China

Dear Client, This week we are sending you a joint Special Report written by my colleagues Xiaoli Tang, Associate Vice President at BCA Research’s Global Asset Allocation, and Qingyun Xu, Associate Editor at China Investment Strategy. In the Special Report Xiaoli and Qing investigate the impact on global portfolios when adding onshore Chinese assets. Their findings confirm our view that Chinese onshore equities have not been a good long-term, buy-and-hold asset for global equity investors due to extremely high volatility. However, they conclude that to improve both the absolute and risk-adjusted returns of the onshore equity market, investors can apply an equal-weighted, five-factor smart-beta strategy or active sector/industry allocation strategies. More importantly, they find that both hedged and unhedged Chinese onshore bonds are excellent risk diversifiers for DM bond investors, and Chinese onshore bonds are also a good risk-diversifier and complementary to Chinese equity-centric portfolios. I trust you will find it insightful. Next week the China Investment Strategy team will take our second of the two-week summer break. We will resume our publication on Wednesday, September 1st. Best regards, Jing Sima, China Strategist Highlights Global investors have become increasingly interested in Chinese onshore equities and bonds as part of their multi-asset portfolios as Chinese onshore equities and bonds have been included in major global stock and bond indexes. In this report, we investigate the impact on global portfolios when adding onshore Chinese assets. Three assets (stocks, bonds and stock-bond combinations) and six home currencies (the USD, JPY, EUR, GBP, CAD and AUD) are included in our portfolio analysis. Chinese onshore equities have not been a good long-term, buy-and-hold asset for global equity investors due to extremely high volatility. To improve both the absolute and risk-adjusted returns of the onshore equity market, however, investors can apply an equal-weighted, five-factor smart-beta strategy or active sector/industry allocation strategies. Hedged Chinese onshore bonds are excellent risk diversifiers for DM bond investors, but higher absolute and risk-adjusted returns may be derived from unhedged bonds, thanks to the positive carry and negative correlation between the onshore Chinese bond index and CNY crosses. Chinese onshore bonds are also a good risk-diversifier and complementary to Chinese equity-centric portfolios, given the negative correlation between the performance of Chinese bonds and equities. Adding a stand-alone Chinese portfolio with equally weighted onshore bonds and equities to a typical 70-30 domestic equity-bond portfolio would significantly improve a non-USD investor’s risk-adjusted return. Global investors may access China’s onshore equity and bond markets through Stock Connect(s), Bond Connect and CIBM Direct. Risk management tools are also available via both onshore and offshore instruments. Feature In the past three decades, China’s financial markets have become the second largest in the world both in terms of equity capitalization and bonds outstanding. Pro-market financial reforms have made the onshore markets increasingly accessible to foreign investors (Appendix 1). As China’s domestic equities and bonds are gradually added to major global equity and bond indexes, the onshore markets have become too sizeable to be ignored by global investors. Chart 1China A Onshore Shares: Highly Volatile Driven By Policy Swings China A Onshore Shares: A Poor Long-Term Asset China A Onshore Shares: A Poor Long-Term Asset Gyrations in China’s equity market in July in response to regulatory changes imposed on various industries (internet, property, education, healthcare and capital markets), however, should be a reminder that volatility in this market is an ever-present aspect. The instability is driven by China’s profound cyclicality in credit, money and macroeconomic policies (Chart 1). Moreover, the unpredictability is exacerbated by periods of geopolitical tensions and domestic political events. We focus on the portfolio impact of adding onshore equities and bonds to global investors’ domestic portfolios with six different home currencies: the USD, euro (EUR), Japanese yen (JPY), British pound (GBP), Australian dollar (AUD) and Canadian dollar (CAD). We also address how to access the onshore markets and what risk management tools are available. Many global investors already have a significant home bias in their portfolios, therefore this report will look at replacing part of a domestic portfolio with Chinese onshore assets. Part 1. Are Chinese Onshore Equities A Good Alternative For Global Equity Investors? 1.1: Chinese Equities Have A Poor Long-Term Return-Risk Profile Chart I-1How Does China A Compare With Global Equities Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? The extremely volatile nature of the MSCI China A onshore equity index (referred to as ‘China A’ in this report) is not a recent phenomenon. Although the volatility in China A has moderated since 2015, the stocks in the index remain highly cyclical and closely correlated with China’s credit growth. China A has gone through two full boom-bust cycles since December 2000 and the third up-cycle started in 2019 is being challenged, as shown in Chart I-1 panel 1. On a rolling three-year basis, China A’s volatility has steadily declined since its peak in early 2015 and is currently comparable to other markets. Meanwhile, its correlation with the rest of the world has steadily risen, standing at around 60% with major equity markets (Chart I-1, bottom 3 panels). The change in correlation with global equity markets could be linked to the launch of the Shanghai Stock Connect and Shenzhen Stock Connect as well as a more market-based RMB exchange rate in the past six years.  Compared with domestic equities for investors in the US, euro area, Japan, UK, Canada and Australia, however, China’s A-shares’ unhedged return-risk profile did not become more attractive after the launch of the Shanghai Stock Connect. As illustrated in Table 1, China A’s underperformance has spanned the entire upcycle in global equities starting in March 2009. It was only in the early years following China’s entrance into the WTO in 2001 that China A-shares performed better than their peers in Japan and the euro area. Table 1Return-Risk Profiles: China A Onshore Index vs Global Equity Indexes and CNY Crosses Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? USD/CNY exchange rate volatility has increased since the 2015 de-pegging from the US dollar, but remains at very low level compared with other CNY crosses. The People’s Bank of China (PBoC) primarily manages the RMB against the dollar by targeting a daily USD/CNY fixing rate, while allowing market forces to drive the RMB value against a basket of currencies in the China Foreign Exchange Trade System (CFETS) index. Chart I-2Correlations Between China A And DM Currencies Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Interestingly, even though CNY crosses with the euro, GBP, JPY, AUD and CAD have much higher volatility, the volatility in unhedged China A-shares in each of those currencies is similar to or lower than that in USD. For example, from December 2014 to July 2021, AUD/CNY had an annualized volatility of 8.8%, much higher than the 4.5% of the USD/CNY, yet the unhedged China A-share's volatility in AUD was 21%, lower than the 24% in USD. The reason lies in correlation, as shown Chart I-2. While China A-shares in CNY have a positive correlation with USD/CNY and JPY/CNY (i.e. China A-share prices tend to rise when China’s currency appreciates against the US dollar and Japanese yen), they have falling and negative correlations with the other four currencies. For equity investors in the US and Japan, exposure to the CNY would increase potential volatility to their home-currency portfolios, but the opposite would be true for investors in the euro area, the UK, Australia and Canada. In addition, Chinese onshore equity correlations with DM equities and EM-ex China equities were low, but have increased since 2015, making onshore shares less attractive for global equity investors looking to diversify. Bottom Line: Chinese onshore shares are a poor long-term asset for global equity investors. 1.2: Factor Strategies Work Well In The Onshore Market Despite Chinese equities’ poor long-term performance, applying a factor strategy to Chinese onshore stocks can create impressive results. In a GAA Special Report on smart-beta strategies for MSCI DM and EM markets, we concluded that a simple, equally weighted five-factor strategy would smooth out the cyclicality of individual factors and outperform the broad market. These five factors are value, equal weight (i.e. size), quality, momentum and minimum volatility, as defined and calculated by MSCI (see Box 1). When we apply the same methodology to the MSCI China A onshore market, the result is even more impressive as shown in Chart I-3. Box 1MSCI Factor Indices Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart I-3Factor Performance: China A Vs Global Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Since December 2004, the value and small cap factors  have outperformed the broad  benchmark by about 11%  and 47%, respectively, in the China A universe, despite sharp corrections since December 2016  for small cap  and Oct 2018 for value. In contrast, in the global universe, value and small cap have underperformed the global benchmark by 24% and 7%, respectively, in the same time frame (Chart I-3, panels 2 and 6.) This confirms anecdotal evidence that the onshore equity market was less efficient than its global peer, although efficiency has improved. Momentum is a consistent factor for global markets. A GAA Special Report on momentum strategy shows that momentum works better in markets with higher individuality where self-attribution and self-confidence are more pervasive, according to Hofstede’s Cultural Dimension theory. This behavioral aspect is confirmed by the performance of momentum in China’s onshore market: in the early years, momentum did not work well, but strengthened after both Shanghai and Shenzhen shares were accessible to foreign investors via the two Stock Connects and mainland institutional investors became more prevalent (Chart I-3, panel 4) Quality is the most consistent factor for global markets because investors reward companies with solid fundamentals. As shown in (Chart I-3, panel 3), this factor has worked even better in the China A market than in the global universe. The fact that good fundamentals have generated superior equity return repels the “myth” that the China A market is a “casino” driven by individual investors, who totally ignore company fundamentals. The minimum volatility factor works in a similar fashion in the onshore Chinese market as in the global markets. Chart I-4Onshore Equity Market Can Be Improved By Smart-Beta Strategies Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Factor timing can hardly generate consistent outperformance. BCA’s GAA team advocates equally weighting the five time-tested factors for the MSCI global universe. This approach also applies to China’s onshore market (Chart I-3, panel 1). Since all the factor indexes became available in August 2013, the equally weighted, five-factor portfolio has outperformed the benchmark by about 20% in total with similar volatility. On a rolling one- and three-year basis, this strategy also performs better than the benchmark (Chart I-4). Some investors may prefer a more active and quantitative approach; they should refer to CIS’s Special Report on factor investing in the A-share market. The CIS report recommends that global investors should opt for industry groups with above-median return on equity (ROE) and below-median ex-post beta when investing in the onshore market. ROE is a quality factor in MSCI (see Box 1 above) and below-median beta is a variation of low volatility. Bottom Line: Factor strategies can improve the return and risk profiles of China’s onshore equity market. Part 2. Chinese Onshore Bonds Chinese onshore bonds have attracted global investors because they offer much higher yields than DM government bonds (Chart II-1). At the same time, as shown in Chart II-2, Chinese onshore bond yields have low to negative correlations with major government bond yields. Thus, the onshore bonds offer potential risk diversification for global bond portfolios. Chart II-1Chinese Bonds Offer Higher Yields Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart II-2Chinese Yields Have Low Correlation With DM Bond Yields Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? For foreign DM government bonds, the conventional wisdom is to hedge foreign currency exposure because currency fluctuations outweigh bond volatility. A GAA Special Report shows that hedged foreign bonds have favorable return-risk profiles compared with domestic bonds in major DM countries. For EM local currency debt (based on the JP Morgan GBI-EM Global Diversified Local Currency Debt Index), USD investors should hedge their EM FX exposure while non-USD DM investors should not hedge. However, non-USD investors should avoid EM local currency debt if their objective is to maximize risk-adjusted return on the long-term horizon. Do Chinese bonds share the same traits as the EM aggregate? Our analysis suggests that Chinese bonds have historically provided better risk-adjusted returns to USD-based bond investors, hedged and unhedged. Thus, allocating a portion of the US Treasury portfolio to Chinese onshore bonds would improve a US bond portfolio’s return-risk profile. The Bloomberg Barclays (BB) China Treasury and Policy Bank Bond Index is used for the analysis. The index has a history starting in January 2004, even though it was included in BB's three flagship bond indexes only in April 2019.  On a hedged basis, Chinese onshore bonds deliver similar returns to global bonds as shown in Chart II-3. This is not surprising because interest-rate parity implies that the expected return on domestic assets equals the exchange-rate adjusted return on foreign currency assets, given foreign exchange market equilibrium. Unhedged returns, however, have outperformed both local and foreign government bonds for bond investors in the US, Japan, UK and the euro area since 2004 (Chart II-4). Carry was negative for USD-, GBP- and euro-based investors before the Global Financial Crisis, but has become positive since that time. The CNY has appreciated in general, albeit with greater movement against the non-USD crosses.  Chart II-3Chinese Bond Performance In A Global Context Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart II-4Carry And Spot CNY Exchange Rate Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Unhedged Chinese bonds have much higher absolute returns and also much higher volatility when compared with hedged bonds. How do Chinese onshore bonds fare on a risk-adjusted return basis? Table 2 compares the risk-return profiles of hedged and unhedged Chinese bonds with local and hedged foreign DM bonds in two periods: one from January 2004 and the other from July 2017 when the Bond Connect was launched. Table 2Return-Risk Profiles: Chinese Onshore Bond Index Vs DM Local Bond Indexes Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Several observations from Table 2: In local currency terms, Chinese bonds have the best risk-adjusted return and the second lowest volatility – only higher than Japanese government bonds (JGBs) – both from January 2004 and from July 2017. Since the start of Bond Connect, the risk-adjusted return of Chinese bonds in CNY has strengthened significantly with higher return and lower volatility. In contrast, there has been a deterioration in DM local bonds and their corresponding hedged foreign government bonds’ return/risk profiles.   In the past four years, Chinese bonds have outperformed all DM local bonds when unhedged, both in terms of absolute return and risk-adjusted return. When compared with a hedged foreign government bond, however, the absolute return advantage has been offset by much higher FX volatility. Still, euro- and JPY-based bond investors enjoy higher risk-adjusted returns from unhedged Chinese bonds than their respective hedged foreign DM government bonds. However, GBP-based investors would be better off with hedged non-UK government bonds. For USD-based bond investors, unhedged Chinese bonds would only be slightly inferior to hedged non-US government bonds. On a hedged basis, Chinese bonds have lower returns and less volatility than local bonds (with the exception of Japan), but they have higher risk-adjusted returns than local bonds in all but the euro area. When compared with hedged foreign bonds, euro- and USD-based investors would do slightly better with the Chinese bonds while JPY- and GBP-based investors would earn slightly more with other DM government bonds. How much should a bond investor replace local bonds with Chinese ones? For illustration, Chart II-5 plots the efficient frontiers for bond investors in the US, euro area, Japan and the UK when hedged Chinese bonds are added to their respective domestic bond portfolios. This addition would reduce portfolio volatility for all domestic bond portfolios, regardless of time frame. This is especially impressive for JGB investors because JGBs already have the lowest volatility among DM bonds. Moreover, returns would be improved for USD- and JPY-based investors when Chinese bonds are gradually included in domestic bond portfolios up to the risk-minimizing point.  Chart II-5Adding Hedged Chinese Bonds Reduces Volatility For All DM Domestic Bond Portfolios* Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? For GBP- and euro-based investors, however, adding hedged Chinese bonds would reduce absolute returns, but significantly improve risk-adjusted returns for GBP-based bond investors. Interestingly, even though euro zone local bonds have had superior risk-adjusted returns to hedged Chinese bonds since 2017, their risk-adjusted returns would still increase by about 18% when 50% of their local-bond portfolio is allocated to Chinese bonds. What is more striking is how unhedged Chinese bonds impact the return/risk profiles of global investors’ domestic bond portfolios. Unlike DM foreign bonds, which have inferior risk-adjusted returns when foreign currency exposure is not hedged, unhedged Chinese onshore bonds actually enhance a domestic bond investor’s absolute and risk-adjusted returns, as shown in Chart II-6. This is because of Chinese bonds’ superior risk-adjusted return measured in CNY (Table 2), negative correlations with CNY crosses (Chart II-7) and low to negative correlations with DM government bonds (Chart II-2). Chart II-6Adding Unhedged Chinese Bonds Enhances Absolute and Risk-Adjusted Returns For All DM Domestic Bond Portfolios* Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? For US bond investors who seek to maximize risk-adjusted return, the domestic Treasury portfolio would be improved significantly if about 40-50% of their holding were allocated to unhedged Chinese bonds. In comparison, the ratios would be lower for bond investors in the euro area, Japan and the UK. The key message is that global investors do not need to hedge the RMB exposure when investing in the Chinese onshore bond market. Chart II-7Chinese Bond Correlation With DM Currencies Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart II-8Chinese Yuan Still Has Upside Potential Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? We still have a favorable cyclical outlook for the CNY against the US dollar, supporting the case not to hedge the currency. The CNY is at about one standard deviation below fair value even though the gap has been narrowing since mid-2020 (Chart II-8). We expect the CNY to keep appreciating in the coming years barring major disruptive geopolitical/political events. China’s relatively strong productivity growth should continue to support the currency’s rising fair value. On a cyclical basis, given that the US Fed is firmly staying behind the curve (capping the upside in real bond yields in the US), the differential in real interest rates between China and other major economies should remain favorable for the RMB.  Bottom line: In a search-for-yield environment, the return-risk profiles of dedicated DM government bond portfolios may be enhanced by adding some exposure to Chinese onshore bonds on an unhedged basis. Part 3. Chinese Onshore Assets For Global Multi-Asset Portfolios Chinese onshore stocks on their own are not suitable for long-term, buy-and-hold strategic investments due to extremely high volatility, and the positive and rising correlation with global stocks and with CNY crosses. Chinese bonds, on the other hand, have an attractive risk-return profile with very low volatility, low correlation with global bonds, and negative correlation with CNY crosses. The negative correlation between Chinese stocks and bonds means that a mixed portfolio of the two assets would provide good diversification (Chart III-1). Chart III-1Chinese Onshore Assets Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart III-2Chinese Multi-Asset Portfolio Correlation With Global Multi-Asset Portfolios Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Investors may have different stock-bond allocations based on their return-risk objectives and constraints. For illustration, we constructed a stand-alone Chinese multi-asset portfolio by equally weighting onshore stocks and bonds. The correlations of this portfolio with six DM domestic 70-30 stock-bond portfolios have varied over time and by different countries, as shown in Chart III-2. Our Chinese-asset portfolio has a relatively high correlation with US and Japanese assets, but a low correlation with European assets, and almost no correlation with Australian and Canadian assets. Accordingly, the diversification effects are much stronger for GBP-, euro-, AUD- and CAD-based investors than for USD- and JPY-based investors, as shown in Chart III-3. Chart III-3Chinese Multi-Asset Portfolio Should Be Treated As A Standalone Asset By Non-US Asset Allocators Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart III-3 shows how the risk-return profile of a standard 70-30 stock-bond portfolio in the US, UK, Japan, euro area, Australia and Canada may be improved by adding some exposure to a 50-50 Chinese stock-bond portfolio. Even though this equally weighted Chinese onshore asset portfolio has unimpressive returns, when added to a domestic stock-bond portfolio there is an improvement in the return-risk profile of all non-USD-based portfolios. The optimal allocation to the stand-alone Chinese onshore portfolio varies with different home currencies, objectives and time periods, as shown in Table 3. Table 3Chinese Assets Improve Global Multi-Asset Portolios' Return-Risk Profiles Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Bottom Line: Unhedged Chinese onshore stocks and bonds may be treated as a stand-alone asset for global asset allocators, especially non-US ones. Adding a simple 50-50 Chinese stock-bond portfolio may boost the return/risk profile of global multi-asset portfolios. Part 4. Operational Q&A Many foreign investors believe that China’s onshore markets are hard to access. However, regulatory changes in the past 10 years, partially since Stock Connect was launched in 2014, have made it simpler from an operational point-of-view to buy and sell Chinese onshore equities and bonds. Below we answer some questions that international investors may have about market access. Q: Are there any access or quota restrictions for offshore investors to invest in China A-shares via Stock Connect? Historically, access to China’s mainland equity market by offshore investors was restricted through investment quotas and local currency controls. Since 2014, with the launch of Stock Connect, offshore investors no longer have access or repatriation restrictions. Stock Connect allows offshore investors to trade selected A-share stocks listed on the Shanghai (SSE) and Shenzhen (SZSE) Stock Exchanges through offshore brokers. Although not all A-shares listed on the SSE or SZSE can be invested in through Stock Connect, eligible stocks include almost all large- and medium-cap A-shares.1 Note that the Shanghai-Hong Kong (SH-HK) Stock Connect and the Shenzhen-Hong Kong (SZ-HK) Stock Connect complement each other, but they have a dual-channel, independent operation mechanism with two distinct Connect operations. Therefore, their shares cannot be cross-traded. Q: How to purchase China’s A-Shares via Stock Connect? Offshore investors need a Hong Kong or international broker (see MMA strong="">< strong="">GO strong="">> on Bloomberg for a list of Offshore brokers for Stock Connect northbound trading), through whom they buy A-shares. Brokers instruct Hong Kong Exchange’s (HKEX) participants to conduct northbound trades on the SSE or SZSE. Hong Kong Exchange’s subsidiary (a SSE or SZSE participant) also takes instructions to conduct trades on the SSE or SZSE stock exchanges. Clearing and settlement services of A-shares executed through Stock Connect are provided by the Hong Kong Securities Clearing Company (HKSCC), a solely-owned subsidiary of the HKEX, through clearing links established with the China Securities Depository and Clearing Corporation Limited (ChinaClear). The shares of offshore investors are held in an onshore omnibus securities account registered under the HKSCC. Q: Is margin trading or short selling allowed for Stock Connect northbound trading stocks? Yes, most eligible Stock Connect northbound trading A-shares are permitted for margin trading or short selling. Nowadays, more than 80% of the total eligible Stock Connect northbound trading stocks in the SSE and more than 70% of that in the SZSE are permitted for margin trading and short selling. HKEX provides a list of eligible equities for margin trading and short selling in a timely manner.2 Q: Are there other ways to tactically manage exposure to China’s A-shares? There are offshore ETFs that investors can use to hedge their exposure to Chinese equities (Table 4). For example, Direxion Daily CSI 300 China A Share Bear 1X ETF listed on the New York Stock Exchange (NYEX) provides 100% of the inverse exposure of the performance for the CSI 300 index. This ETF may be used to hedge offshore investors’ exposure to domestic China A- shares. Table 4ETFs That Can Be Used To Hedge Investors’ Exposure To Chinese Equities Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Q: Describe the main differences between Bond Connect and CIBM Direct. How do overseas investors hedge their currency exposure when investing in China’s onshore bond market? Bond Connect and China Interbank Bond Market (CIBM) Direct are the official channels for offshore investors to invest in China's onshore bond market except for Qualified Foreign Institutional Investors (QFII) and RMB Qualified Foreign Institutional Investors (RQFII). Around 680 foreign institutional investors have entered China’s interbank bond market since Bond Connect’s launch in July 2017.3 Here are some differences between CIBM Direct and Bond Connect: Bond Connect is based offshore, which gives overseas investors easy and quota-free access to China’s onshore interbank bond market through offshore trade platforms. Bond Connect permits investors to open accounts, trade, and settle transactions in the offshore market whereas CIBM Direct stipulates the process must be completed in the onshore market. CIBM Direct offers greater access to opportunities in the onshore market because it has access to a wider range of products and hedge tools, such as repos, interest rate swaps, bond lending and bond forwards. In comparison, the only Bond Connect products are bonds traded in China’s inter-bank bond market, and hedge tools are limited. In terms of currency hedging, both CIBM Direct and Bond Connect allow FX hedge tools such as forwards, swaps and options to help investors hedge their exposure to CNY (Chinese yuan traded in the onshore market). CIBM Direct trades in CNY rather than CNH (CNH is Chinese yuan traded in the offshore market) and allows investors to hold onshore balances in CNY. Bond Connect, however, does not allow investors to hold CNY balances. Under Bond Connect, investors are required to exchange CNY into CNH for any excess cash from trading or coupon payments, which can be a currency risk when funds are repatriated. However, offshore investors can hedge their FX exposure with FX Settlement Banks by engaging in various FX trades and FX hedge tools that match their bond position. FX Settlement Banks are banks in Hong Kong approved by the China Foreign Exchange Trade System (CFETS) to access the FX market of CIBM as RMB participation banks. Offshore FX Settlement Banks may square positions in either offshore or onshore FX markets. Investors should contact their Hong Kong custodians, which will appoint an FX Settlement Bank for FX conversion and hedging. Q: Is there another currency hedge mechanism for investors’ CNY exposure?  CNY exposure can be hedged using the usual instruments, such as CNH-forwards or CNY-non deliverable forwards (NDF). However, the CNH-forward has CNH basis risk, which arises from the differences between CNY and CNH spot rates. Investors may consider short CNY currency ETFs listed on the offshore market, such as the WisdomTree Chinese Yuan Strategy Fund (CYB) on the NYEX. CYB offers exposure to the overnight Chinese yuan and uses both short- and long-forward currency contracts for both CNH and CNY to manage its expectations for the currency. It seeks to achieve total returns reflective of money market rates in China available to foreign investors and of changes in the value of the yuan versus the dollar. Xiaoli Tang Associate Vice President, Global Asset Allocation xiaoliT@bcaresearch.com Qingyun Xu, CFA Associate Editor, China Investment Strategy qingyunx@bcaresearch.com   Appendix 1: The Evolution of The Chinese Onshore Markets China’s onshore equity and bond markets have grown dramatically in the past two decades. The equity market is the second largest in the world with more than 4,400 listed companies; the combined market capitalization of the Shanghai and Shenzhen stock exchanges has reached USD12.2 trillion (Chart A1). China’s bond market also is ranked second globally, after the US, with amounts outstanding at USD18.6 trillion (Chart A2). Chart A1China’s Stock Market Has Grown Sharply In The Past Two Decades China's Stock Market Has Grown Sharply In The Past Two Decades China's Stock Market Has Grown Sharply In The Past Two Decades Chart A2China’s Onshore Bond Market Is Second Largest In World Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Thanks to China’s financial market liberalization since the early 2000s, foreign investors can now access China's onshore stock and bond markets to include China A-shares and onshore bonds in portfolios. Various tools are available, including QFII, RQFII, Stock Connect, CIBM Direct and Bond Connect (Diagram 1). Since the launch of Stock Connect in late 2014, the cumulative net northbound flows to the Shanghai and Shenzhen exchanges have been more than RMB1.2 trillion (Chart A3, top panel). The cumulative net capital inflows through CIBM Direct and Bond Connect have reached more than RMB3.5 trillion since these mechanisms were introduced in 2016 and 2017, respectively (Chart A4, bottom panel).  Diagram 1China’s Financial Market Liberalization Roadmap Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart A3Net Inflows To China’s Onshore Markets Through Stock And Bond Connect Net Inflows To China's Onshore Markets Through Stock And Bond Connect Net Inflows To China's Onshore Markets Through Stock And Bond Connect Chart A4Growing Foreign Holdings Of China’s Onshore Equities And Bonds Growing Foreign Holdings Of China's Onshore Equities And Bonds Growing Foreign Holdings Of China's Onshore Equities And Bonds Although foreign investors’ holding of RMB-denominated assets increased significantly in recent years, their share of the total onshore market is still small, highlighting the potential for more capital inflows to China’s onshore market (Chart A4). Following the inclusion of China A-shares in global equity indexes, bond indexes have followed suit and Chinese government bonds are now offered in the world’s three major bond indices. Bloomberg Barclays Global Aggregate Index (BBGA) was the first to include Chinese government bonds in April 2019, followed by the JP Morgan Government Bond-Emerging Market Index (GBI-EM) in February 2020 and finally FTSE Russell’s World Government Bond Index (WGBI) in October 2021.   Footnotes 1The list of eligible A-shares for Shanghai and Shenzhen Connect can be accessed via the HK Exchange 2List of eligible equities for margin trading and short selling 3List of approved investors under Bond Connect Market/Sector Recommendations Cyclical Investment Stance

Highlights The chaotic US withdrawal from Afghanistan is symbolic – the US is conducting a strategic pivot to Asia Pacific to confront China. US-Iran negotiations are the linchpin of this pivot. If they fail, war risk will revive in the Middle East and the US will remain entangled in the region. At the moment, there is no deal, so investors should brace for a geopolitical risk premium in oil prices. That is, as long as global demand holds up despite COVID-19, and as long as the OPEC 2.0 cartel remains disciplined. We think they will in the short run. The US and Iran still have fundamental reasons to agree to a deal. If they do, the US will regain global room for maneuver while China’s and Russia’s window of opportunity will close. The implication is that markets face near-term oil supply risks – and long-term geopolitical risks due to Great Power rivalry in Eastern Europe and East Asia. Feature Events in Afghanistan have little macroeconomic significance but the geopolitical changes underway are profound and should be viewed through the lens of our second key view for 2021: the US strategic pivot to Asia. Chart 1The US Pivot To Asia Runs Through Iran Not Afghanistan The US Pivot To Asia Runs Through Iran Not Afghanistan The US Pivot To Asia Runs Through Iran Not Afghanistan As we go to press the Taliban is reconquering swathes of Afghanistan while US armed forces evacuate embassy staff and civilians. The chaotic scenes are reminiscent of the US’s humiliating flight from Saigon, Vietnam in 1975. As with Vietnam, the immediate image is one of American weakness but the reality over the long run is likely to be different. Over the past decade we have chronicled the US’s efforts to disentangle itself from wars of choice in the Middle East and South Asia. In accordance with US grand strategy, Washington is refocusing its attention on its rivalries with Russia and especially China, the only power capable of supplanting the US as a global leader (Chart 1). The US has struggled to conduct this “pivot to Asia” over the past decade but the underlying trajectory is clear: while trying to manage its strategic interests in the Middle East through naval power, the US will need to devote greater resources and attention to shoring up its economic and military ties in Asia Pacific (Map 1). The Middle East still plays a critical role – notably through China’s energy import needs – but primarily via the Persian Gulf. Map 1The US Seeks Balance In Middle East In Order To Pivot To Asia And Confront China Afghanistan? Watch Iran And China Afghanistan? Watch Iran And China Thus the critical geopolitical risks today stem from Iran and the Middle East on one hand, and China on the other. They do not stem from the US’s belated and messy exit from Afghanistan, which has limited market relevance outside of South Asia. First, however, we will address the political impact in the United States. US Political Implications Chart 2Americans Agree With Biden And Trump On Exit From Afghanistan Afghanistan? Watch Iran And China Afghanistan? Watch Iran And China American popular opinion has long turned against the “forever wars” in Iraq and Afghanistan, which cumulatively have cost $6.4 trillion and about 7,000 American troops dead1 (Chart 2). Three presidents, from two political parties, campaigned and won election on the basis of winding down these wars. The only presidential candidate since Republicans George W. Bush and John McCain who took a hawkish stance for persistent military engagement, Hillary Clinton, nearly lost the Democratic nomination and did lose the general election to a Republican, President Trump, who had reversed his party’s stance to advocate strategic withdrawal. War hawks have been sidelined in both parties. This is notable even if it were not the case that the current President Biden, whose son Beau fought in Afghanistan, had opposed the troop surge there under Obama. True, Biden will use drones, surgical strikes, and limited troop rotations to manage the aftermath in Afghanistan, both militarily and politically. Americans are still concerned about terrorism in general and any sign of a resurgent terrorist threat to the US homeland will be politically potent (Chart 3). But neither Biden nor the US can roll back the Taliban’s latest gains or achieve anything in Afghanistan that has not been achieved over the past twenty years.   Chart 3American Public Cares About Terrorism, Not Afghanistan Per Se Afghanistan? Watch Iran And China Afghanistan? Watch Iran And China True, Biden will suffer a political black eye from Afghanistan. His approval rating has already fallen to 49.6%, slipping beneath 50% for the first time, in the face of the Delta variant of COVID-19 and the Afghan debacle. In both cases his early optimistic statements have now become liabilities. Biden is also 79 years old, which will make the 2024 campaign questionable, and he faces mounting problems in other areas, from lax border security and immigration enforcement to rising domestic crime. Nevertheless, Biden still has sufficient political capital to push through one or both of his major domestic legislative proposals by the end of the year, despite thin majorities in both the House and Senate. Afghanistan will not affect that, for three reasons: 1. The US economy is likely to continue to recover despite hiccups due to the lingering pandemic, since the vaccines so far are effective. The labor market is recovering and business capex and government support are robust. Setbacks, such as volatile consumer confidence, will help Biden pass bills designed to shore up the economy. 2. The public fundamentally agrees with Biden (and Trump) on military withdrawal, as mentioned. Voters will only turn against him if a major attack reinforces an image of weakness on terrorism. A major attack based in Afghanistan is not nearly as likely to succeed as it was prior to the September 11, 2001 attacks. But Biden also faces an imminent increase in tensions in the Middle East that could result in attacks on the US or its allies, or other events that reinforce any image of foreign policy failure. 3. Biden has broad popular support for his infrastructure deal, which also has bipartisan buy-in, with 19 Republican Senators already having voted for it. Further, the Democratic Party has a special fast-track mechanism for passing his social spending agenda, though conviction levels must be modest on this $3.5 trillion bill, which is controversial and will have to be winnowed to pass on a partisan vote in the Senate. If we are correct that Afghanistan will not derail Biden’s legislative efforts then it will not fundamentally affect US fiscal policy or the global macro outlook. Note, however, that a failure of Biden’s bills would be significant for both domestic and global economy and financial markets as it would suggest that US fiscal policy is dysfunctional even under single party rule and would thus help to usher back in a disinflationary context. Might Afghanistan affect the midterm elections and hence the US policy setup post-2022? Not decisively. Republicans are more likely than not to retake at least the House of Representatives regardless. This is a cyclical aspect of US politics driven by voter turnout and other factors. Democrats are partly shielded in public opinion due to the Trump administration’s attempts to pull out of foreign wars. But surely a black eye on terrorism or foreign policy would not help. Similarly, a major failure to manage the Middle East, South Asia, and the pivot to Asia Pacific would marginally hurt the Democrats in 2024, but that is a long way off. Geopolitical Implications The Taliban’s reconquest of Afghanistan has very little if any direct significance for global financial markets. Pakistan and India are the two major markets most likely to be directly affected – and their own geopolitical tensions will escalate as a result – yet both equity markets have been outperforming over the course of the Taliban’s military gains (Chart 4). Afghanistan’s impacts are indirect at best. However, the US withdrawal connects with major geopolitical currents, with both macro and market significance. Afghanistan often marks the tendency of empires to overreach. Russia’s failure in Afghanistan contributed to the collapse of the Soviet Union, though Russia’s command economy was unsustainable anyway. British failures in Afghanistan in the nineteenth and twentieth centuries did not lead to the British empire’s decline – that was due to the world wars – but Afghanistan did accentuate its limitations. Since 9/11 and the US’s wars in Iraq and Afghanistan, the US public’s economic malaise, political polarization, and loss of faith in public institutions have gotten worse. In turn, political divisions have impeded the government’s ability to respond cogently to financial and economic crisis, the resurgence of Russia, the rise of China, nuclear proliferation, constitutional controversies, and the COVID-19 pandemic. Once again Afghanistan marked imperial overreach. It is natural for investors to be concerned about the stability of the United States. And yet the US’s global power has recently stabilized (Chart 5). The US survived the 2020 stress test and innovated new vaccines for the pandemic. It is passing laws to upgrade its domestic technological, manufacturing, and infrastructural base and confronting its global rivals. Chart 4If Indo-Pak Markets Shrug Off Taliban Wins, So Can You If Indo-Pak Markets Shrug Off Taliban Wins, So Can You If Indo-Pak Markets Shrug Off Taliban Wins, So Can You Chart 5US Geopolitical Power Is Stabilizing Afghanistan? Watch Iran And China Afghanistan? Watch Iran And China Chart 6US Not Shrinking From Global Role US Not Shrinking From Global Role US Not Shrinking From Global Role The US is not retreating from its global role, judging by defense spending or trade balances (Chart 6). While the desire to phase out wars could theoretically open the way to defense cuts, the reality is that the great power confrontation with China and Russia will demand continued large defense spending. The US also continues to run large trade deficits, due to its shortage of domestic savings, which gives it influence as a consumer and provider of dollar liquidity across the world. The critical geopolitical problem is Iran, where events have reached a critical juncture: To create a semblance of a balance of power in the Middle East, the US needs an understanding with Iran, which is locked in a struggle with Saudi Arabia over the vulnerable buffer state of Iraq. President Biden was not able to rejoin the 2015 détente with Iran prior to the inauguration of the new president, Ebrahim Raisi, who is a hawk and whose confrontational policies will lead to an escalation of Middle Eastern geopolitical risk in the short term – and, if no US-Iran deal is reached, over the long term. Iran recognizes the US’s war-weariness, as demonstrated by withdrawals from Iraq and Afghanistan. It was also exposed to economic sanctions after the US’s 2018-19 abrogation of the 2015 nuclear deal – it cannot trust the US to hold to a deal across administrations. Still, both the US and Iran face substantial strategic forces pressuring them to conclude a deal. The US needs to pivot to Asia while Iran needs to improve its economy and reduce social unrest prior to its looming leadership succession. But the time frame for negotiation is uncertain. Any failure to agree would revive the risk of a major war that would keep the US entangled in the region. Thus the pivot to Asia could be disrupted again, with major consequences for global politics, not because of Afghanistan but because of a failure to cut a deal with Iran. If the US succeeds in reducing its commitments to the Middle East and South Asia, the window of opportunity that China and Russia have enjoyed since 2001 will close. They will face a United States that has greater room for maneuver on a global scale. This is a threat to their own spheres of influence. But neither Beijing nor Moscow has an interest in a nuclear-armed Iran, so a US-Iran deal is still possible. Unless and until the US and Iran normalize relations, the Middle East is exposed to heightened geopolitical risk and hence oil supply risk. Global oil spare capacity is sufficient to swallow small disturbances but not major risks to stability, such as in Iraq or the Strait of Hormuz. Investment Takeaways Chart 7Near-Term US-Iran Risks Help Oil...Long-Term US-China Risks Help Dollar Near-Term US-Iran Risks Help Oil...Long-Term US-China Risks Help Dollar Near-Term US-Iran Risks Help Oil...Long-Term US-China Risks Help Dollar Back in 2001, the combination of American war spending, and conflict in the Middle East, combined with China’s massive economic opening after joining the WTO, led to a falling US dollar and an oil bull market. Today the US’s massive budget deficits and current account deficits present a structural headwind to the US dollar. Yet the greenback has remained resilient this year. While the pandemic will fade as long as vaccines continue to be effective, China’s potential growth is slowing even as it faces an unprecedented confrontation with the US and its allies. Until the US and Iran normalize relations, geopolitics will tend to threaten Middle Eastern oil supply and put upward pressure on oil prices. However, if the US manages the pivot to Asia, China will face more resolute opposition in its sphere of influence, which will tend to strengthen the dollar. The dollar and oil still tend to move in opposite directions. These geopolitical trends will be influential in determining which direction prevails (Chart 7). Thus geopolitics poses an upward risk to oil prices for now.     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Please see Crawford, Neta, "United States Budgetary Costs and Obligations of Post 9/11 Wars Through FY 2020: $6.4 trillion", Watson Institute, Brown University.

Highlights Global growth is peaking, which makes it important to monitor the risks for signs that it is time to reduce equity exposure. We are especially focused on five risks: 1) The emergence of vaccine-resistant Covid variants; 2) a possible “goods recession”; 3) higher real bond yields; 4) higher US corporate tax rates; and 5) a weaker Chinese economy and regulatory crackdown. For now, we recommend a modest overweight to global equities. We will likely pare back exposure early next year. Stocks And The Business Cycle Our “golden rule” for asset allocation is to remain bullish on equities unless there is a good reason to think that a recession is around the corner. This rule has strong empirical support. Chart 1 shows that equity bear markets rarely occur outside of major business cycle downturns. Chart 1Recessions And Bear Markets Tend To Overlap Five Risks We Are Monitoring Five Risks We Are Monitoring Nevertheless, there are different shades of bullishness. Stocks generally perform best coming out of recessions; that is, when the economy is weak but improving. Stocks perform worst when the economy is falling into recession. We are currently in an intermediate phase, where global growth is weakening but still solidly above trend. Historically, stocks have posted positive but uninspiring returns during such phases (Table 1). Table 1The Economic Cycle And Financial Assets Five Risks We Are Monitoring Five Risks We Are Monitoring Monitoring The Risks In “post peak growth” environments, it is important to monitor the risks for signs that it is time to reduce equity exposure. We are especially focused on five risks:   Risk 1: New Covid Variants Chart 2A New Covid Wave Five Risks We Are Monitoring Five Risks We Are Monitoring The Delta strain continues to roll through the US and a number of other countries (Chart 2). While the new strain does not seem to be any more deadly than other variants, it is a lot more contagious. CDC internal estimates suggest the R0 for the Delta variant is between 5-to-8, similar to that of chickenpox, and 40% higher than the original strain.1 Countries such as Thailand and Vietnam, which were able to keep the pandemic at bay last year, have succumbed to Delta. In Australia, the 7-day average of new cases has climbed above 300, the highest since last August. China has detected the Delta variant in more than a dozen cities since July 20. Even if the country succeeds in quashing the new variant, it will come at an economic cost. Lockdowns in major Chinese cities could further clog a global supply chain that is still reeling from the dislocations caused by the pandemic. While still vulnerable to the Delta variant, the symptoms of vaccinated individuals tend to be mild and non-life threatening. The Lambda variant, which surfaced in Peru this past December, appears more vaccine-resistant than the Delta variant. Fortunately, it is not as contagious as Delta, and has struggled to propagate outside of South America. The risk is that a new variant emerges which is: 1) highly contagious; 2) vaccine resistant; and 3) as or more lethal than the original strain. Chart 3The Divergence Between Goods And Services Spending The Divergence Between Goods And Services Spending The Divergence Between Goods And Services Spending Our Assessment: The current suite of vaccines confers substantial protection. While a vaccine-resistant strain could emerge, it is likely that vaccine producers will be able to adjust their formula to keep the virus at bay. As such, we see Covid as only a modest risk to global stocks.   Risk #2: A Goods Recession Even if Covid fades from view, the dislocations caused by the pandemic will persist for a while longer. As we discussed last week, the pandemic induced a major reallocation of spending from services to goods: Overall consumer spending in the US is broadly back to its pre-pandemic trend. However, service spending remains below trend while goods spending is above trend (Chart 3). Retail sales, which are dominated by goods, are also firmly above trend (Chart 4). We do not expect spending on goods to drop off anytime soon. A variety of manufactured goods, ranging from automobiles to major appliances, remain in short supply. The need to fill backorders and replenish inventories will keep production elevated for the next four quarters. However, at some point in the second half of 2022, manufacturers and retailers could find themselves with a glut of goods on their hands. Chart 4AUS Retail Spending Is Well Above Trend (I) US Retail Spending Is Well Above Trend (I) US Retail Spending Is Well Above Trend (I) Chart 4BUS Retail Spending Is Well Above Trend (II) US Retail Spending Is Well Above Trend (II) US Retail Spending Is Well Above Trend (II) Manufacturing accounts for only 11% of US GDP. However, goods producers account for about a third of S&P 500 market capitalization. Thus, while a slowdown in spending on goods is unlikely to push the US into recession, it could cause S&P 500 earnings growth to slow sharply, similar to what occurred during the 2015-16 manufacturing recession (Chart 5). Our Assessment: A goods recession represents a threat to both US and overseas stocks, particularly manufacturers and retailers. Most likely, however, that threat will not become visible to investors until next year.   Risk #3: Higher Real Bond Yields Stocks represent a claim on future corporate cash flows. Higher real interest rates reduce the present value of those claims, leading to lower stock prices. Chart 6 shows that there is a strong correlation between the US 10-year TIPS yield and the forward P/E ratio for the stock market. Chart 5The 2015-16 Manufacturing Recession Weighed On Earnings The 2015-16 Manufacturing Recession Weighed On Earnings The 2015-16 Manufacturing Recession Weighed On Earnings Chart 6Higher Real Rates Would Be A Headwind For Equity Valuations Higher Real Rates Would Be A Headwind For Equity Valuations Higher Real Rates Would Be A Headwind For Equity Valuations US real yields jumped in the wake of July’s stellar employment report. However, they still remain negative and far below pre-pandemic levels. Looking out, real yields could rise for two diametrically different reasons. On the one hand, an adverse demand shock could drive up real yields by pushing down inflationary expectations. This is precisely what happened during the early days of the pandemic.     Such a deflationary shock could arise if a vaccine-resistant variant emerges or if spending on manufactured goods declines faster than we expect. The failure of the US Congress to pass the infrastructure bill and/or a budget reconciliation bill could also exacerbate fiscal tightening next year. Under current law, fiscal policy will subtract around two percentage points from growth next year (Chart 7). Chart 7After A Strong Boost, Fiscal Thrust Is Turning Negative Five Risks We Are Monitoring Five Risks We Are Monitoring On the other hand, real yields could rise if an overheated economy prompts the Fed to hike rates more aggressively than markets are discounting. The US 10-year yield tends to track expected policy rates three years out (Chart 8). Chart 810-Year Treasurys Track Expected Policy Rates Three Years Out 10-Year Treasurys Track Expected Policy Rates Three Years Out 10-Year Treasurys Track Expected Policy Rates Three Years Out Chart 9Both The Fed And Market Participants Have Revised Down Their Estimate Of The Neutral Rate Of Interest Both The Fed And Market Participants Have Revised Down Their Estimate Of The Neutral Rate Of Interest Both The Fed And Market Participants Have Revised Down Their Estimate Of The Neutral Rate Of Interest   An increase in the market’s estimate of the terminal rate could also push up real yields. According to the New York Fed’s survey of primary dealers and market participants, investors think that the fed funds rate will top out at around 2%. Not only is this extremely low by historic standards, but it is also lower than the Fed’s estimate of the terminal rate (Chart 9). In the past, we have made a distinction between the strong- and weak-form versions of secular stagnation. The strong-form version is one where an economy is unable to reach full employment even with zero interest rates. Japan is a good example. The weak-form version is one where the economy can achieve full employment but only in the presence of low positive interest rates (Chart 10). Chart 10Strong- Versus Weak-Form Secular Stagnation Five Risks We Are Monitoring Five Risks We Are Monitoring In many respects, weak-form secular stagnation is better for equities than the normal state of affairs where the economy is at full employment and interest rates are near their historic average. This is because weak-form secular stagnation allows equity investors to have their cake and eat it too – to enjoy full employment and high corporate profits, all with the persistent tailwind of very low rates. Our Assessment: Our baseline view on the US envisions a goldilocks scenario of sorts: An economy that is hot enough to keep deflationary forces at bay, but not so hot that the Fed has to intervene to raise rates. While there are risks on both sides of this view, they are fairly modest. US households are sitting on nearly $2.5 trillion in excess savings, which should support consumption over the next few years. BCA’s geopolitical team, led by Matt Gertken, thinks that there is an 80% chance that Congress will pass an infrastructure bill. Assuming an infrastructure bill passes, they also see a 65% chance that the Democrats will succeed in pushing through a watered-down $3.5 trillion budget reconciliation bill. Meanwhile, as the July CPI report illustrates, inflationary forces are already starting to die down, which should keep rate expectations from rising too rapidly.   Risk #4: Higher US Corporate Tax Rates Chart 11Bettors Expect US Corporate Tax Rates To Rise, But Not By Much Five Risks We Are Monitoring Five Risks We Are Monitoring Congress’ passage of a budget reconciliation bill would blunt some of the fiscal tightening slated for next year. However, to pay for the additional spending, Democrats will seek to levy more taxes on corporations and higher-income earners. The Biden Administration is aiming to raise the corporate tax rate from 21% to 28%, bringing it halfway back to the 35% level that prevailed prior to the Trump tax cuts. Joe Manchin, a key swing voter in the Senate, has indicated a preference for 25%. PredictIt, a popular betting site, assigns 31% odds to no tax hike. Among bettors forecasting higher tax rates, the median estimate is around 25% (Chart 11). Analyst estimates do not appear to reflect the prospect of higher taxes. This is not surprising. Chart 12 shows that analysts did not adjust their earnings estimates until shortly after President Trump signed the Tax Cuts and Jobs Act into law on December 22, 2017. Chart 12Analysts Have Not Adjusted Their Earnings Estimates To Reflect The Likelihood Of Higher Taxes Analysts Have Not Adjusted Their Earnings Estimates To Reflect The Likelihood Of Higher Taxes Analysts Have Not Adjusted Their Earnings Estimates To Reflect The Likelihood Of Higher Taxes Chart 13Until Recently, Companies That Stand To Lose The Most From Higher Taxes Have Fared Well Until Recently, Companies That Stand To Lose The Most From Higher Taxes Have Fared Well Until Recently, Companies That Stand To Lose The Most From Higher Taxes Have Fared Well It is more difficult to know what markets are discounting. Chart 13 displays the performance of Goldman‘s “Formerly High Tax” and “Formerly Low Tax” equity baskets. The formerly high-taxed companies gained the most from Trump’s tax cuts and presumably would lose the most if the tax cuts were rolled back. While formerly high-taxed companies have underperformed the market since early May, they are still up relative to their low-taxed peers since the Georgia runoff election, which handed control of the Senate to the Democrats. Moreover, companies that are vulnerable to higher taxes on overseas profits – many of which are in the tech space – have continued to fare well. Our Assessment: BCA’s geopolitical team thinks that corporate taxes will rise more than current market expectations suggest. However, even under our baseline scenario, higher tax rates will only cut earnings-per-share for S&P 500 companies by about 5% in 2022. Given that earnings are expected to rise by 9% next year, this would still leave earnings growth in positive territory.   Risk #5: China The Chinese economy grew at an annualized rate of only 3.5% in the first half of 2021 (Chart 14). While stricter Covid restrictions will weigh on growth in Q3, activity should pick up again in the fourth quarter. Chart 14Chinese Growth Was Weak In The First Half of 2021 Chinese Growth Was Weak In The First Half of 2021 Chinese Growth Was Weak In The First Half of 2021 The degree to which China’s economy recovers later this year will depend on the overall policy stance. Both credit and money growth fell short of expectations in July. Aggregate social financing declined to CNY 1.06 trillion from CNY 3.7 trillion in June, missing expectations of a CNY 1.7 trillion increase. M2 money growth clocked in at 8.3% year-over-year, below consensus estimates of 8.7%. As of July, local governments had used only 37% of their annual bond issuance quota, compared with 61% over the same period last year and 78% in 2019. BCA Chief China strategist, Jing Sima, thinks that local governments were waiting for a clear signal from the Politburo meeting held on July 30th before issuing new debt. If so, the fiscal stance should turn more expansionary over the coming months. Nevertheless, Beijing continues to send conflicting messages – on the one hand, telling local governments that they need to support growth, while on the other hand admonishing them for wasteful spending. Chart 15Chinese Tech Stocks Have Underperformed Their Global Peers This Year Chinese Tech Stocks Have Underperformed Their Global Peers This Year Chinese Tech Stocks Have Underperformed Their Global Peers This Year Stepped-up regulation of China’s major internet companies has also unnerved investors. Chinese internet stocks have underperformed the global tech sector by more than 40% since February (Chart 15). Our Assessment: With credit growth back down to its 2018 lows, the authorities are likely to ease policy over the coming months. While the crackdown on internet companies will continue, it is unlikely to spill over to other sectors. Unlike Chinese companies in, say, the telecom or semiconductor sectors, Beijing does not see most online platforms as contributing much to the economy. What they do see are companies with the potential to undermine the authority of the Communist Party (and in the case of online education providers, reduce the birth rate by burdening parents with high educational expenses). Investment Conclusions Chart 16Equities Look More Attractive Than Bonds Equities Look More Attractive Than Bonds Equities Look More Attractive Than Bonds We will likely pare back equity exposure early next year. For now, however, we recommend that asset allocators maintain a modest overweight to global equities. Growth is slowing but will remain solidly above trend for the remainder of the year. The forward earnings yield on the MSCI All-Country World Index stands at 5.2%. While this is not particularly high in absolute terms, it is still very high in relation to bond yields (Chart 16). Stocks outside the US trade at a still-decent earnings yield of 6.4% (compared to 4.6% in the US). Granted, the earnings performance of many non-US companies leaves much to be desired. Nevertheless, relative valuations largely discount this fact. Moreover, continued above-trend global growth, Chinese stimulus, and rising bond yields should benefit cyclical stocks and value names, which are overrepresented in overseas indices. Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  The basic reproduction number, R0 (pronounced “R naught”), corresponds to the average number of people a carrier of the virus will infect in a population with no natural or vaccine-induced immunity.   Global Investment Strategy View Matrix Five Risks We Are Monitoring Five Risks We Are Monitoring Special Trade Recommendations Five Risks We Are Monitoring Five Risks We Are Monitoring Current MacroQuant Model Scores Five Risks We Are Monitoring Five Risks We Are Monitoring

Highlights A critical aspect of the diffusion of global geopolitical power – “multipolarity” – is the structural rise of India. India will gain influence in the coming five years as a growing importer of goods, services, oil, and capital. Trade with China is a positive factor in Sino-Indian relations but it will not be enough to offset the build-up of strategic tensions. Indo-Russian relations will also wane. India’s slow transition to green energy will give it greater sway in the Middle East but will not remove its vulnerability if the region destabilizes anew over Iran. Sino-Indian tensions have already affected capital flows, with the US building on its position as a major foreign investor. Feature Chart 1Sino-Pak Alliance’s Geopolitical Power Is Thrice That Of India The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil India’s geopolitical power pales in comparison to that of the China-Pakistan alliance (Chart 1). India is traditionally an independent and “non-aligned” power that has managed conflicts with its neighbors by influencing either Russia or America to display a pro-India tilt. This strategy has held India in good stead as it helps create the illusion of a “balance of power” in the South Asian region. Structural changes are now afoot: Sino-Pakistani assertiveness toward India continues. But in a break from the past India’s Modi-led Bhartiya Janata Party (BJP) has been constrained to adopt a far more assertive stance itself. Russo-Indian relations face new headwinds. Russia has been a close historical partner of India. But Russia under President Vladimir Putin has courted closer ties with China, while the US has tried to warm up with India since President Bush. Under Presidents Trump and Biden, the US is taking a more confrontational approach to Russia and China and will continue to court India. Against this backdrop the key question is this: In a multipolar world, how will India’s relations with the Great Powers evolve over the next five years? Will the alliances of the early 2000s stay the same or will they change? And if they change, what will it mean for global investors? In this special report we provide a helicopter view of India’s relations with key countries. We do so by examining India’s trade and capital flows with the world. A country’s power to a large extent is a function not only of its population and military strength but also of the business interests it represents. India today is the second largest arms importer globally (guns), fifth largest recipient of global FDI flows (capital) and third largest importer of energy (oil). Looking at the trajectory of these business relations, we quantify the magnitude and sources of India’s geopolitical power over the next five years and its investment implications. Trade: India’s Imports Not Enough To Offset China Tensions “The 11th Law of Power - Learn to Keep People Dependent on You. To maintain your independence, you must always be needed and wanted. The more you are relied on, the more freedom you have.” – Robert Greene, The 48 Laws of Power1 A small and closed economy in the 1980s, India today is large and open. Since India lacked industrial capabilities, and was energy-deficient to start with, its import needs grew manifold over this period. India’s current account deficit has increased by nine times from 1980 to 2019. The magnitude of India’s appetite for imports is such that its current account deficit is the fifth largest in the world today (Chart 2). Chart 2India Is The Fifth Largest Importer Of Goods And Services The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Given its lack of domestic energy and industrial capabilities, India’s role as a client of the world will only become more pronounced as it grows. In fact, India appears all set to become the third largest importer of goods and services globally over the next five years (Chart 3). Chart 3India Will Become The Third Largest Net Importer, After US And UK, By 2026 The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Global history suggests that the client is king. The rise and fall of empires have been driven by the strength of their economies and militaries. Great powers import lots of goods and resources – and tend to export arms. The UK’s geopolitical decline over the nineteenth century, and America’s rise over the twentieth, were linked to their respective status as importers within the global economy. India’s rise as a large global importer will prove to be a key source of diplomatic leverage over the next five years. For example, India’s high appetite for imports from China will give India much-needed leverage in bilateral relations. Also, India’s slow transition to green energy continued reliance on oil will strengthen its bargaining power vis-à-vis oil producers. But these trends also bring challenges. Structurally, Sino-Indian tensions are rising and trade will not be enough to prevent them. Meanwhile dependency on the volatile Middle East is a geopolitical vulnerability. China: India’s Growing Might As A Consumer Increases Leverage Vis-à-Vis China China’s rising assertiveness in South Asia and India’s own inclination to adopt an assertive foreign policy stance will lead to structurally higher geopolitical tensions in the region. So, is a full-blooded confrontation between the two nigh? No. First, Sino-Indian wars have always been constrained by geography: they are separated by the Himalayas, which help to keep their territorial disputes contained, driving them toward proxy battles rather than direct and total war. Second, India, Pakistan, and China are nuclear-armed powers which means that war is constrained by the principle of mutually assured destruction. This principle is not absolute – world history is filled with tragedy. There are huge structural tensions lurking in the combination of China’s Eurasian strategy and growing Sino-Indian naval competition that will keep Sino-Indian geopolitical risks elevated. Nevertheless, the bar to a large-scale war remains high. In the meantime, India’s growing might as a consumer could act as a much-needed deterrent to conflict. The last two decades saw America’s share in Chinese exports decline from a peak of 21% to 17% today. With US-China relations expected to remain fraught under Biden and with the US looking to revive its strategic anchor in the Pacific and shore up its domestic manufacturing strength, China’s trade relations with America will continue to deteriorate regardless of which party holds the White House. Against such a backdrop, China will try to build stronger trading ties with countries like India whose share in China’s exports has been growing (Chart 4). After excluding Hong Kong, India today is the eighth-largest exporting destination for China. While it only accounts for 3% of China’s exports, this ratio is comparable to that of larger exporting partners like Vietnam (4% share in China’s exports), South Korea (4%), Germany (3%), Netherlands (3%), and the UK (3%). In other words, China’s need for India is underrated and growing. There are two problems with Sino-Indian trade going forward. First, the strategic tensions mentioned above could prevent trade ties from improving. Over the past decade, Sino-Indian maritime and territorial disputes have escalated while Sino-Indian trade has merely grown in line with that of other emerging markets (Chart 5). China’s rising import dependency has led it to develop both a navy and an overland Eurasian strategy. The Eurasian strategy threatens India’s security in border areas of South Asia, while India’s own naval rise and alliances heighten China’s maritime supply insecurity. These trends may or may not prevent trade from living up to its potential, but they could result in strategic conflict regardless. Chart 4Amongst Top Chinese Export Clients, India’s Importance Has Increased The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Chart 5India’s Imports From China Have Broadly Grown In Line With Peers India's Imports From China Have Broadly Grown In Line With Peers India's Imports From China Have Broadly Grown In Line With Peers Second, the trade relationship itself is imbalanced. India imports heavily from China but sells little into China. China is responsible for more than a third of India’s trade deficit. At the same time, India increasingly shares the western world’s concern about network security in a world where cheap Chinese hardware could become integral to the digital economy. If Sino-Indian diplomacy cannot redress trade imbalances, then trade will generate new geopolitical tensions rather than resolve other ones. One should expect China to court India in the context of rising American and western strategic pressure. Yet China has failed to do so. Why? Because China’s economic transition – falling export orientation and declining potential GDP – is motivating a rise in nationalism and an assertive foreign policy. Meanwhile India’s own economic difficulties – the need to create jobs for a growing population – are generating an opposing wave of nationalism. Thus, while Sino-Indian trade will discourage conflict on the margin, it may not be enough to prevent it over the long run. Oil: As India Lags On Green Transition, Its Significance As An Oil Consumer Will Rise Whilst renewable energy’s share of India’s energy mix is expected to grow, the pace will be slow. Moreover, India’s increased reliance on green energy sources over the next decade will come at the expense of coal and not oil (Chart 6). Consequently, India’s reliance on oil for its energy needs is expected to stay meaningful. Chart 6India’s Reliance On Oil Will Persist For The Next Decade And Beyond The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Chart 7India’s Importance As An Oil Client Has Been Rising The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil The International Energy Agency (IEA) forecasts that India’s net dependence on imported oil for its overall oil needs will increase from 75% today to above 90% by 2040. But India’s relative importance as an oil client will also grow as most large oil consumers will be able to transition to green energy faster than India. In fact, data pertaining to the last decade confirms that this trend is already underway. India’s share of the global oil trade has been rising (Chart 7). In particular, India has taken advantage of Iraq’s rise as a producer after the second Gulf War and has marginally increased imports from Saudi Arabia (Chart 8). Chart 8India’s Importance As A Client Has Been Rising For Top Oil Exporters The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Iran is the country most likely to gain from this dynamic in the coming years – if the US and Iran strike a deal to curb Iran’s nuclear program in exchange for the US lifting economic sanctions. India has maintained stable imports from the Middle East over the past decade despite nominally eliminating imports of oil from Iran (Chart 9). Chart 9India Has Maintained Stable Imports From The Middle East The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil However, while India will have greater bargaining power between OPEC and non-OPEC suppliers, dependency on the unstable Middle East is always a geopolitical liability. If the US and Iran fail to arrive at a deal, a regional conflict is likely, in which case India’s slow green transition and vulnerability to supply disruptions will become a costly liability. Bottom Line: India’s growing importance to both Chinese manufacturers and global oil producers will give it leverage in trade negotiations. However, ultimately, national security will trump economics when it comes to China, while India will remain extremely vulnerable to instability in the Middle East. Guns: Indo-Russian Relations Weaken “When the war broke out [between India & Pakistan in 1971], the Soviet Union cast aside all pretentions of neutrality and non-partisanship… the Russians were in no hurry to terminate the fighting since their interest was better served by the continuation of hostilities leading to an India victory … The factors that decisively determined the outcome of the war were: first, Soviet military assistance to India; secondly the USSR’s role in the UN Security council; and thirdly, Russia strategy to prevent a direct Chinese intervention in the war.” – Zubeida Mustafa, "The USSR and the Indo-Pakistan War"2 The true origins of Russia’s pro-India tilt can be traced back to 1971. The former Soviet Union’s support for India played a critical role in helping India win the Indo-Pakistan war of 1971. Half a century later the Indo-Russia relationship persists, but its intensity has declined and will continue declining over the next few years. We see three reasons: America’s withdrawal from Iraq and Afghanistan will allow the US to focus more intently on its rivalry with China and Russia – a dynamic that is reinforcing China’s and Russia’s move closer together. Meanwhile India’s relationship with the US continues to improve. The China-Pakistan alliance continues to strengthen. Beyond cooperation on China’s ambitious Belt and Road Initiative, Pakistan shares a deep relationship with China based on defense and trade (Chart 10). Hence India is distrustful of closer Russo-Chinese relations. In light of this strategic re-alignment, Russia may see value in developing a closer defense relationship with China. Trading relations between Russia and India are minimal even today. Hence unlike in the case of China, there exists no backstop on weakening of Russo-Indian relations. Less than 1.5% of India’s merchandise imports come from Russia and less than 1% of India’s exports go to Russia. Russia’s share of Indian oil imports has grown in recent years but only to 1.4% of total. Meanwhile the US share of India’s imports has catapulted to 5.7% since the US became an exporter. Any removal of Iran sanctions will come at the cost of other Middle Eastern exporters, not these two alternatives to the risky Persian Gulf, but Russia’s share is still small. Now the backbone of Indo-Russia relations has been their arms trade. However, India’s reliance on Russia for arms could decline over the next five years. India today is Russia’s largest arms client accounting for 23% of its arms sales (Chart 10). However, second in line is China which accounts for 18% of Russia’s arms sales. Given that Russia’s share in global arms exports has been declining (Chart 11), Russia will be keen to reverse or at least halt this trend. Russia can do so most easily by selling more arms to India or to China. Even as China appears to be increasingly focused on developing indigenous arms production capabilities, for reasons of strategy, China appears like a better client for Russia to bank on for the next decade. After all, in 1989, when western countries imposed an arms embargo against China in response to events at Tiananmen Square, Russia became the prime supplier of arms to China. Chart 10India Is A Key Client For Russia, As Is China The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil By contrast, for reasons of strategy India appears like a less promising client to bank on for Russia. India’s import demand for arms has been declining while China’s demand is increasing (Chart 12). India under the Modi-led Bhartiya Janata Party (BJP) has been reducing its reliance on imported arms. Last month, for example, the Indian Ministry of Defense (MoD) said that it has set aside 64% of the defense capital budget for acquisitions from domestic companies.3 This is an increase of 6% over last year, which was the first time such a distinction between domestic and foreign defense expenditure was made. Whilst it will take years for India to develop its domestic arms production capabilities, India’s inward tilt is worrying for traditional suppliers like Russia. Chart 11Among Top Arms Exporters, Russia Is Losing Market Share The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Chart 12India’s Appetite For Arms Imports Is Falling The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Moreover, Russia is aware that the situation is rife for US-India arms trade to strengthen given that India is starting to display a pro-US tilt. Groundwork for a sound defense relationship with India has already been laid out by the US as evinced by: Foundational agreements: India and the US signed the Communications, Compatibility, and Security Agreement (COMCASA) in 2018 and the Basic Exchange and Cooperation Agreement (BECA) in 2020. Sanction exemptions: The US had applied sanctions on Turkey under the Countering America's Adversaries Through Sanctions Act (CAATSA) for Ankara’s purchase of Russia’s S-400 missile defense system in 2020. The US has threatened India with CAATSA sanctions for buying S-400 missile defense systems from Russia but has not applied these sanctions to India (at least not yet). Not applying CAATSA sanctions to India allows the US to strengthen its strategic relations with India that can help further the American goal of creating a counter to China in Asia. Bottom Line: India-Russia relations will remain amicable, but this relationship is bound to fade over the next five years as the US counters China and Russia. Limited backstops exist for Indo-Russia ties. Economic ties between India and Russia are minimal, as India is cutting back on arms imports and only marginally increasing oil imports. Capital: China Investment Down, US Investment Up “America has no permanent friends or enemies, only interests.” – Henry Kissinger, Former US Secretary of State India’s economic growth rates could be higher if it did not have to deal with the paradox of plentiful savings alongside capital scarcity. Even as Indian households are known to be thrifty, only a limited portion of their savings is available for being borrowed by small firms. Almost a quarter of bank deposits are blocked in government securities. More than a third of adjusted net bank credit must be made available for government-directed lending. With what is left, banks prefer lending the residual funds to large top-rated corporates. It is against this backdrop that foreign direct investment (FDI) flows provide much needed succor to Indian corporates, particularly capital-guzzling start-ups. FDI inflows into India have become a key source of funding for Indian corporates over the last decade with annual FDI flows often exceeding new bank credit. Correspondingly, for FDI investors, India provides the promise of high returns on investment in an emerging market that offers political stability. India emerged as the fifth largest FDI destination globally in 2020. Amongst suppliers of FDI into India (excluding tax havens like Cayman Islands), the US and China have been top contributors. Whilst China has been a leading investor into the Indian start-up space, geopolitical tensions have translated into regulatory barriers that prevent Chinese funds from investing in India. Separately, as Indo-US relations improve, the symbiotic relationship between capital-rich US funds and capital-hungry Indian start-ups should strengthen. In fact, in 2020 itself, Chinese private equity (PE) and venture capital (VC) investments into India shrank whilst American investments into India doubled, according to Venture Intelligence (Chart 13). Distinct from Chinese funds’ restrained ability to invest in Indian firms, Indian tech start-ups could potentially benefit from reduced global investor appetite in Chinese tech stocks owing to China’s regulatory crackdown and breakup with the United States. China’s foreign policy assertiveness and domestic policy uncertainty may lead to a reallocation of FDI flows away from China and into India. China (including Hong Kong) has been a top host country for FDI, attracting 4x times more funds than India (Chart 14). However, India’s ability to absorb these reallocated funds over the next five years will be a function of sectoral competencies. For instance, India’s information and communications technology (ICT) sector appears best positioned to benefit from this trend. But the same may not be the case for sectors like manufacturing that traditionally attract large FDI flows in China yet are relatively underdeveloped in India. On the goods’ front, given that India’s comparative advantage lies in the production of capital-light, labor-light and medium-tech intensive products, pharmaceuticals and chemicals could be two other industries that attract FDI flows in India. Chart 13Chinese PE/VC Investments Into India In 2020 Slowed Significantly The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Chart 14China Has Been A Top Host Country For FDI, Attracting 4x More Flows Than India The Future Of India’s Power: Trade, Guns, Capital, And Oil The Future Of India’s Power: Trade, Guns, Capital, And Oil Bottom Line: Whilst trade between India and China has not been affected much by geopolitical tensions, capital flows have been. Given that the US historically has been a top FDI contributor in India, and given improving Indo-US relations, FDI investment into India from the US appears set to rise steadily over the next five years, particularly into the ICT sector. Investment Conclusions China-India geopolitical tensions are here to stay and will be a recurring feature of South Asia’s geopolitical landscape. However, a growing trade relationship could discourage conflict, especially if it becomes more balanced. It may not be enough to prevent conflict forever but it is an important constraint to acknowledge. India’s current account deficit will remain vulnerable to swings in oil prices, but it may be able to manage its energy bill better as its bargaining power relative to oil suppliers improves. The problem then will become energy insecurity, particularly if the US and Iran fail to normalize relations. As India and Russia explore new alignments with USA and China respectively, the historic Indo-Russia relationship will weaken. It will not collapse entirely because Russia provides a small but growing alternative to Mideast oil. US-India business interests may deepen as India considers joint ventures with American arms manufacturers and American funds court India’s capital-hungry information and communications technology sector. Against this backdrop we reiterate our constructive strategic view on India. However, for the next 12 months, we remain worried about near-term geopolitical and macro headwinds that India must confront.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 (Viking Press, 1998). 2 Mustafa, Zubeida. "The USSR and the Indo-Pakistan War, 1971" Pakistan Horizon 25, No. 1 (1972): 45-52. 3 Ajai Shukla, "Local procurement for defence to see 6% hike this year: Govt to Parliament" Business Standard, July 2021.

Highlights Going into the new crop year, we expect the course of the broad trade-weighted USD to dictate the path taken by grain and bean prices (Chart of the Week). Higher corn stocks in the coming crop year, flat wheat stocks and lower rice stocks will leave grain markets mostly balanced vs the current crop year.  Soybean stocks and carryover estimates from the USDA and International Grains Council (IGC) are essentially unchanged year-on-year (y/y). In the IGC's estimates, changes in production, trade, and consumption for the major grains and beans largely offset each other, leaving carryovers unchanged. Supply-demand fundamentals leave our outlook for grains and beans neutral.  This does not weaken our conviction that continued global weather volatility will tip the balance of price risk in grains and beans over the coming year to the upside. Our strategically bearish USD view also tips the balance of price risk in grains – and commodities generally – to the upside. We believe positioning for higher-volatility weather events and a lower US dollar is best done with index products like the S&P GSCI and the COMT ETF, which tracks a version of the GSCI optimized for backwardation.  Feature Chart of the WeekUSD Will Drive Global Grain Markets USD Will Drive Global Grain Markets USD Will Drive Global Grain Markets Chart 2Opening, Closing Grain Stocks Will Be Largely Unchanged Global Grain, Bean Markets Balanced; USD Expected To Drive '21/22 Prices Global Grain, Bean Markets Balanced; USD Expected To Drive '21/22 Prices Going into the new crop year, opening and closing stocks are expected to remain flat overall vs the current crop years, with changes in production and consumption largely offsetting each other in grain and bean markets (Chart 2).1 This will leave overall prices a function of weather – which no one can predict – and the path taken by the USD over the coming year. The IGC's forecast calls for mostly unchanged production and consumption for grains and beans globally, with trade volumes mostly flat y/y. This leaves global end-of-crop-year carryover stocks essentially unchanged at 594mm tons. The USDA expects wheat ending stocks at the end of the '21/22 crop year up a slight 0.5%; rice down ~ 4.5%, and corn up ~ 4%. Below we go through each of the grain and bean fundamentals, and assess the impact of COVID-19 on global trade in these commodities. We then summarize our overall view for the grain and bean complex, and our positioning recommendations. Rice The IGC forecasts higher global rice production and consumption, and, since they expect both to change roughly by the same amount, ending stocks are projected to remain unchanged in the '21/22 crop year relative to the current year (Chart 3). The USDA, on the other hand, is expecting global production to increase by ~ 1mm MT in the new crop year, with consumption increasing by ~ 8mm MT. This leaves ending inventories for the new crop year just under 8mm MT below '20/21 ending stocks, or 4.5%. Chart 3Global Rice Balances Roughly Unchanged Global Rice Balances Roughly Unchanged Global Rice Balances Roughly Unchanged Corn The IGC forecasts global corn production will rise 6.5% to a record high in the '21/22 crop year, while global consumption is expected to increase 3.6%. Trade volumes are expected to fall ~ 4.2%, leaving global carryover stocks roughly unchanged (Chart 4). In the USDA's modelling, global production is expected to rise 6.6% in the '21/22 crop year to 1,195mm MT, while consumption is projected to rise ~ 2.4% to 1,172mm MT. The Department expects ending balances to increase ~ 11mm MT, ending next year at 291.2mm MT, or just over 4% higher. Chart 4Corn Balances Y/Y Remain Flat Corn Balances Y/Y Remain Flat Corn Balances Y/Y Remain Flat Wheat The IGC forecasts global wheat production in the current crop year will increase by ~ 16mm MT y/y, which will be a record if realized. Consumption is expected to rise 17mm MT, with trade roughly unchanged. This leaves expected carryover largely unchanged at ~ 280mm MT globally (Chart 5). The USDA's forecast largely agrees with the IGC's in its ending-stocks assessment for the new crop year. Global wheat production is expected to increase 16.6mm MT y/y in '21/22, and consumption will rise ~ 13mm MT, or 1.7% y/y. Ending stocks for the new crop year are expected to come in at just under 292mm MT, or 0.5% higher. Chart 5Ending Wheat Stocks Mostly Unchanged Ending Wheat Stocks Mostly Unchanged Ending Wheat Stocks Mostly Unchanged Soybeans Both the IGC and USDA expect increases in soybean ending stocks for the '21/22 crop year. However, the USDA’s estimates for ending stocks are nearly double the IGC projections.2 We use the IGC's estimates in Chart 6 to depicts balances. USDA - 2021/22 global soybean ending stocks are set to increase by ~3 mm MT to 94.5 mm MT, as higher stocks from Brazil and Argentina are partly offset by lower Chinese inventories. US production is expected to make up more than 30% of total production, rising 6% year-on-year. Chart 6Higher Bean Production Meets Higher Consumption Higher Bean Production Meets Higher Consumption Higher Bean Production Meets Higher Consumption Impact Of COVID-19 On Ags Trade Global agricultural trade was mostly stable throughout the COVID-19 pandemic. China was the main driver for this resilience, accounting for most of the increase in agricultural imports from 2019 to 2020. Ex-China, global agricultural trade growth was nearly zero. During this period, China was rebuilding its hog stocks after an outbreak of the African Swine Flu, which prompted the government to grant waivers on tariffs in key import sectors, which increased trade under the US-China Phase One agreement. As a result, apart from COVID-19, other factors were influencing trade. Arita et. al. (2021) attempted to isolate the impact of COVID on global agricultural trade.3 Their report found that COVID-19 – through infections and deaths – had a small impact on global agricultural trade. Government policy restrictions and reduced mobility in response to the pandemic were more detrimental to agricultural trade flows than the virus itself in terms of reducing aggregate demand. Policy restrictions and lower mobility reduced trade by ~ 10% and ~ 6% on average over the course of the year. Monthly USDA data shows that the pandemic was not as detrimental to agricultural trade as past events. Rates of decline in global merchandise trade were sharper during the Great Recession of 2007 – 2009 (Chart 7). Many agricultural commodities are necessities, which are income inelastic. Furthermore, shipping channels for these types of commodities did not require substantial human interactions, which reduced the chances of this trade being a transmission vector for the virus, when governments declared many industries using and producing agricultural commodities as necessities. This could explain why agricultural trade was spared by the pandemic. Amongst agricultural commodities, the impact of the pandemic was heterogenous. For necessities such as grains or oilseeds, there was a relatively small effect, and in few instances, trade actually grew. For example, trade in rice increased by ~4%. The value of trade in higher-end items, such as hides, Chart 7COVID-19 Spares Ag Trade Global Grain, Bean Markets Balanced; USD Expected To Drive '21/22 Prices Global Grain, Bean Markets Balanced; USD Expected To Drive '21/22 Prices Chart 8Grains Rallied During Pandemic Global Grain, Bean Markets Balanced; USD Expected To Drive '21/22 Prices Global Grain, Bean Markets Balanced; USD Expected To Drive '21/22 Prices tobacco, wine, and beer fell during the pandemic. This was further proof of the income inelasticity of many agricultural products which kept global trade in this sector resilient. Indeed, the UNCTAD estimates global trade for agriculture foods increased 18% in 1Q21 relative to 1Q19. Over this period, Bloomberg's spot grains index was up 47.08% (Chart 8). Investment Implications We remain neutral grains and beans based on our assessment of the new crop-year fundamentals. That said, we have a strong-conviction view global weather volatility will tip the balance of price risk in grains over the coming year to the upside. Our strategically bearish USD view also tips the balance of price risk in grains – and commodities generally – to the upside. Weather-induced grain and bean prices volatility is supportive for our recommendations in the S&P GSCI and the COMT ETF, which tracks a version of the GSCI optimized for backwardation. These positions are up 5.8% and 7.9% since inception, and are strategic holdings for us.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish US natural gas prices remain well supported by increased power-generation demand due to heat waves rolling through East and West coasts, lower domestic production and rising exports. The US EIA estimates natgas demand for July rose 3.9 bcf/d vs June, taking demand for the month to 75.8 bcf/d. Exports – pipeline and LNG – rose 0.4 bcf/d to 18.2 bcf/d, while US domestic production fell to 92.7 bcf/d, down 0.2 bcf/d from June's levels. As US and European distribution companies and industrials continue to scramble for gas to fill inventories, we expect natgas to remain well bid as the storage-injection season winds down. We remain long 1Q22 call spreads, which are up ~214% since the position was recommended April 8, 2021 (Chart 9). Base Metals: Bullish Labor and management at BHP's Escondida copper mine – the largest in the world – have a tentative agreement to avoid a strike that would have crippled an already-tight market. The proposed contract likely will be voted on by workers over the next two days, according to reuters.com. Separately, the head of a trade group representing Chile's copper miners said prices likely will remain high over the next 2-3 years as demand from renewables and electric vehicles continues to grow. Diego Hernández, president of the National Society of Mining (SONAMI), urged caution against expecting a more extended period of higher prices, however, mining.com reported (Chart 10). We remain bullish base metals generally, copper in particular, which we expect to remain well-bid over the next five years. Precious Metals: Bullish US CPI for July rose 0.5% month-over-month, suggesting the inflation spike in June was transitory. While lower inflation may reduce demand for gold, it will allow the Fed to continue its expansionary monetary policy. The strong jobs report released on Friday prompted markets and some Fed officials to consider tapering asset purchases sooner than previously expected. The jobs report also boosted an increasing US dollar. A strong USD and an increase in employment were negative for gold prices on Monday. There also were media reports of a brief “flash crash” caused by an attempt to sell a large quantity of gold early in the Asian trading day, which swamped available liquidity at the time. This also was believed to trigger stops and algorithmic trading programs, which exacerbated the move. The potential economic impact of the COVID-19 Delta variant is the only unequivocally supportive development for gold prices. Not only will this increase safe-have demand for gold, but it will also prevent the Fed from being too hasty in tapering its asset purchases and subsequently raising interest rates. Chart 9 Natgas Prices Recovering Natgas Prices Recovering Chart 10 Copper Prices Going Down Copper Prices Going Down Footnotes 1     The wheat crop year in the US begins in June; the rice crop year begins this month; and the corn and bean crop years begin in September. 2     Historical data indicate this difference is persistent, suggesting different methods of calculating ending stocks.  The USDA estimates ending stocks for the '21/22 crop year will be 94.5mm tons, while the IGC is projecting a level of 53.8mm.  3    Please refer to ‘Has Global Agricultural Trade Been Resilient Under Coronavirus (COVID-19)? Findings from an Econometric Assessment. This is a working paper published by Shawn Arita, Jason Grant, Sharon Sydow, and Jayson Beckman in May 2021.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Image

Dear client,  In addition to this abridged Strategy Report, we are sending a report written by Arthur Budaghyan, Chief Strategist of BCA’s Emerging Market Investment service. Arthur shares his thoughts on the future of Chinese TMT stocks, a subject we trust you will find insightful and beneficial. Jing Sima China Strategist Highlights Wealth and income inequality may be the most important contributors to rising populism in the past three decades. China has its share of increasing populism; reducing income inequality and improving social welfare are core principles of President Xi’s reform agenda. July’s economic data continues to indicate a softening in China’s economy. However, the magnitude of the slowdown is within policymakers’ pain threshold while the economy remains supported by strong external demand. For now, stay underweight in Chinese stocks within a global equity portfolio.  Policy stance has yet to turn reflationary. Feature Populism Takes Root BCA's China Investment Strategy has argued that China is accelerating the pace of its structural reforms; addressing income inequality is at the core of the current administration’s reform agenda. Wealth and income inequality may be the most important structural cause of rising global populism and political polarization (Chart 1). The severity of income inequality in China is illustrated in Chart 2. It is noteworthy that China, whose political and economic ideology is based on creating a classless society, has found itself not far behind the US in terms of a widening wealth and income gap. Chart 1Populism Has Been On The Rise Globally For The Past 30 Years Populism Finds Fertile Ground In China Populism Finds Fertile Ground In China Chart 2The Great Gatsby Curve Paints A Not-So-Great Equality Picture Of China Populism Finds Fertile Ground In China Populism Finds Fertile Ground In China The relationship between inequality and intergenerational income mobility is captured in the "Great Gatsby Curve" – a concept based on a research paper by economist Miles Corak and later introduced by Alan Krueger, the late professor and Chairman of the Council Economic Advisers, during his speech at the Center for American Progress in 2012.1 The US has experienced a sharp rise in wealth and income inequality since the 1980s. On the eve of the Global Financial Crisis, income inequality in the US was as sharp as it had been since the time of "The Great Gatsby” novel set in the 1920s. After three decades of rapid industrialization and economic expansion, China also faces the challenge of escalating income inequality and discontent among middle-class households. Populism, defined as political stances that emphasize the idea of "the people", often benefits middle-class households, but not big business or corporate earnings (“the elite”). An increase in populist governments is usually positively correlated with rising number of antitrust investigations, since populist leaders tend to pander to popular outcries against big corporations by limiting or breaking up the corporations. In the US, the rise of Reaganism/neoliberalism in the 1980s led to a big drop in antitrust cases – a trend that was sustained for nearly three decades as the free-market Washington Consensus pushed against antitrust and other populist stances (Chart 3). However, the tide turned in 2016 when the US elected a populist president for first time, and antitrust threats started reemerging (Chart 4). Chart 3Antitrust Reinforcement In The US Has Been On A Secular Decline In The Past Two Decades… Populism Finds Fertile Ground In China Populism Finds Fertile Ground In China Chart 4...But Antitrust Noise Is Getting Louder In The US (And Lately In China) ...But Antitrust Noise Is Getting Louder In The US (And Lately In China) ...But Antitrust Noise Is Getting Louder In The US (And Lately In China) Both China and the US have transitioned towards larger government involvement in the economy.  More restrictions on private enterprise and a greater redistribution of wealth will be forthcoming. In the US, there has been a shift towards a larger share of labor compensation versus capital in the country’s national income (Chart 5). In China, the “dual circulation” economic goal set by the 14th Five Year Plan, coupled with an economic divorce between the Middle Kingdom and the US, requires that China expands its domestic market. However, that expansion is constrained by its relatively low labor share (Chart 6). The external and internal challenges are fertile ground for rising and sustaining populism. Thus, reforms that promote the bargaining power of workers at the expense of corporate earnings will likely become a secular trend in China. Chart 5Labor Makes A Comeback Versus Capital In The US... Labor Makes A Comeback Versus Capital In The US... Labor Makes A Comeback Versus Capital In The US... Chart 6...And In China Too ...And In China Too ...And In China Too Checking In On The Data China’s economic data continues to soften as evidenced by a slew of new numbers published last weekend. On the growth front, the contraction in the volume of imports in the past two months reflects the sagging domestic economy, despite elevated commodity prices supporting the value of total imports (Chart 7). Global demand for Chinese goods, on the other hand, remains strong compared with the historical norm, and continues to offset weaknesses in China’s old economy sectors. Meanwhile, Chinese producers face persistent inflationary pressures stemming from elevated global commodity prices and a broken price transmission to pass on inflation to domestic consumers (Chart 8). Instead of stimulating demand in the near term, Chinese policymakers will likely address supply-side issues by releasing strategic reserves and curbing raw material exports, and relaxing domestic production restrictions. Chart 7Strong External Demand Continues To Offset Domestic Economic Weaknesses Strong External Demand Continues To Offset Domestic Economic Weaknesses Strong External Demand Continues To Offset Domestic Economic Weaknesses Chart 8Inflationary Pressures On Producers Remains Elevated Inflationary Pressures On Producers Remains Elevated Inflationary Pressures On Producers Remains Elevated We expect that Beijing will need greater economic pain before it decides to stimulate the economy more substantially. Monetary conditions have eased since earlier this year on the back of rising inflation, falling real interest rates and recently a breather in the RMB’s ascent (Chart 9). Nonetheless, as we noted in a previous report, a decisive rebound in the rate of credit expansion requires clear easing signals from China’s top leadership for local governments and corporates to ramp up leverage again. The July Politburo meeting pledged more fiscal support for the economy this year. Meanwhile, policymakers have intensified their tough regulatory stances on private-sector businesses and oversight on the public-sector’s balance sheet. Hence, the current policy backdrop does not suggest any imminent or meaningful reflationary measures. Chart 9A Meaningful Rebound In Credit Growth Requires More Than Monetary Easing A Meaningful Rebound In Credit Growth Requires More Than Monetary Easing A Meaningful Rebound In Credit Growth Requires More Than Monetary Easing Chart 10War Against Delta-Variant Remains A Risk War Against Delta-Variant Remains A Risk War Against Delta-Variant Remains A Risk The COVID-19 Delta-variant remains the biggest risk to our view. The mutated virus has spread to 14 provinces in China and triggered the strictest pandemic-control measures since Q1 last year. The drag on the service sector’s activities and employment will be substantial if measures are maintained for more than a month (Chart 10). In this case, the leadership may need to step in with policy supports to stabilize the economy and sentiment. For now, the pullback of stimulus and ongoing regulatory tightening since Q4 last year continue to dominate China’s financial assets. Thus, investors should maintain an underweight allocation to Chinese equities within a global equity portfolio.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1Krueger, Alan (12 January 2012). "The Rise and Consequences of Inequality in the United States" (PDF).  Market/Sector Recommendations Cyclical Investment Stance