​​​ Hence Indonesia and Philippines will prosper while Thailand, and to some extent Vietnam, lack the ability to diversify away from trade through domestic market growth. Malaysia sits in the middle: it is trade dependent and has the smallest population, but it has a young and growing population, and its labor force is still growing. Yet falling population growth is not a disaster if productivity and income growth are high. Productivity trends often contrast with population trends: Indonesia had the weakest productivity growth despite having a large, young, and growing population, while Vietnam had the strongest growth, despite a population slowdown. In fact Vietnam has the strongest productivity growth in Southeast Asia, at a 5-year, pre-pandemic average of 6.3%, followed by the Philippines (Chart 12A). By comparison China’s productivity growth averaged between 3%-6.6%, depending on the data source. Chart 12AProductivity And Potential GDP Productivity And Potential GDP Productivity And Potential GDP ​​​​​​ Chart 12BProductivity And Potential GDP Productivity And Potential GDP Productivity And Potential GDP ​​​​​​ Chart 13Capital Formation Favors Philippines Capital Formation Favors Philippines Capital Formation Favors Philippines Productivity growth adds to labor force growth to form potential GDP. In 2019, Philippines had the highest potential GDP growth at 6.9%, followed by the Vietnam at 6.8%, Indonesia at 5.6%, Malaysia at 3.9% and Thailand at 2.3%. In comparison China’s potential GDP growth was 3.6%-5.9%, again depending on data. Thailand is undoubtedly the weakest from both a population and productivity standpoint, while the Philippines has strength in both (Chart 12B). Countries invest in their economies to increase productivity. In 2019, Vietnam recorded the highest growth in grossed fixed capital formation at around 10.6%, followed by Indonesia at 6.9%, Philippines at 6.3%, and Thailand at 2.2%. Gross fixed capital formation has rebounded from the contractions countries suffered during the pandemic lockdowns in 2020 (Chart 13). Bottom Line: The Philippines has strong potential GDP growth, but Indonesia is not far behind as it invests in its economy. Vietnam has the highest investment and productivity growth, but its demographic dividend is waning. Malaysia is slightly better than Thailand because it has a growing population, but it has stopped investing and it is as trade dependent as Thailand. Thailand is weak on all accounts: it is trade dependent, has a shrinking population, and has a low potential GDP growth. Investment Takeaways Bringing it all together, ASEAN is witnessing the erosion of key dividends (peace, globalization, and demographics). Yet it offers attractive investment opportunities on a relative basis, given the permanent step up in geopolitical risk premiums for other major emerging markets like Russia, eastern Europe, China, and (soon) the Gulf Arab states (Charts 14A & 14B). Indeed the long under-performance of ASEAN stocks as a bloc, relative to global stocks, has recently reversed. As investors recognize China’s historic confluence of internal and external risks, they increasingly turn to ASEAN despite its flaws. Chart 14AASEAN Will Continue To Outperform China ASEAN Will Continue To Outperform China ASEAN Will Continue To Outperform China The US and China will use rewards and punishments to try to win over ASEAN states as strategic and economic partners. Those that have a US security guarantee, or are most distant from potential conflict, will see a lower geopolitical risk premium. Chart 14BASEAN Will Continue To Outperform China ASEAN Will Continue To Outperform China ASEAN Will Continue To Outperform China ​​​​​​ Chart 15Favor The Philippines Favor The Philippines Favor The Philippines The Philippines is the most attractive Southeast Asian market based on our criteria: it has an American security guarantee, domestic-oriented growth, and high productivity. Populism in the Philippines has come with productivity improvements and yet has not overthrown the US alliance. Philippine equities can outperform their emerging market peers (Chart 15). Indonesia is the second most attractive – it does not have direct territorial disputes with China, maintains defense ties with the West, is not excessively trade reliant, and keeps up decent productivity growth. It is vulnerable to nationalism and populism but its democracy is effective overall and the regime has maintained general political stability after near-dissolution in 1998. Thailand is geopolitically secure but lacking in potential growth. Vietnam has high potential growth but is geopolitically insecure over the long run. Investors should only pursue tactical investments in these markets. We maintain our long-term favorable view of Malaysia, although it is trade dependent and productivity has weakened. In future reports we will examine ASEAN markets in greater depth and with closer consideration of their domestic political risks.   Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary Onshore Equity Market Outflow Pressures Remain, At Least In The Near Term Onshore Equity Market Outflow Pressures Remain, At Least In The Near Term Onshore Equity Market Outflow Pressures Remain, At Least In The Near Term China’s foreign exchange (FX) reserves fell in the first three months of 2022. The reduction was the largest quarterly fall since 2016, but it is minor in absolute terms given China’s massive FX reserves.  However, the underlying drivers of the decline in the FX reserves are cause for concern. The current drawdown in FX reserves reflects losses in China’s official FX asset portfolio and increased capital outflows, which differs from in 2H20 when Chinese banks increased their FX purchases to slow the pace of the RMB appreciation. Onshore equity market net outflows will likely continue in the near term. Even though Beijing has stepped up stimulus measures, private sector sentiment and domestic demand remain subdued. The country’s zero-tolerance COVID policy will also continue to weigh down the effectiveness of the stimulus. Pressure on the bond market’s outflow will be sustained in the next 6 to 12 months as policy cycles between the US and China continue to diverge. The RMB will modestly devalue relative to the USD in the next few month. In the longer term, the RMB should be underpinned by fundamentals such as a current account surplus, positive real interest rates and a valuation cushion. Bottom Line: The drop in the first quarter FX reserves reflects losses in China’s official FX asset portfolio and increased capital outflows. Feature Chart 1The Quarterly Drop In China's FX Reserves This Year Was Largest Since 2016 The Quarterly Drop In China's FX Reserves This Year Was Largest Since 2016 The Quarterly Drop In China's FX Reserves This Year Was Largest Since 2016 Newly released data shows that China’s FX reserves dropped by US$25.8 billion to US$3.188 trillion in March. This represented a US$62 billion decrease from December 2021 and it was the largest quarterly drop since 2016 (Chart 1). The RMB also weakened slightly in March from February. The reduction in China’s FX reserves in Q1 is due to several factors, including fluctuations in the dollar versus other major currencies and the drop in market prices of foreign asset holdings. The country’s current account surplus also narrowed in the first three months of the year compared with Q4 last year. Notably, foreign holdings of Chinese local currency bonds posted a record decline in Q1 and onshore equity market outflows also accelerated. The illicit movement of capital via import over-invoicing has also picked up. We expect that the bond market outflow pressure will continue for the year and perhaps beyond as economic, inflation and monetary policy cycles in China and the US continue to diverge. Equity outflow pressures will also be sustained, at least through the next few months, while China’s COVID-induced lockdown measures in major cities significantly weaken the economic outlook. Furthermore, the country’s zero-tolerance toward COVID will continue restraining mobility in 2H22. Anticipated lockdowns will severely disrupt the local economy and weigh down the effectiveness of Chinese stimulus, which policymakers had pledged to boost. As such, we maintain our neutral position on Chinese onshore stocks and an underweight stance on Chinese investable stocks in a global portfolio. A Drawdown In FX Reserves Chart 2The Size Of Capital Outflows In Q1 Is Comparable To That In 2H20 The Size Of Capital Outflows In Q1 Is Comparable To That In 2H20 The Size Of Capital Outflows In Q1 Is Comparable To That In 2H20 Capital outflows intensified in Q1, with the magnitude similar to 2H20 (Chart 2). However, the underlying drivers of the depletion have changed. In 2H20, China’s state-owned banks strategically accumulated FX assets to slow the pace of a rising RMB, whereas the Q1 loss this year was mainly driven by fluctuations in global financial markets and weak domestic economic fundamentals. The reduction in China’s official FX reserves in the past three months was partly due to a stronger dollar versus other major currencies and price declines in China’s holdings of foreign currency assets. China's official FX reserves are marked-to-market and converted into US dollars.  The value of China’s official reserves has been significantly impacted by two factors: the dollar’s increase of more than 4% in trade-weighted terms since its trough in May last year and the simultaneous decline in prices of both global stocks and bonds in Q1 2022 (Chart 3). In addition, China’s trade surplus narrowed in the first two months of the year from Q4 2021 and has likely dipped further in March (data has not yet been released) (Chart 4).  Slower growth in China’s exports, coupled with rising global commodity prices that boosted China’s commodity import costs, has probably contributed to a smaller current account surplus, which was insufficient to offset the increased capital outflows. Chart 3The Dollar Exchange Rate And The Value Of China's Official FX Reserves The Dollar Exchange Rate And The Value Of China's Official FX Reserves The Dollar Exchange Rate And The Value Of China's Official FX Reserves Chart 4China's Trade Surplus Narrowed In Q1 This Year China's Trade Surplus Narrowed In Q1 This Year China's Trade Surplus Narrowed In Q1 This Year Meanwhile, the acceleration in capital outflows does not seem to be driven by an increase in China’s domestic banks and companies’ foreign currency holdings. It does not appear that banks have been buying foreign currencies to slow down the pace of the RMB appreciation against other currencies. As noted in a previous report since 2018 net FX purchases by China’s banks have been more tightly correlated with the spread between the CNY/USD exchange rate and the CFETS index (Chart 5, top panel). When the RMB falls relative to the USD, but not by enough to slow its increase against other trading partners, China’s banks would ramp up their FX purchases to push down the CNY/USD exchange rate and/or raise the value of other currencies in the CFETS basket (Chart 5, bottom panel). This occurred in 2H20 but does not seem to be the case this year. Chart 5No Sign Of Chinese Banks' Ramping Up FX Purchases This Year No Sign Of Chinese Banks' Ramping Up FX Purchases This Year No Sign Of Chinese Banks' Ramping Up FX Purchases This Year Chart 6FX Settlement Has Been Net Positive... FX Settlement Has Been Net Positive... FX Settlement Has Been Net Positive... Chinese companies have not increased their demands for USD either. Chart 6 shows a positive net FX settlement rate by banks on behalf of clients. This means more non-financial enterprises (such as exporters and investors) sold their foreign exchange holdings to banks than bought foreign exchange from banks.  Moreover, Chart 7 highlights that the level of Chinese firms’ short-term foreign obligations (outstanding foreign currency loans, trade credit and liquid deposits) has remained steady. This implies that domestic firms have not been rushing to buy FX to pay back their dollar-denominated debts. Chart 7…And Chinese Firms Are Not Rushing To Pay Off External Debt A Fall In China’s FX Reserves: Cause For Concern? A Fall In China’s FX Reserves: Cause For Concern? Bottom Line: Q1’s capital outflows were not driven by Chinese banks’ strategic accumulation of FX reserves to slow the pace of the RMB’s appreciation, nor by the demand for USD by Chinese companies. Accelerated Portfolio Outflows China's recent capital drain may be grouped into two categories: reduced foreign portfolio inflows (and accelerated outflows) and the illicit seepage of capital. China’s bond market contributed largely to the acceleration in Q1’s portfolio outflows. Foreign holding of Chinese bonds posted a record depletion of US$30 billion in February and March this year and the trend likely continued through April (Chart 8). As the Fed enters its hiking cycle following the March lift-off, the US-China nominal interest rate has narrowed meaningfully (Chart 9). Despite a widening inflation gap between the US and China, China’s bond market has become less attractive to global investors compared with last year (Chart 9, bottom panel). Chart 8A Record Bond Market Outflow In Q1 This Year A Record Bond Market Outflow In Q1 This Year A Record Bond Market Outflow In Q1 This Year Chart 9Rate Differentials Between China and The US Have Narrowed Substantially, In Both Nominal And Real Terms Rate Differentials Between China and The US Have Narrowed Substantially, In Both Nominal And Real Terms Rate Differentials Between China and The US Have Narrowed Substantially, In Both Nominal And Real Terms   Outflows from onshore equity market also accelerated in Q1, in part because of China’s disappointing domestic economic data, rising geopolitical tensions and risk-off sentiment among global investors. Losses of Northbound net flows reached US$7.6 billion in March, comparable to the amount in early 2020 when China was hit hard by the pandemic (Chart 10). Importantly, while service trade deficits from outbound tourism continued to narrow due to international travel restrictions, our estimate of the illicit capital seepage through import over-invoicing has gathered speed since 2H21 (Chart 11).  The sharp rise in our illicit capital outflow indicator suggests that the private sector and Chinese residents may be moving capitals offshore. Chart 10Chinese Onshore Equity Market Also Saw Substantial Investment Outflows In Q1 Chinese Onshore Equity Market Also Saw Substantial Investment Outflows In Q1 Chinese Onshore Equity Market Also Saw Substantial Investment Outflows In Q1 Chart 11Illicit Capital Outflows Picked Up Illicit Capital Outflows Picked Up Illicit Capital Outflows Picked Up   Bottom Line: The drain of capital escalated in Q1 through accelerated foreign portfolio outflows and perhaps illicit capital streaming out of the country. Investment Conclusions Chart 12Onshore Equity Market Outflow Pressures Remain, At Least In The Near Term Onshore Equity Market Outflow Pressures Remain, At Least In The Near Term Onshore Equity Market Outflow Pressures Remain, At Least In The Near Term Equity market net outflows will likely continue, at least for the next couple months while China struggles to contain the ongoing COVID flareups in major cities. We maintain our recommended neutral allocation to Chinese onshore stocks and an underweight stance on Chinese offshore stocks in a global equity portfolio (Chart 12). While China’s stimulus should be able to stabilize the economy over a cyclical time horizon (the next 6 to 12 months), the nation’s zero-tolerance COVID position poses significant downside risks to the effectiveness of policy easing. It will be harder for China to contain infections as the virus mutates and variants become more contagious. There may be more frequent and larger-scale lockdowns affecting the economy than there have been in the past two years. Meanwhile, outflow pressures on China’s bond market may carry on through the next 6 to 12 months while the economic, inflation and monetary policy cycles in the US and China continue to diverge. Although the RMB has not moved into outright expensive territory, reduced foreign portfolio flows into RMB assets and a smaller current account surplus will pose near-term downward stress on the RMB against the USD. A depreciation in the RMB would be a boon to China’s domestic economy since it will help the export sector pricing power. Beyond the near term and in the next 12 to 18 months, however, fundamentals, such as China’s current account surplus, positive real interest rates and a valuation cushion, will underpin strength in the RMB (Chart 13A & 13B). Chart 13AOnshore Equity Market Outflow Pressures Remain, At Least In The Near Term The RMB Is At Fair Value Based On Productivity Trends... The RMB Is At Fair Value Based On Productivity Trends... Chart 13B...But Is Cheap Based On Relative Prices ...But Is Cheap Based On Relative Prices ...But Is Cheap Based On Relative Prices   Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations

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

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