China

In this <i>Strategy Outlook</i>, we present the major investment themes and views we see playing out for the rest of the year and beyond.

Executive Summary Accelerating wages will make core consumer inflation sticky in the US. In addition, inflation is a lagging variable and is still well above the Fed’s target. These dynamics imply that the Fed will not make a dovish pivot imminently. Following the re-normalization of economic activity after reopening, China’s recovery will be U-shaped, rather than V-shaped. Global manufacturing and exports are heading into contraction. Contracting global trade is bullish for the trade-weighted US dollar given that it is a counter-cyclical currency. A hawkish Fed is also positive for the greenback. Hence, the US dollar will likely overshoot. EM equities are unlikely to rally/outperform on a sustainable basis until an EM profit contraction is priced in and the US dollar starts depreciating. Asian Currencies Will Depreciate Asian Currencies Will Depreciate Asian Currencies Will Depreciate Bottom Line: Absolute return investors should stay defensive for now. The global equity selloff has entered its final capitulation phase. Feature Global equity and fixed-income portfolios should maintain an underweight allocation to EM. That said, we will likely be upgrading EM versus DM later this year. EM currencies have more downside. Global and EM risk assets will likely continue selling off. Our major macro themes remain intact. Accelerating wages will make core consumer inflation sticky in the US. In addition, inflation is a lagging variable and is still well above the Fed’s target. These dynamics imply that the Fed will not make a dovish pivot imminently. Meanwhile, global growth is slowing rapidly, and global trade volumes are on the verge of contracting. US and EU demand for consumer goods (ex autos) is set to shrink.  EM ex-China domestic demand will be weakening from already very low levels.  Following the re-normalization of Chinese economic activity after the reopening, China’s recovery will be U-shaped, rather than V-shaped. Overall, global profits − including US and EM –will contract. Our bias is that equity markets have not fully discounted a profit contraction. The combination of shrinking corporate profits and a hawkish Fed  that is focused on taming inflationary pressures is bearish for global stocks and risk assets. As long as the Fed maintains its hawkish bias and/or global trade contracts, the US trade-weighted dollar will continue to appreciate. The USD will likely overshoot in the near term. Contracting global trade is bullish for the counter-cyclical greenback. EM currencies will therefore continue to depreciate, weighing on EM bonds and stocks. Typically, EM stocks do not out outperform DM ones when the dollar is strengthening. Even though global risk assets have already sold off significantly and there is a temptation to buy, odds are high that there will be another downleg. Several markets are already breaking down below their technical support lines: The Nasdaq 100 index is slipping below its 3-year moving average which proved to be a major support in past selloffs (Chart 1, top panel). The average exchange rate of AUD, NZD and CAD (which are all cyclical commodity currencies) versus the US dollar has fallen below its 3-year moving average (Chart 1, bottom panel). In the commodity space, we have similar breakdowns. Share prices of gold mining companies, silver prices and the silver-to-gold price ratio have all clearly crossed below their 3-year moving averages (Chart 2). Chart 1Breakdowns in The Nasdaq 100 And Commodity Currencies Breakdowns in The Nasdaq 100 And Commodity Currencies Breakdowns in The Nasdaq 100 And Commodity Currencies Chart 2Precious Metal Prices Are Breaking Down Too Precious Metal Prices Are Breaking Down Too Precious Metal Prices Are Breaking Down Too   Emerging Asian financial markets underscore that growth is relapsing and demand for raw materials is weak. The top panel of Chart 3 illustrates that Korean materials stocks have broken below their 3-year moving average. Further, in China, rebar steel, rubber, cement and plate glass prices are all falling (Chart 3, middle and bottom panels). Chart 3Bearish Signals For Raw Materials From Asia Bearish Signals For Raw Materials From Asia Bearish Signals For Raw Materials From Asia The charts below provide more evidence, supporting our macro themes and investment strategy. Investment Conclusions Absolute return investors should stay defensive for now. The global equity selloff has entered its final capitulation phase. Global equity and fixed-income portfolios should continue underweighting EM. That said, we will likely be upgrading EM versus DM later this year. The US dollar has more upside. EM/Asian FX and commodity currencies are vulnerable. We also continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN, PHP and IDR; as well as HUF vs. CZK, and KRW vs. JPY. A buying opportunity in global and EM risk assets will emerge once US Treasury yields roll over decisively, the US dollar begins its descent and China provides more stimulus. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com The US Equity Bear Market: How Advanced Is It? If this US equity selloff is part of an ongoing bull market that began in 2009, then the drop in share prices is probably over. However, if this same bull market has reached its end, then this selloff has further room to go. Our best guess is that it is the latter, i.e., we might be witnessing the end of the S&P 500 bull market that commenced in 2009. Our S&P 500 Capitulation Indicator is low, but it can drop further. Also, the S&P 500 will likely break below its 3-year moving average, which acted as a support in the 2011, 2015-16 and 2018 selloffs. Chart 4The US Equity Bear Market: How Advanced Is It? The US Equity Bear Market: How Advanced Is It? The US Equity Bear Market: How Advanced Is It? US Corporate Credit And Share Prices The US corporate credit market does not yet point to a durable bottom in US share prices. Rising corporate HY ex-energy bond yields, and the underperformance of HY ex-energy corporate credit versus IG credit, point to lower share prices for now. Chart 5US Corporate Credit And Share Prices US Corporate Credit And Share Prices US Corporate Credit And Share Prices Chart 6US Corporate Credit And Share Prices US Corporate Credit And Share Prices US Corporate Credit And Share Prices The US Inflation Genie Is Out Of The Bottle US labor demand is outstripping labor supply by a record margin since 1950. US wages have accelerated and will remain sticky in the coming months. High wage growth and weaker output entail rising unit labor costs. The latter is a key driver of core inflation. Unless the unemployment rate rises, US core inflation will not drop below 3.5-4%. In fact, median and trimmed-mean CPI have continued rising even though core CPI has rolled over. Chart 7The US Inflation Genie Is Out Of The Bottle The US Inflation Genie Is Out Of The Bottle The US Inflation Genie Is Out Of The Bottle Chart 8The US Inflation Genie Is Out Of The Bottle The US Inflation Genie Is Out Of The Bottle The US Inflation Genie Is Out Of The Bottle       Chart 9The US Inflation Genie Is Out Of The Bottle The US Inflation Genie Is Out Of The Bottle The US Inflation Genie Is Out Of The Bottle Chart 10The US Inflation Genie Is Out Of The Bottle The US Inflation Genie Is Out Of The Bottle The US Inflation Genie Is Out Of The Bottle   US Manufacturing Is Downshifting Rapidly Railroad carload is declining, and new orders from the US regional Feds’ manufacturing surveys are in free fall. The ISM new orders index will drop below the critical 50 line. Chart 11US Manufacturing Is Downshifting Rapidly US Manufacturing Is Downshifting Rapidly US Manufacturing Is Downshifting Rapidly Chart 12US Manufacturing Is Downshifting Rapidly US Manufacturing Is Downshifting Rapidly US Manufacturing Is Downshifting Rapidly Chart 13US Manufacturing Is Downshifting Rapidly US Manufacturing Is Downshifting Rapidly US Manufacturing Is Downshifting Rapidly     The US Is Entering A Major Growth Slump US household demand for consumer goods ex-autos will shrink. The basis is excessive goods purchases in the last two years, falling household disposable income in real terms and a shift in preference for services versus goods. US retail inventories of consumer goods ex-autos have surged. Retailers will substantially cut back on their orders. Asian/Chinese exports are set to shrink. US consumption of gasoline is also contracting. Chart 14The US Is Entering A Major Growth Slump The US Is Entering A Major Growth Slump The US Is Entering A Major Growth Slump Chart 15The US Is Entering A Major Growth Slump The US Is Entering A Major Growth Slump The US Is Entering A Major Growth Slump Chart 16The US Is Entering A Major Growth Slump The US Is Entering A Major Growth Slump The US Is Entering A Major Growth Slump       Global Manufacturing And Exports Are Heading Into Contraction The relative performance of global cyclical stocks versus defensives points to a major relapse in global manufacturing. Chinese import volumes have been contracting and EM import volumes will drop too with the deteriorating purchasing power of households across many developing economies. Chart 17Global Manufacturing And Exports Are Heading Into Contraction Global Manufacturing And Exports Are Heading Into Contraction Global Manufacturing And Exports Are Heading Into Contraction Chart 18Global Manufacturing And Exports Are Heading Into Contraction Global Manufacturing And Exports Are Heading Into Contraction Global Manufacturing And Exports Are Heading Into Contraction Chart 19Global Manufacturing And Exports Are Heading Into Contraction Global Manufacturing And Exports Are Heading Into Contraction Global Manufacturing And Exports Are Heading Into Contraction     Contracting Asian Exports Are Negative For Asian Currencies There are already signs of contraction in Asian manufacturing/exports. Downshifting global trade typically leads to Asian currency depreciation. Chart 20Contracting Asian Exports Are Negative For Asian Currencies Contracting Asian Exports Are Negative For Asian Currencies Contracting Asian Exports Are Negative For Asian Currencies Chart 21Contracting Asian Exports Are Negative For Asian Currencies Contracting Asian Exports Are Negative For Asian Currencies Contracting Asian Exports Are Negative For Asian Currencies       Chart 22Contracting Asian Exports Are Negative For Asian Currencies Contracting Asian Exports Are Negative For Asian Currencies Contracting Asian Exports Are Negative For Asian Currencies Chart 23Contracting Asian Exports Are Negative For Asian Currencies Contracting Asian Exports Are Negative For Asian Currencies Contracting Asian Exports Are Negative For Asian Currencies   The USD Has More Upside, EM FX More Downside The EM ex-China currency total return index has failed to break above its technical resistance line. This entails a major downside. The underperformance of global cyclicals versus defensives points to lower Asian currencies. The US dollar (shown inverted on Chart 24) will be supported by a deceleration in global US dollar liquidity. Chart 24The USD Has More Upside, EM FX More Downside The USD Has More Upside, EM FX More Downside The USD Has More Upside, EM FX More Downside Chart 25The USD Has More Upside, EM FX More Downside The USD Has More Upside, EM FX More Downside The USD Has More Upside, EM FX More Downside     Chart 26The USD Has More Upside, EM FX More Downside The USD Has More Upside, EM FX More Downside The USD Has More Upside, EM FX More Downside EM Equity Capitulation Our EM Equity Capitulation Indicator has dropped significantly but is still above its 2008, 2015-16 and 2020 lows. Given the global and EM macro backdrops, odds point to an undershoot in EM share prices. Chart 27EM Equity Capitulation EM Equity Capitulation EM Equity Capitulation EM Equity And Bond Sentiment Investor sentiment on EM stocks and EM USD bonds is downbeat. This is positive from a contrarian perspective. However, as global risk assets continue selling off and the US dollar overshoots, EM stocks and bonds might undershoot. Chart 28EM Equity And Bond Sentiment EM Equity And Bond Sentiment EM Equity And Bond Sentiment Chart 29EM Equity And Bond Sentiment EM Equity And Bond Sentiment EM Equity And Bond Sentiment EM Equity Valuations And Profits Based on our cyclically adjusted P/E ratio, EM equity valuations have improved to one standard deviation below the mean. Relative to the S&P 500, EM stock valuations are at their record low based on a similar measure. Nevertheless, EM equities are unlikely to rally/outperform on a sustainable basis until an EM profit contraction is priced in and the US dollar starts depreciating. Chart 30EM Equity Valuations And Profits EM Equity Valuations And Profits EM Equity Valuations And Profits Chart 31EM Equity Valuations And Profits EM Equity Valuations And Profits EM Equity Valuations And Profits       Chart 32EM Equity Valuations And Profits EM Equity Valuations And Profits EM Equity Valuations And Profits Chart 33EM Equity Valuations And Profits EM Equity Valuations And Profits EM Equity Valuations And Profits   Four Large-Cap EM Stocks The four largest EM stocks (by market value) might not be out of the woods. Alibaba is facing resistance at its 200-day moving average. Tencent, TSMC and Samsung will likely drop to their next technical support lines. Chart 34Four Large-Cap EM Stocks Four Large-Cap EM Stocks Four Large-Cap EM Stocks Chart 35Four Large-Cap EM Stocks Four Large-Cap EM Stocks Four Large-Cap EM Stocks       Chart 36Four Large-Cap EM Stocks Four Large-Cap EM Stocks Four Large-Cap EM Stocks Chart 37Four Large-Cap EM Stocks Four Large-Cap EM Stocks Four Large-Cap EM Stocks   Chinese And EM ex-China Stocks The rally in the Chinese onshore CSI 300 stock index will probably dwindle at its 200-day moving average. Technical supports have held up for Chinese investable TMT and non-TMT stocks. However, the recent rebound is unlikely to be sustained if the global selloff continues. Finally, EM ex-China stocks have been in a free fall. Chart 38Chinese And EM ex-China Stocks Chinese And EM ex-China Stocks Chinese And EM ex-China Stocks Chart 39Chinese And EM ex-China Stocks Chinese And EM ex-China Stocks Chinese And EM ex-China Stocks       Chart 40Chinese And EM ex-China Stocks Chinese And EM ex-China Stocks Chinese And EM ex-China Stocks Chart 41Chinese And EM ex-China Stocks Chinese And EM ex-China Stocks Chinese And EM ex-China Stocks   Global Cross-Asset Interlinkages Rising US TIPS yields will keep upward pressure on EM local bond yields and downward pressure on EM currencies. The mainstream EM ex-China currencies are not cheap. Without EM currencies rallying, it will be difficult for EM stocks to outperform DM ones. Chart 42Global Cross-Asset Interlinkages Global Cross-Asset Interlinkages Global Cross-Asset Interlinkages Chart 43Global Cross-Asset Interlinkages Global Cross-Asset Interlinkages Global Cross-Asset Interlinkages Chart 44Global Cross-Asset Interlinkages Global Cross-Asset Interlinkages Global Cross-Asset Interlinkages     A Structural Breakdown In Chinese Real Estate The Chinese real estate market is experiencing a structural breakdown, as is illustrated by the collapse in share prices of Chinese property developers and their corporate bond prices. The breakdown in property developers’ financing heralds lower construction volumes with negative implications for raw material prices. Chart 45A Structural Breakdown In Chinese Real Estate A Structural Breakdown In Chinese Real Estate A Structural Breakdown In Chinese Real Estate Chart 46A Structural Breakdown In Chinese Real Estate A Structural Breakdown In Chinese Real Estate A Structural Breakdown In Chinese Real Estate       Chart 47A Structural Breakdown In Chinese Real Estate A Structural Breakdown In Chinese Real Estate A Structural Breakdown In Chinese Real Estate Chart 48A Structural Breakdown In Chinese Real Estate A Structural Breakdown In Chinese Real Estate A Structural Breakdown In Chinese Real Estate   Chinese Domestic Demand Has Been Absent Over The Past 12 Months Chinese imports of various commodities and goods have been contracting over the past 12 months. The resilience of commodity prices has not been due to China. As investors start pricing in the US economic downturn and the need for inflation protection wanes, commodity prices could gap down. Chart 49Chinese Domestic Demand Has Been Absent Over The Past 12 Months Chinese Domestic Demand Has Been Absent Over The Past 12 Months Chinese Domestic Demand Has Been Absent Over The Past 12 Months Chart 50Chinese Domestic Demand Has Been Absent Over The Past 12 Months Chinese Domestic Demand Has Been Absent Over The Past 12 Months Chinese Domestic Demand Has Been Absent Over The Past 12 Months     Will The Pendulum Swing From Inflation To Deflation? The US equity and bond market selloffs of the past 12 months have wiped out about $12 trillion and $3.5 trillion of their respective market value, respectively. This adds up to a combined $15 trillion or about 60% of US GDP, which already exceeds the wipeouts that occurred during the March 2020 crash and all other bear markets. Such wealth destruction and a hawkish Fed could swing the pendulum from inflation to deflation. Commodity prices are currently vulnerable. Stay tuned. Chart 51Will The Pendulum Swing From Inflation To Deflation? Will The Pendulum Swing From Inflation To Deflation? Will The Pendulum Swing From Inflation To Deflation? Chart 52Will The Pendulum Swing From Inflation To Deflation? Will The Pendulum Swing From Inflation To Deflation? Will The Pendulum Swing From Inflation To Deflation? Chart 53Will The Pendulum Swing From Inflation To Deflation? Will The Pendulum Swing From Inflation To Deflation? Will The Pendulum Swing From Inflation To Deflation?     Footnotes Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Executive Summary Long-Term Contracts Needed To Increase LNG Supply EU Will Reverse Course On Fossil Fuels EU Will Reverse Course On Fossil Fuels The EU will have to reverse course and execute long-term contracts with natural gas producers, LNG shippers and pipeline operators to incentivize production of supplies needed to contain energy prices. Long-term contracting will offer the EU an opportunity to address political and economic fragmentation risks via joint taxation policies.  This would transform state-level risks via-a-vis energy and military security into joint-and-several obligations. The G7’s plan to cap Russian oil prices will be DOA.  The most oil import-dependent EM economies – China and India – will find deeply discounted crude irresistible. Hydrocarbon producers and refiners will increase investments in carbon-capture and storage technology, to maintain their new-found advantage as secure energy sources.  Additional subsidies and funding for this technology will be forthcoming. Bottom Line: The hard realities of military conflict and a lack of investment in production and refining will force governments to incentivize substantial investments in hydrocarbons – particularly natural gas and LNG infrastructure – to address global energy scarcity during a time of war.  We remain long oil and gas exposures via the COMT ETF, and long equity refining and services exposures via the CRAK and IEZ ETFs.  We will re-establish our producer-oriented XOP ETF position if prompt Brent futures trade down to $105/bbl in the front month.  We also remain tactically long Brent and eurozone natgas futures and options. Feature The G7 last opined on liquified natural gas (LNG) supply in May, and as was the case this week, it left even casual observers uncertain as to what it is seeking to achieve: It advocated for a halt to further investments in fossil-fuel projects and, at the same time, called for higher LNG supplies to be provided for the EU states.1  The EU faces daunting energy security and supply constraints.2 A deepening energy scarcity will, we expect, push the EU into recession later this year, as natural-gas rationing is invoked to ensure there are sufficient supplies to meet human needs this winter.  Natgas scarcity will force the EU to reverse course on its renewable-energy transition in the medium term and prioritize fossil-fuel investments, in our view.  Long-term contracting with LNG suppliers will be required to incentivize needed investment in production and transportation to replace Russian gas imports.  Such contracting is a necessity for hydrocarbon producers, given governments’ continued calls for no additional fossil-fuel investment.  Quicksilver shifts in policy are a continuing source of uncertainty for investors and energy-supply firms. Over time, the EU will have to replace close to 7 Tcf/yr of Russian gas imports (Chart 1, middle panel).  This will propel the EU into the ranks of the world’s largest LNG importers (Chart 2).  Chart 1EU Needs To Replace ~ 7 Tcf/yr Of LNG EU Will Reverse Course On Fossil Fuels EU Will Reverse Course On Fossil Fuels Chart 2EU Will Become A World-Class LNG Importer EU Will Become A World-Class LNG Importer EU Will Become A World-Class LNG Importer Chart 3Long-Term Contracts Needed To Increase LNG Supply EU Will Reverse Course On Fossil Fuels EU Will Reverse Course On Fossil Fuels Given the length of contracts typically executed with LNG exporters – in excess of 20-plus years – EU governments will be compelled to allow firms and member states to sign long-term contracts for these supplies.  EU governments also will be required to begin planning for and developing LNG importing infrastructure, as these supplies become available over the next 3-5 years. In the meantime, LNG prices will remain under pressure as competition heats up globally ahead of the coming winter (Chart 3). G7 Price-Cap Scheme Will Be DOA The G7’s scheme to impose a price cap on Russian oil exports will be DOA as soon as details are presented.  This is because the world’s largest oil import-dependent economies – China and India – not only have long trading histories with Russia, but they also operate their own oil-transport fleets that can circumvent insurance-related obstacles imposed by the US and the UK.  China and India already find discounted Russian oil irresistible, and are unlikely to acquiesce to US demands for a price cap.  China imports 75% of its 15.5mm b/d of oil consumption, while India imports ~ 85% of the 5mm b/d of oil it consumes.  Even if oil importers taking Russia's exports going to the EU were to sign on to a price-cap scheme, Russia could always unilaterally cut its oil and condensate production by 20-30% and force Brent prices sharply higher for remaining contract holders. This would almost surely lead to higher prices – above $140/bbl, based on our earlier estimates – and raise Russia’s net export proceeds in the process, since the G7 does not want all of Russia's oil taken off the market.3 Government Interventions Exacerbate Scarcity Governments of states with contestable elections increasingly are intervening – or attempting to do so – in global energy markets and imposing often-contradictory policies that nominally favor consumers at the expense of energy producers.  This almost always is counter-productive: Price caps intended to soften the blow of higher-cost electricity and hydrocarbons discourages the necessary conservation of scarce resources.  So-called windfall profits taxes discourage the investment required to address supply scarcity.  Higher demand and lower supply does not lead to lower prices.  Even grander schemes – e.g., the monopsony cartels floated by G7 member states like the US and EU, along with China – almost surely would reduce the profitability of developing and marketing new energy supplies, which also would exacerbate scarcity of supply by discouraging investment. These quick ad hoc fixes work at cross purposes in solving the problem of global energy scarcity.  While they are in keeping with a penchant of governments to demonstrate they are addressing voters’ concerns, such policies mistake a quick response for long-term solutions. Investment Implications The EU will, in our opinion, be forced to reverse course and sign long-term LNG supply contracts to replace Russian natural gas imports.  This will not derail its renewable-energy transition strategy, but it will significantly delay it.  We remain long oil and gas exposures via the S&P GSCI and COMT ETF, and long equity refining and services exposures via the CRAK and IEZ ETFs.  We will re-establish our producer-focused XOP ETF position if Brent trades down to $105/bbl in the front month.  We also remain tactically long Brent and eurozone natgas futures and options (see p. 7 below). Housekeeping Notes We were stopped out of our long S&P GSCI position with a gain of 64%.  We are getting long again at the close. We also were stopped out of our long 4Q22 $120/bbl Brent calls with a 16% return. Separately, there will be no Commodity Round-Up in this week’s publication.  We are broadcasting our Commodity Round-Up today at 9 a.m. EDT.    Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1     Please see The G7 wants to dump natural gas … but not yet published by politico.com 27 May 2022.  The report notes, “The G7 called for an end to international investments in fossil fuels by the end of this year and slammed private finance for continuing to back dirty energy — but left a big out for EU countries desperate to replace Russian gas.  ‘We acknowledge that investment in [the liquefied natural gas] sector is necessary in response to the current crisis, in a manner consistent with our climate objectives and without creating lock-in effects,’ the ministers said.” 2     Please see One Hot Mess: EU Energy Policy, published 26 May 2022.  This report delves into the EU’s post-Cold War foreign policy.  For three decades, EU foreign policy largely was set by Germany, the organization's most powerful economy.  Successive generations of German politicians championed the idea that the West could bring the former Soviet Union – and later Russia – into the modern world of global trade through Ostpolitik, which had, at its core, a belief in the power of trade to effect political and economic change.  This policy is kaput. 3    Please see Higher Gasoline, Diesel Prices Ahead, which we published 2 June 2022.  It is available at ces.bcaresearch.com. Investment Views and Themes Strategic Recommendations Tactical Trades Trades Closed in 2022

Executive Summary Depressing Housing Market And Service Sector Activity Depressing Housing Market And Service Sector Activity Depressing Housing Market And Service Sector Activity May’s economic data ticked up from extremely depressed levels in April, driven by a normalization in the supply chain and a resumption in production. The service sector and housing market continued to shrink on a year-on-year (YOY) basis and sentiment among households and corporates remains lackluster. The rebound in exports growth in May will likely be unsustainable. Chinese exports are set to contract from 2021 as external demand for goods weakens. The rapidly worsening labor market dynamics reinforce households’ unwillingness to consume and hence, will hinder the recovery in household consumption. Although industrial production showed a decent rebound in May, the manufacturing production recovery might be derailed by rolling lockdowns and prolonged logistic bottlenecks. Barring major lockdowns, China’s economy will likely improve in 2H 2022 from the very low base in Q2. That said, the country’s economic recovery faces several challenges and the magnitude of the rebound will be subdued. Bottom Line: The elements for a robust and sustainable recovery in the Chinese economy are not yet in place. The recent rally in the A-share market reflects a mean-reversal to the pre-March lockdown price level, rather than the beginning of a cyclical bull market. Investors should remain cautious on Chinese equities in the next several months. Feature China’s economic data moved up slightly in May from an extremely depressed level in April. A normalization of the supply chain and a resumption of production post-lockdown in Shanghai and other cities led to a modest recovery in business activities. However, indicators from the service sector and housing market continued to shrink on a YOY basis, highlighting persistent weaknesses on the demand side. Chart 1Import Dynamics Reflect Weak Domestic Demand Import Dynamics Reflect Weak Domestic Demand Import Dynamics Reflect Weak Domestic Demand May’s import data also reflects sluggish domestic demand. The increase in imports value from a year ago was largely driven by the elevated prices in energy and agriculture products. China’s imports in May, in volume terms, continued to contract on a YOY basis, albeit improved from its historical low in April (Chart 1). Barring major lockdowns, China’s economy will likely improve in the second half of this year. However, the economic recovery in 2H 2022 will be very subdued due to the following challenges: Downbeat sentiment among households and enterprises; Continued real estate woes; A contraction in exports; Deteriorating labor market conditions; and Risk of rolling lockdowns and persistent logistic bottlenecks. The recent rebound in the A-share market reflects an improvement in investors’ sentiment buttressed by the easing of lockdowns and a resumption of production. In other words, the rebound in Chinese stock prices is probably a mean-reversal to pre-lockdown levels, rather than a sustainable rally (Chart 2). Our cautious view on Chinese equities is also corroborated by the divergence between falling raw industrial prices, which reflect weak China’s growth, and rising Chinese equity prices (Chart 3). Overall, we continue to recommend a neutral stance in Chinese equities within a global portfolio. Chart 2Too Early To Turn Bullish On Chinese Stocks Too Early To Turn Bullish On Chinese Stocks Too Early To Turn Bullish On Chinese Stocks Chart 3Falling Prices In Raw Materials Do Not Signal An Imminent Round In Demand Falling Prices In Raw Materials Do Not Signal An Imminent Round In Demand Falling Prices In Raw Materials Do Not Signal An Imminent Round In Demand   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Downbeat Household And Corporate Sentiment Chart 4Subdued Bank Loan Growth Has Been A Drag On Credit Expansion Subdued Bank Loan Growth Has Been A Drag On Credit Expansion Subdued Bank Loan Growth Has Been A Drag On Credit Expansion Although China’s credit growth improved sequentially in May after a very weak reading in April, the magnitude of May’s credit rebound is much more subdued compared with the months following the first lockdowns in early 2020 (Chart 4). In addition, May’s rebound in credit growth was mainly driven by an acceleration in local government bond issuance. The modest pickup in the credit impulse - calculated as a 12-month change in total social financing (TSF) as a percentage of nominal GDP - is much more muted when excluding local government bond issuance (Chart 5). Furthermore, as noted in our previous report, given that most of the planned local government special purpose bonds (SPBs) will be issued by the end of June, barring any increase in this year’s SPBs quota, the support from local government bond issuance to TSF growth will likely wane significantly in the second half of 2022. Meanwhile, confidence among consumers and businesses remained downbeat through May (Chart 6). The poor private-sector sentiment will continue to dampen credit demand and thus, limit the effectiveness of monetary stimulus. Chart 5The Rebound In Credit Impulse Is Much More Muted When Excluding Local Government Bond Issuance The Rebound In Credit Impulse Is Much More Muted When Excluding Local Government Bond Issuance The Rebound In Credit Impulse Is Much More Muted When Excluding Local Government Bond Issuance Chart 6Gloomy Sentiment Among Chinese Households And Enterprises Gloomy Sentiment Among Chinese Households And Enterprises Gloomy Sentiment Among Chinese Households And Enterprises Private-sector credit demand remains very frail. Household medium- to long-term loans are still contracting from previous month, while bank loans to corporate peers were also weak in May (Chart 7 & 8). Chart 7Depressed Household Loan Demand Depressed Household Loan Demand Depressed Household Loan Demand Chart 8Corporate Demand For Credit Remains Weak Despite Accommodative Monetary Conditions Corporate Demand For Credit Remains Weak Despite Accommodative Monetary Conditions Corporate Demand For Credit Remains Weak Despite Accommodative Monetary Conditions Chart 9Deterioration In Corporate Sentiment Is Also Reflected In Surveys of Business Conditions Deterioration In Corporate Sentiment Is Also Reflected In Surveys of Business Conditions Deterioration In Corporate Sentiment Is Also Reflected In Surveys of Business Conditions On the other hand, corporate bill financing as a portion of new bank loans, although rolled over from April’s record high, remained very elevated through May (Chart 8, bottom panel). Moreover, enterprises’ financing and investment expectations deteriorated further in May (Chart 9).   Persisting Real Estate Woes The near-term outlook for China’s property market remains uninspiring. So far, easing measures in the housing sector have not been successful in reviving home sales and homebuyers’ sentiment. Residential property sales and real estate investment growth ticked up slightly in May after plummeting by 43% and 10% in April, respectively (Chart 10). However, the modest improvement in May does not mark the start of a full-fledged cyclical recovery. High-frequency data show a renewed weakening in floor space sales, particularly in tier-one and tier-two cities, during the first two weeks of June (Chart 11). Chart 10The Slight Improvement In Housing Market Indicators Does Not Signal A Cyclical Recovery The Slight Improvement In Housing Market Indicators Does Not Signal A Cyclical Recovery The Slight Improvement In Housing Market Indicators Does Not Signal A Cyclical Recovery Chart 11Renewed Deterioration In Home Sales In June Renewed Deterioration In Home Sales In June Renewed Deterioration In Home Sales In June Chart 12Real Estate Developers' Decreased Funding Will Further Dampen Housing Construction Activities Real Estate Developers' Decreased Funding Will Further Dampen Housing Construction Activities Real Estate Developers' Decreased Funding Will Further Dampen Housing Construction Activities Funds to real estate developers have been contracting at the fastest rate since data collection began in 1998. The lack of funding for real estate developers will further depress housing construction activities in the near term (Chart 12). Moreover, new home prices, which tend to lead housing starts, started to decrease on a YOY basis in May. This was the first price contraction since 2016. Our housing price diffusion index suggests that home price growth will continue to shrink in the next six to nine months (Chart 13). Many local cities reduced mortgage rates, by anywhere from 15 to more than 100 basis points, after the PBoC lowered mortgage rate floor and the benchmark rate (5-year LPR) in May. However, the average cost of mortgage loans remains higher than households’ income growth, making mortgage borrowing less attractive to ordinary households (Chart 14). Chart 13Housing Prices Are Set To Decline Further In 2H 2022 Housing Prices Are Set To Decline Further In 2H 2022 Housing Prices Are Set To Decline Further In 2H 2022 Chart 14Mortgage Rates Have Dropped, But Still Higher Than Income And Home Price Growth Mortgage Rates Have Dropped, But Still Higher Than Income And Home Price Growth Mortgage Rates Have Dropped, But Still Higher Than Income And Home Price Growth In addition, the widening gap between the average mortgage rate and the pace of housing price appreciation implies that housing has become much less appealing to residents who purchase homes as investment (Chart 14, bottom panel). In short, property purchases will remain weak given neither “to live in” nor investment demand for properties is likely to recover fast. China's Exports Are Set To Contract In 2H 2022 China’s exports rebounded in May from the April low as supply chain interruptions subsided and logistic disruptions began to ease. However, as US and European consumer spending on goods (excluding autos) declines, Chinese shipments will shrink in the months ahead. May’s improvement in suppliers’ delivery times and product inventory subindexes of China’s official Purchasing Managers’ Index (PMI) suggests that logistics were less of a drag on economic activity than in April (Chart 15). In addition, Shanghai and China’s exports freight indexes recovered significantly on a month-over-month basis (Chart 16) with the lifting of lockdown measures. Chart 15Chinese Logistics Pressures Have Eased Slightly In May... Chinese Logistics Pressures Have Eased Slightly In May... Chinese Logistics Pressures Have Eased Slightly In May... Chart 16...And Export Freight Indices Have Rebounded ...And Export Freight Indices Have Rebounded ...And Export Freight Indices Have Rebounded Chart 17Global Demand Is Dwindling Global Demand Is Dwindling Global Demand Is Dwindling Meanwhile, global demand for goods has been weakening. Korean exports volume growth, a bellwether for global trade, has been trending down since late 2021 (Chart 17). Moreover, the US and Euro Area manufacturing PMIs have been falling (Chart 17, bottom panel). Spending in developed economies is shifting from manufactured goods to services. Retail inventories in the US are well above their pre-pandemic trend, suggesting that the demand growth for Chinese goods will dwindle when US retailers start to destock their inventories (Chart 18). Falling US and Euro Area real household disposable income will also reinforce the downward trend in external demand (Chart 19). Therefore, China's exports are set to shrink in the second half of this year. Chart 18Well-Stocked Shelves In The US Bode Poorly For Chinese Export Demand Well-Stocked Shelves In The US Bode Poorly For Chinese Export Demand Well-Stocked Shelves In The US Bode Poorly For Chinese Export Demand Chart 19A Contraction in US and Euro Area Household Real Disposable Income A Contraction in US and Euro Area Household Real Disposable Income A Contraction in US and Euro Area Household Real Disposable Income Deteriorating Labor Market Conditions Will Curb Household Consumption Recovery Although improved from April’s extreme low, Chinese retail sales and service activity remained in contractionary territory in May, highlighting sluggish household demand (Chart 20). In addition, the cinema audience, which is used to gauge the impact of the pandemic on the service sector, indicates a further deterioration in the sector’s activity in June (Chart 20, bottom panel). The lackluster consumer demand is also evidenced by soft core and service consumer prices (CPI) in May (Chart 21). Chart 20Chinese Retail Sales And Service Activity Continued To Contract In May Chinese Retail Sales And Service Activity Continued To Contract In May Chinese Retail Sales And Service Activity Continued To Contract In May Chart 21Soft Core And Service CPIs Also Reflect Lackluster Household Demand Soft Core And Service CPIs Also Reflect Lackluster Household Demand Soft Core And Service CPIs Also Reflect Lackluster Household Demand   Labor market conditions have also worsened. Although the nationwide urban survey-based unemployment rate fell moderately in May, the 31-large city surveyed unemployment rate climbed to an all-time high in the 10-year history of this survey. Moreover, employment in the service sector deteriorated to the worst level since mid-2020 (Chart 22). Furthermore, urban new job creation fell into deep shrinkage on a YOY basis, while the unemployment rate among younger workers rose to the highest point since data collection began in 2018 (Chart 23). Chart 22Labor Market Situation Is Worsening Rapidly... Labor Market Situation Is Worsening Rapidly... Labor Market Situation Is Worsening Rapidly... Chart 23...Particularly Among Younger Workers ...Particularly Among Younger Workers ...Particularly Among Younger Workers Chart 24Weak Sentiment On Future Income Contributes To Households' Unwillingness To Consume Weak Sentiment On Future Income Contributes To Households' Unwillingness To Consume Weak Sentiment On Future Income Contributes To Households' Unwillingness To Consume The rapidly worsening labor market dynamics and income prospects reinforce households’ downbeat sentiment (Chart 24). The latter will impede household consumption recovery in the second half of this year.   Production Recovery Faces Risks Of Persistent Logistic Bottlenecks   The uptick in industrial activity in May was due to a lifting of Covid-related lockdown restrictions. Although industrial production showed a decent rebound, underlying data suggest that economic fundamentals remained subdued. Chart 25Industrial Activity Improved Only Slightly In May Industrial Activity Improved Only Slightly In May Industrial Activity Improved Only Slightly In May Chart 26Construction Material Production Continues To Shrink On A YOY Basis Construction Material Production Continues To Shrink On A YOY Basis Construction Material Production Continues To Shrink On A YOY Basis Electricity output remained in contractionary territory through May (Chart 25). Cement and steel output continued shrinking from the same period last year (Chart 26). Moreover, their prices have been falling even though production growth has been waning, which indicates that demand in the construction sector is depressed (Chart 3, bottom panel). Consumer durable goods production also remains well below their levels from a year ago (Chart 27 & 28). Chart 27Auto And Smartphone Production Keeps Decreasing From A Year Ago... Auto And Smartphone Production Keeps Decreasing From A Year Ago... Auto And Smartphone Production Keeps Decreasing From A Year Ago... Chart 28… As Well As Production Of Home Appliances ...As Well As Production Of Home Appliances ...As Well As Production Of Home Appliances Chart 29Prolonged Logistic Bottlenecks Prolonged Logistic Bottlenecks Prolonged Logistic Bottlenecks Chinese manufacturing investment rebounded in May. However, since exports will likely shrink in the second half of this year, it will create a major headwind for manufacturing investment and output. Moreover, China’s manufacturing production will likely be challenged by persistent logistic bottlenecks in 2H 2022. Chinese road freight was still declining in the first three weeks in June from the same period last year as shown in Chart 29. The risk of renewed Covid-induced lockdowns or mobility restrictions are nontrivial since China will maintain its zero-Covid policy at least through the end of this year.   Table 1China Macro Data Summary A Muted Post-Lockdown Recovery Ahead A Muted Post-Lockdown Recovery Ahead Table 2China Financial Market Performance Summary A Muted Post-Lockdown Recovery Ahead A Muted Post-Lockdown Recovery Ahead Footnotes Strategic Themes Cyclical Recommendations

Executive Summary Russia Squeezes EU Natural Gas Russia Squeezes EU Natural Gas Russia Squeezes EU Natural Gas Major geopolitical shocks tend to coincide with bear markets, so the market is getting closer to pricing this year’s bad news. But investors are not out of the woods yet. Russia is cutting off Europe’s natural gas supply ahead of this winter in retaliation to Europe’s oil embargo. Europe is sliding toward recession. China is reverting to autocratic rule and suffering a cyclical and structural downshift in growth rates. Only after Xi Jinping consolidates power will the ruling party focus exclusively on economic stabilization. The US can afford to take risks with Russia, opening up the possibility of a direct confrontation between the two giants before the US midterm election. A new strategic equilibrium is not yet at hand. Tactical Recommendation Inception Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 18.3% Bottom Line: Maintain a defensive posture in the third quarter but look for opportunities to buy oversold assets with long-term macro and policy tailwinds. Feature 2022 is a year of geopolitics and supply shocks. Global investors should remain defensive at least until the Chinese national party congress and US midterm election have passed. More fundamentally, an equilibrium must be established between Russia and NATO and between the US and Iran. Until then supply shocks will destroy demand. Checking Up On Our Three Key Views For 2022 Our three key views for the year are broadly on track: 1.  China’s Reversion To Autocracy: For ten years now, the fall in Chinese potential economic growth has coincided with a rise in neo-Maoist autocracy and foreign policy assertiveness, leading to capital flight, international tensions, and depressed animal spirits (Chart 1). Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Rising incomes provided legitimacy for the Communist Party over the past four decades. Less rapidly rising incomes – and extreme disparities in standards of living – undermine the party and force it to find other sources of public support. Fighting pollution and expanding the social safety net are positives for political stability and potentially for economic productivity. But converting the political system from single-party rule to single-person rule is negative for productivity. Mercantilist trade policy and nationalist security policy are also negative. China’s political crackdown, struggle with Covid-19, waning exports, and deflating property market have led to an abrupt slowdown this year. The government is responding by easing monetary, fiscal, and regulatory policy, though so far with limited effect (Chart 2). Economic policy will not be decisive in the third quarter unless a crash forces the administration to stimulate aggressively. Chart 1China's Slowdown Leads To Maoism, Nationalism China's Slowdown Leads To Maoism, Nationalism China's Slowdown Leads To Maoism, Nationalism ​​​​​​ Chart 2Chinese Policy Easing: Limited Effect So Far Chinese Policy Easing: Limited Effect So Far Chinese Policy Easing: Limited Effect So Far ​​​​​ Chart 3Nascent Rally In Chinese Shares Will Be Dashed Nascent Rally In Chinese Shares Will Be Dashed Nascent Rally In Chinese Shares Will Be Dashed Once General Secretary Xi Jinping secures another five-to-ten years in power at the twentieth national party congress this fall, he will be able to “let 100 flowers bloom,” i.e. ease policy further and focus exclusively on securing the economic recovery in 2023. But policy uncertainty will remain high until then. The party may have to crack down anew to ensure Xi’s power consolidation goes according to plan. China is highly vulnerable to social unrest for both structural and cyclical reasons. The US would jump to slap sanctions on China for human rights abuses. Hence the nascent recovery in Chinese domestic and offshore equities can easily be interrupted until the political reshuffle is over (Chart 3). If China’s economy stabilizes and a recession is avoided, investors will pile into the rally, but over the long run they will still be vulnerable to stranded capital due to Chinese autocracy and US-China cold war. If the Politburo and Politburo Standing Committee are stacked with members of Xi’s faction, as one should expect, then the reduction in policy uncertainty will only be temporary. Autocracy will lead to unpredictable and draconian policy measures – and it cannot solve the problem of a shrinking and overly indebted population. If the Communist Party changes course and stacks the Politburo with Xi’s factional rivals, to prevent China from going down the Maoist, Stalinist, and Putinist route, then global financial markets will cheer. But that outcome is unlikely. Hawkish foreign policy means that China will continue to increase its military threats against Taiwan, while not yet invading outright. Beijing has tightened its grip over Tibet, Xinjiang, and Hong Kong since 2008; Taiwan and the South China Sea are the only critical buffer areas that remain to be subjugated. Taiwan’s midterm elections, US midterms, and China’s party congress will keep uncertainty elevated. Taiwan has underperformed global and emerging market equities as the semiconductor boom and shortage has declined (Chart 4). Hong Kong is vulnerable to another outbreak of social unrest and government repression. Quality of life has deteriorated for the native population. Democracy activists are disaffected and prone to radicalization. Singapore will continue to benefit at Hong Kong’s expense (Chart 5). Chart 4Taiwan Equity Relative Performance Peaked Taiwan Equity Relative Performance Peaked Taiwan Equity Relative Performance Peaked ​​​​​​ Chart 5Hong Kong Faces More Troubles Hong Kong Faces More Troubles Hong Kong Faces More Troubles ​​​​​​ Chart 6Japan Undercuts China Japan Undercuts China Japan Undercuts China China and Japan are likely to engage in clashes in the East China Sea. Beijing’s military modernization, nuclear weapons expansion, and technological development pose a threat to Japanese security. The gradual encirclement of Taiwan jeopardizes Japan’s vital sea lines of communication. Prime Minister Fumio Kishida is well positioned to lead the Liberal Democratic Party into the upper house election on July 10 – he does not need to trigger a diplomatic showdown but he would not suffer from it. Meanwhile China is hungry for foreign distractions and unhappy that Japan is reviving its military and depreciating its currency (Chart 6). A Sino-Japanese crisis cannot be ruled out, especially if the Biden administration looks as if it will lose its nerve in containing China. Financial markets would react negatively, depending on the magnitude of the crisis. North Korea is going back to testing ballistic missiles and likely nuclear weapons. It is expanding its doctrine for the use of such weapons. It could take advantage of China’s and America’s domestic politics to stage aggressive provocations. South Korea, which has a hawkish new president who lacks parliamentary support, is strengthening its deterrence with the United States. These efforts could provoke a negative response from the North. Financial markets will only temporarily react to North Korean provocations unless they are serious enough to elicit military threats from Japan or the United States. China would be happy to offer negotiations to distract the Biden administration from Xi’s power grab. South Korean equities will benefit on a relative basis as China adds more stimulus. 2.  America’s Policy Insularity: President Biden’s net approval rating, at -15%, is now worse than President Trump’s in 2018, when the Republicans suffered a beating in midterm elections (Chart 7). Biden is now fighting inflation to try to salvage the elections for his party. That means US foreign policy will be domestically focused and erratic in the third quarter. Aside from “letting” the Federal Reserve hike rates, Biden’s executive options are limited. Pausing the federal gasoline tax requires congressional approval, and yet if he unilaterally orders tax collectors to stand down, the result will be a $10 billion tax cut – a drop in the bucket. Biden is considering waiving some of former President Trump’s tariffs on China, which he can do on his own. But doing so will hurt his standing in Rust Belt swing states without reducing inflation enough to get a payoff at the voting booth – after all, import prices are growing slower from China than elsewhere (Chart 8). He would also give Xi Jinping a last-minute victory over America that would silence Xi’s critics and cement his dictatorship at the critical hour. Chart 7Democrats Face Shellacking In Midterm Elections Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning ​​​​​​ Chart 8Paring Trump Tariffs Won't Reduce Inflation Much Paring Trump Tariffs Won't Reduce Inflation Much Paring Trump Tariffs Won't Reduce Inflation Much ​​​​​​ Chart 9Only OPEC Can Help Biden - And Help May Come Late Only OPEC Can Help Biden - And Help May Come Late Only OPEC Can Help Biden - And Help May Come Late Biden is offering to lift sanctions on Iran, which would free up 1.3 million barrels of oil per day. But Iran is not being forced to freeze its nuclear program by weak oil prices or Russian and Chinese pressure – quite the opposite. If Biden eases sanctions anyway, prices at the pump may not fall enough to win votes. Hence Biden is traveling to Saudi Arabia to make amends with Crown Prince Mohammed bin Salman. OPEC’s interest lies in producing enough oil to prevent a global recession, not in flooding the market on Biden’s whims to rescue the Democratic Party. Saudi and Emirati production may come but it may not come early in the third quarter. Lifting sanctions on Venezuela is a joke and Libya recently collapsed again (Chart 9). Even in dealing with Russia the Biden administration will exhibit an insular perspective. The US is not immediately threatened, like Europe, so it can afford to take risks, such as selling Ukraine advanced and long-range weapons and providing intelligence used to sink Russian ships. If Russia reacts negatively, a direct US-Russia confrontation will generate a rally around the flag that would help the Democrats, as it did under President John F. Kennedy in 1962 – one of the rare years in which the ruling party minimized its midterm election losses (Chart 10). The Cuban Missile Crisis counted more with voters than the earlier stock market slide. 3.  Petro-States’ Geopolitical Leverage: Oil-producing states have immense geopolitical leverage this year thanks to the commodity cycle. Russia will not be forced to conclude its assault on Ukraine until global energy prices collapse, as occurred in 2014. In fact Russia’s leverage over Europe will be greatly reduced in the coming years since Europe is diversifying away from Russian energy exports. Hence Moscow is cutting natural gas flows to Europe today while it still can (Chart 11). Chart 10Biden Can Afford To Take Risks With Russia Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning ​​​​​​ Chart 11Russia Squeezes EU's Natural Gas Russia Squeezes EU's Natural Gas Russia Squeezes EU's Natural Gas ​​​​​​ Chart 12EU/China Slowdown Will Weigh On World Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning Russia’s objective is to inflict a recession and cause changes in either policy or government in Europe. This will make it easier to conclude a favorable ceasefire in Ukraine. More importantly it will increase the odds that the EU’s 27 members, having suffered the cost of their coal and oil embargo, will fail to agree to a natural gas embargo by 2027 as they intend. Italy, for example, faces an election by June 2023, which could come earlier. The national unity coalition was formed to distribute the EU’s pandemic recovery funds. Now those funds are drying up, the economy is sliding toward recession, and the coalition is cracking. The most popular party is an anti-establishment right-wing party, the Brothers of Italy, which is waiting in the wings and can ally with the populist League, which has some sympathies with Russia. A recession could very easily produce a change in government and a more pragmatic approach to Moscow. The Italian economy is getting squeezed by energy prices and rising interest rates at the same time and cannot withstand the combination very long. A European recession or near-recession will cause further downgrades to global growth, especially when considering the knock-on effects in China, where the slowdown is more pronounced than is likely reported. The US economy is more robust but it will have to be very robust indeed to withstand a recession in Europe and growth recession in China (Chart 12). Russia does not have to retaliate against Finland and Sweden joining NATO until Turkey clears the path for them to join, which may not be until just before the Turkish general election due in June 2023. But imposing a recession on Europe is already retaliation – maybe a government change will produce a new veto against NATO enlargement. Russian retaliation against Lithuania for blocking 50% of its shipments to the Kaliningrad exclave is also forthcoming – unless Lithuania effectively stops enforcing the EU’s sanctions on Russian resources. Russia cannot wage a full-scale attack on the Baltic states without triggering direct hostilities with NATO since they are members of NATO. But it can retaliate in other ways. In a negative scenario Moscow could stage a small “accidental” attack against Lithuania to test NATO. But that would force Biden to uphold his pledge to defend “every inch” of NATO territory. Biden would probably do so by staging a proportionate military response or coordinating with an ally to do it. The target would be the Russian origin of attack or comparable assets in the Baltic Sea, the Black Sea, Ukraine, Belarus, or elsewhere. The result would be a dangerous escalation. Russia could also opt for cyber-attacks or economic warfare – such as squeezing Europe’s natural gas supply further. Ultimately Russia can afford to take greater risks than the US over Kaliningrad, other territories, and its periphery more broadly. That is the difference between Kennedy and Biden – the confrontation is not over Cuba. Russia is also likely to take a page out of Josef Stalin’s playbook and open a new front – not so much in Nicaragua as in the Middle East and North Africa. The US betrayal of the 2015 nuclear deal with Iran opens the opportunity for Russia to strengthen cooperation with Iran, stir up the Iranians’ courage, sell them weapons, and generate a security crisis in the Middle East. The US military would be distracted keeping peace in the Persian Gulf while the Europeans would lose their long-term energy alternative to Russia – and energy prices would rise. The Iranians – who also have leverage during a time of high oil prices – are not inclined to freeze their nuclear program. That would be to trade their long-term regime survival for economic benefits that the next American president can revoke unilaterally. Bottom Line: Xi Jinping is converting China back into an autocracy, the Biden administration lacks options and is willing to have a showdown with Russia, and the Putin administration is trying to inflict a European recession and political upheaval. Stay defensive. Checking Up On Our Strategic Themes For The 2020s As for our long-term themes, the following points are relevant after what we have learned in the second quarter: 1.  Great Power Rivalry: The war in Ukraine has reminded investors of the primacy of national security. In an anarchic international system, if a single great nation pursues power to the neglect of its neighbors’ interests, then its neighbors need to pursue power to defend themselves. Before long every nation is out for itself. At least until a new equilibrium is established. For example, Russia’s decision to neutralize Ukraine by force is driving Germany to abandon its formerly liberal policy of energy cooperation in order to reduce Russia’s energy revenues and avoid feeding its military ambitions. Russia in turn is reducing natural gas exports to weaken Europe’s economy this winter. Germany will re-arm, Finland and Sweden will eventually join NATO, and Russia will underscore its red line against NATO bases or forces in Finland and Sweden. If this red line is violated then a larger war could ensue. Chart 13China Will Shift To Russian Energy China Will Shift To Russian Energy China Will Shift To Russian Energy Until Russia and NATO come to a new understanding, neither Europe nor Russia can be secure. Meanwhile China cannot reject Russia’s turn to the east. China believes it may need to use force to prevent Taiwan independence at some point, so it must prepare for the US and its allies to treat it the same way that they have treated Russia. It must secure energy supply from Russia, Central Asia, and the Middle East via land routes that the US navy cannot blockade (Chart 13). Beijing must also diversify away from the US dollar, lest the Treasury Department freeze its foreign exchange reserves like it did Russia’s. Global investors will see diversification as a sign of China’s exit from the international order and preparation for conflict, which is negative for its economic future. However, the Russo-Chinese alliance presents a historic threat to the US’s security, coming close to the geopolitical nightmare of a unified Eurasia. The US is bound to oppose this development, whether coherently or not, and whether alone or in concert with its allies. After all, the US cannot offer credible security guarantees to negotiate a détente with China or Iran because its domestic divisions are so extreme that its foreign policy can change overnight. Other powers cannot be sure that the US will not suffer a radical domestic policy change or revolution that leads to belligerent foreign policy. Insecurity will drive the US and China apart rather than bringing them together. For example, Russia’s difficulties in Ukraine will encourage Chinese strategists to go back to the drawing board to adjust their plans for military contingencies in Taiwan. But the American lesson from Ukraine is to increase deterrence in Taiwan. That will provoke China and encourage the belief that China cannot wait forever to resolve the Taiwan problem. Until there is a strategic understanding between Russia and NATO, and the US and China, the world will remain in a painful and dangerous transitional phase – a multipolar disequilibrium. Chart 14Hypo-Globalization: Globalizing Less Than Potential Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning 2.  Hypo-Globalization: If national security rises to the fore, then economics becomes a tool of state power. Mercantilism becomes the basis of globalization rather than free market liberalism. Hypo-globalization is the result. The term is fitting because the trade intensity of global growth is not yet in a total free fall (i.e. de-globalization) but merely dropping off from its peaks during the phase of “hyper-globalization” in the 1990s and early 2000s (Chart 14). Hypo-globalization is probably a structural rather than cyclical phenomenon. The EU cannot re-engage with Russia and ease sanctions without rehabilitating Russia’s economy and hence its military capacity – which could enable Russia to attack Europe again. The US and China can try to re-engage but they will fail. Russo-Chinese alliance ensures that the US would be enriching not one but both of its greatest strategic rivals if it reopened its doors to Chinese technology acquisition and intellectual property theft. Iran will see its security in alliance with Russia and China. China has an incentive to develop Iran’s economy so as not to depend solely on Russia and Central Asia. Russia has an incentive to develop Iran’s military capacity so as to deprive Europe of an energy alternative. Both Russia and China wish to deprive the US of strategic hegemony in the Middle East. By contrast the US and EU cannot offer ironclad security guarantees to Iran because of its nuclear ambitions and America’s occasional belligerence. Thus the world can see expanding Russian and Chinese economic integration with Eurasia, and expanding American and European integration with various regions, but it cannot see further European integration with Russia or American integration with China. And ultimately Europe and China will be forced to sever links (Chart 15). Globalization will not cease – it is a multi-millennial trend – but it will slow down. It will be subordinated to national security and mercantilist economic theory. 3.  Populism/Nationalism: In theory, domestic instability can cause introversion or extroversion. But in practice we are seeing extroversion, which is dangerous for global stability (Chart 16). Chart 15Global Economic Disintegration Global Economic Disintegration Global Economic Disintegration ​​​​​​ Chart 16Internal Sources Of Nationalism Internal Sources Of Nationalism Internal Sources Of Nationalism ​​​​​​ Russia’s invasion of Ukraine derived from domestic Russian instability – and instability across the former Soviet space, including Belarus, which the Kremlin feared could suffer a color revolution after the rigged election and mass protests of 2020-21. The reason the northern European countries are rapidly revising their national defense and foreign policies to counter Russia is because they perceive that the threat to their security is driven by factors within the former Soviet sphere that they cannot easily remove. These factors will get worse as a result of the Ukraine war. Russian aggression still poses the risk of spilling out of Ukraine’s borders. China’s Maoist nostalgia and return to autocratic government is also about nationalism. The end of the rapid growth phase of industrialization is giving way to the Asian scourge: debt-deflation. The Communist Party is trying to orchestrate a great leap forward into the next phase of development. But in case that leap fails like the last one, Beijing is promoting “the great rejuvenation of the Chinese nation” and blaming the rest of the world for excluding and containing China. Taiwan, unfortunately, is the last relic of China’s past humiliation at the hands of western imperialists. China will also seek to control the strategic approach to Taiwan, i.e. the South China Sea. China’s claim that the Taiwan Strait is sovereign sea, not international waters, will force the American navy to assert freedom of passage. American efforts to upgrade Taiwan relations and increase deterrence will be perceived as neo-imperialism. The United States, for its part, could also see nationalism convert into international aggression. The US is veering on the brink of a miniature civil war as nationalist forces in the interior of the country struggle with the political establishment in the coastal states. Polarization has abated since 2020, as stagflation has discredited the Democrats. But it is now likely to rebound, making congressional gridlock all but inevitable. A Republican-controlled House will find a reason to impeach President Biden in 2023-24, in hopes of undermining his party and reclaiming the presidency. Another hotly contested election is possible, or worse, a full-blown constitutional crisis. American institutions proved impervious to the attempt of former President Trump and his followers to disrupt the certification of the Electoral College vote. However, security forces will be much more aggressive against rebellions of whatever stripe in future, which could lead to episodes in which social unrest is aggravated by police repression. If the GOP retakes the White House – especially if it is a second-term Trump presidency with a vendetta against political enemies and nothing to lose – then the US will return to aggressive foreign policy, whether directed at China or Iran or both. In short, polarization has contaminated foreign policy such that the most powerful country in the world cannot lead with a steady hand. Over the long run polarization will decline in the face of common foreign enemies but for now the trend vitiates global stability. Chart 17Germany And Japan Rearming Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning It goes without saying that nationalism is also an active force in Iran, where 83-year-old Supreme Leader Ayatollah Khamenei is attempting to ensure the survival of his regime in the face of youthful social unrest and an unclear succession process. If Khamenei takes advantage of the commodity cycle, and American and Israeli disarray, he can make a mad dash for the bomb and try to achieve regime security. But if he does so then nationalism will betray him, since Israel and/or the US are willing to conduct air strikes to uphold the red line against nuclear weaponization. If any more proof of global nationalism is needed, look no further than Germany and Japan, the principal aggressors of World War II. Their pacifist foreign policies have served as the linchpins of the post-war international order. Now they are both pursuing rearmament and a more proactive foreign policy (Chart 17). Nationalism may be very nascent in Germany but it has clearly made a comeback in Japan, which exacerbates China’s fears of containment. The rise of nationalism in India is widely known and reinforces the trend. Bottom Line: Great power rivalry is intensifying because of Russia’s conflict with the West and China’s inability to reject Russia. Hypo-globalization is the result since EU-Russia and US-China economic integration cannot easily be mended in the context of great power struggle. Domestic instability in Russia, China, and the US is leading to nationalism and aggressive foreign policy, as leaders find themselves unwilling or unable to stabilize domestic politics through productive economic pursuits. Investment Takeaways BCA has shifted its House View to a neutral asset allocation stance on equities relative to bonds (Chart 18). Chart 18BCA House View: Neutral Stocks Versus Bonds BCA House View: Neutral Stocks Versus Bonds BCA House View: Neutral Stocks Versus Bonds Geopolitical Strategy remains defensively positioned, favoring defensive markets and sectors, albeit with some exceptions that reflect our long-term views. Tactically stay long US 10-year Treasuries, large caps versus small caps, and defensives versus cyclicals. Stay long Mexico and short the UAE (Chart 19). Strategically stay long gold, US equities relative to global, and aerospace/defense sectors (Chart 20). Among currencies favor the USD, EUR, JPY, and GBP. Chart 19Stay Defensive In Q3 2022 Stay Defensive In Q3 2022 Stay Defensive In Q3 2022 ​​​​​​ Chart 20Stick To Long-Term Geopolitical Trades Stick To Long-Term Geopolitical Trades Stick To Long-Term Geopolitical Trades ​​​​​​ Chart 21Favor Semiconductors But Not Taiwan Favor Semiconductors But Not Taiwan Favor Semiconductors But Not Taiwan ​​​​​ Chart 22Indian Tech Will Rebound Amid China's Geopolitical Risks Indian Tech Will Rebound Amid China's Geopolitical Risks Indian Tech Will Rebound Amid China's Geopolitical Risks ​​​​​ Chart 23Overweight ASEAN Overweight ASEAN Overweight ASEAN Go long US semiconductors and semi equipment versus Taiwan broad market (Chart 21). While we correctly called the peak in Taiwanese stocks relative to global and EM equities, our long Korea / short Taiwan trade was the wrong way to articulate this view and remains deeply in the red. Similarly our attempt to double down on Indian tech versus Chinese tech was ill-timed. China eased tech regulations sooner than we expected. However, the long-term profile of the trade is still attractive and Chinese tech will still suffer from excessive government and foreign interference (Chart 22). Go long Singapore over Hong Kong, as Asian financial leadership continues to rotate (see Chart 5 above). Stay long ASEAN among emerging markets. We will also put Malaysia on upgrade watch, given recent Malaysian equity outperformance on the back of Chinese stimulus and growing western interest in alternatives to China (Chart 23).     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

    Executive Summary At our monthly view meeting on Monday, BCA strategists voted to change the House View to a neutral asset allocation stance on equities, with a slight plurality favoring an outright underweight. The view of the Global Investment Strategy service is somewhat more constructive, as I think it is still more likely than not that the US will avoid a recession; and that if a recession does occur, it will be a fairly mild one. Nevertheless, the risks to my view have increased. I now estimate 40% odds of a recession during the next 12 months, up from 20% a month ago. In The Past, When Unemployment Has Started Rising In The US, It Has Kept On Rising In The Past, When Unemployment Has Started Rising In The US, It Has Kept On Rising In The Past, When Unemployment Has Started Rising In The US, It Has Kept On Rising Bottom Line: With the S&P 500 down 27% in real terms from its highs at the time of the meeting, the view of the Global Investment Strategy service is that a modest overweight is appropriate. However, investors should refrain from adding to equity positions until more clarity emerges about the path for inflation and growth. Heading For Recession? Every month, BCA strategists hold a view meeting to discuss the most important issues driving the macroeconomy and financial markets. This month’s meeting, which was held yesterday, was especially pertinent as it comes on the heels of a substantial decline in global equities. The key issue that we grappled with was whether the Fed could achieve a proverbial soft landing or whether the US and the rest of the global economy were spiraling towards recession (if it wasn’t already there). I began the meeting by showing one of my favorite charts, a deceptively simple chart of the US unemployment rate (Chart 1). The chart makes three things clear: 1) The US unemployment rate is rarely stable; It is almost always either rising or falling; 2) Once it starts rising, it keeps rising. In fact, the US has never averted a recession when the 3-month average of the unemployment rate has risen by more than a third of a percentage point; and 3) As a mean-reverting series, the unemployment rate is most likely to start rising when it is very low. Chart 1In The Past, When Unemployment Has Started Rising In The US, It Has Kept On Rising In The Past, When Unemployment Has Started Rising In The US, It Has Kept On Rising In The Past, When Unemployment Has Started Rising In The US, It Has Kept On Rising Taken at face value, the chart paints a damning picture about the economic outlook. The US unemployment rate is near a record low, which means that it has nowhere to go but up. And once the unemployment rate starts going up, history suggests that a recession is inevitable. Five Caveats Despite this ominous implication, I did highlight five caveats. First, the observation that even a modest increase in the unemployment rate invariably heralds a recession is based on a limited sample of business cycles from the US. Across the G10, soft landings have occurred, Canada being one example (Chart 2). Second, unlike the unemployment rate, the employment-to-population ratio is still 1.1 percentage points below its pre-pandemic level, and 4.6 percentage points below where it was in April 2000. A similar, though less pronounced, pattern holds if one focuses only on the 25-to-54 age cohort (Chart 3). Chart 2G10 Economies Sometimes Manage To Avoid A Recession Amid Rising Unemployment G10 Economies Sometimes Manage To Avoid A Recession Amid Rising Unemployment G10 Economies Sometimes Manage To Avoid A Recession Amid Rising Unemployment Chart 3The Employment-To-Population Ratio Remains Below Pre-Pandemic Levels The Employment-To-Population Ratio Remains Below Pre-Pandemic Levels The Employment-To-Population Ratio Remains Below Pre-Pandemic Levels   While the number of people not working either because they are worried about the pandemic, or because they are still burning through their stimulus checks, has been trending lower, it is still fairly high in absolute terms (Chart 4). As my colleague Doug Peta discussed in his latest report, one can envision a scenario where job growth remains positive, but the unemployment rate nonetheless edges higher as more workers rejoin the labor force. Chart 4ALabor Supply Should Increase As Covid Fears Continue To Abate And More Workers Burn Through Their Stimulus Savings (I) Labor Supply Should Increase As Covid Fears Continue To Abate And More Workers Burn Through Their Stimulus Savings (I) Labor Supply Should Increase As Covid Fears Continue To Abate And More Workers Burn Through Their Stimulus Savings (I) Chart 4BLabor Supply Should Increase As Covid Fears Continue To Abate And More Workers Burn Through Their Stimulus Savings (II) Labor Supply Should Increase As Covid Fears Continue To Abate And More Workers Burn Through Their Stimulus Savings (II) Labor Supply Should Increase As Covid Fears Continue To Abate And More Workers Burn Through Their Stimulus Savings (II)     Third, the job vacancy rate is extremely high today – much higher than a pre-pandemic “Beveridge Curve” would have predicted (Chart 5). This provides the labor market with a wide moat against an increase in firings. As Fed governor Christopher Waller has emphasized, the main effect of the Federal Reserve’s efforts to cool labor demand could be to push down vacancies rather than to push up unemployment. Fourth, as we have highlighted in past research, the Phillips curve is kinked at very low levels of unemployment (Chart 6). This means that a decline in unemployment from high to moderate levels may do little to spur inflation, but once the unemployment rate falls below its full employment level, then watch out! Chart 5The Fed Hopes That Its Tightening Policy Will Bring Down Job Openings More Than It Pushes Up The Unemployment Rate The Fed Hopes That Its Tightening Policy Will Bring Down Job Openings More Than It Pushes Up The Unemployment Rate The Fed Hopes That Its Tightening Policy Will Bring Down Job Openings More Than It Pushes Up The Unemployment Rate Chart 6The Phillips Curve Is Kinked At Very Low Levels Of Unemployment Hard Or Soft Landing? BCA Strategists Debate The Question Hard Or Soft Landing? BCA Strategists Debate The Question   The converse is also true, however. If a small decrease in unemployment can trigger a large increase in inflation, then a small increase in unemployment can trigger a large decrease in inflation, provided that long-term inflation expectations remain reasonably well anchored in the meantime. In other words, it is possible that the so-called “sacrifice ratio” — the amount of output that has to be sacrificed to reduce inflation — may be quite low. Fifth, and perhaps most importantly, there is a lot of variation from one recession to the next in how much unemployment rises. In general, the greater the financial and economic imbalances going into a recession, the deeper it tends to be. US household balance sheets are in reasonably good shape these days. Households are sitting on $2.2 trillion in excess savings (Chart 7). Yes, most of those savings belong to relatively well-off households. But as Chart 8 illustrates, even rich people spend well over half of their income. Chart 7Households Have Only Just Begun To Draw Down Their Accumulated Savings Households Have Only Just Begun To Draw Down Their Accumulated Savings Households Have Only Just Begun To Draw Down Their Accumulated Savings Chart 8Even The Rich Spend The Majority Of Their Income Hard Or Soft Landing? BCA Strategists Debate The Question Hard Or Soft Landing? BCA Strategists Debate The Question     The ratio of household debt-to-disposable income in the US is down by a third since its peak in 2008. Despite falling equity prices, the ratio of household net worth-to-disposable income is still up nearly 50 percentage points since the end of 2019, mainly because home prices have risen (Chart 9). As is likely to be the case in many other countries, home prices in the US will level off and quite possibly decline over the next few years. In and of itself, that may not be such a bad outcome for equity markets since lower real estate prices will cool aggregate demand, thus lowering inflation without the need for much higher interest rates. The danger, of course, is that we could see a replay of the GFC. This risk cannot be ignored but is probably quite small. The quality of mortgage lending has been very strong over the past 15 years. Moreover, unlike in 2007, when there was a large glut of homes, the homeowner vacancy rate today is at a record low. Tepid homebuilding has pushed the average age of the US residential capital stock to 31 years, the highest since 1948 (Chart 10). Chart 9The US Household Debt Burden Has Come Down Significantly Since 2008, While Net Worth Is Still Higher Than Before The Pandemic The US Household Debt Burden Has Come Down Significantly Since 2008, While Net Worth Is Still Higher Than Before The Pandemic The US Household Debt Burden Has Come Down Significantly Since 2008, While Net Worth Is Still Higher Than Before The Pandemic Chart 10Tight Supply Conditions In The Housing Market Argue Against A Repeat Of The GFC Tight Supply Conditions In The Housing Market Argue Against A Repeat Of The GFC Tight Supply Conditions In The Housing Market Argue Against A Repeat Of The GFC   A Bleaker Picture Outside The US The situation is admittedly dicier outside the US. Putin’s despotic regime continues to wage war on Ukraine. While European natural gas prices are still well below their March peak, they have recently surged as Russia has begun to throttle natural gas exports (Chart 11). The euro area manufacturing PMI clocked in a respectable 54.6 in May but is likely to drop over the coming months as higher energy prices restrain production. The only saving grace is that fiscal policy in Europe has turned more expansionary. The IMF’s April projection foresaw the structural primary budget balance easing from a surplus of 1.2% of GDP between 2014 and 2019 to a deficit of 1.2% of GDP between 2022 and 2027, the biggest swing among the major economies (Chart 12). Even the IMF’s numbers probably underestimate the fiscal easing that will transpire considering the need for Europe to invest more in energy independence and defense. Chart 11The European Economy Is Threatened By Rising Gas Prices The European Economy Is Threatened By Rising Gas Prices The European Economy Is Threatened By Rising Gas Prices Chart 12Euro Area Fiscal Policy Is Expected To Be More Expansionary In The Years To Come Than Before The Pandemic Hard Or Soft Landing? BCA Strategists Debate The Question Hard Or Soft Landing? BCA Strategists Debate The Question   The Chinese economy continues to suffer from the “triple threat” of renewed Covid lockdowns, a shift of global demand away from manufactured goods towards services, and a floundering property market. We expect the Chinese property market to ultimately succumb to the same fate that befell Japan 30 years ago. Chart 13Chinese Stocks Are Cheap Chinese Stocks Are Cheap Chinese Stocks Are Cheap Unlike Japanese stocks in the early 1990s, however, Chinese stocks are trading at fairly beaten down valuations – 10.9-times earnings and 1.4-times book for the investable index (Chart 13). With the Twentieth Party Congress slated for later this year and the population jaded by lockdowns, the political incentive to shower the economy with cash and loosen the reins on regulation will intensify. A Scenario Analysis For The S&P 500 Corralling all these moving parts is no easy matter. We would put the odds of a US recession over the next 12 months at 40%. This is double what we would have said a month ago when we tactically upgraded stocks after the S&P 500 fell below the 4,000 mark. The May CPI report was clearly a shocker, both to the Fed and the markets. The median dot in the June Summary of Economic Projections sees the Fed funds rate rising to 3.8% next year, smack dab in the middle of our once highly out-of-consensus estimate of 3.5%-to-4% for the neutral rate of interest. With interest rates potentially moving into restrictive territory next year, equity investors are right to be concerned. Yet, as noted above, if a recession does occur, it is likely to be a fairly mild one. At the time of the BCA monthly view meeting, the S&P 500 was already down 23% in nominal terms and 27% in real terms from its peak in early January. We assume that the S&P 500 will fall a further 10% in real terms over the next 12 months in a “mild recession” scenario (30% odds) and by 25% in a “deep recession” scenario (10% odds). Conversely, we assume that the S&P 500 will be 20% higher in 12 months’ time in a “no recession” scenario (60% odds). Note that even in a “no recession” scenario, the real value of the S&P 500 would still be down 12% in June 2023 from its all-time high. On a probability-weighted basis, the expected 12-month real return across all three scenarios works out to 6.5%, or 8% with dividends (Table 1). That is enough to justify a modest overweight in my view – but given the risks, just barely. Investors focused on capital preservation should consider a more conservative stance. Table 1S&P 500 Drawdowns Depending On Whether The US Will Enter A Recession And How Severe It Will Be Hard Or Soft Landing? BCA Strategists Debate The Question Hard Or Soft Landing? BCA Strategists Debate The Question Most of my colleagues were more cautious than me, as they generally thought that the odds of a recession were greater than 50%. They voted to shift the BCA house view to a neutral asset allocation stance on equities, with a slight plurality favoring an outright underweight (10 for underweight; 9 for neutral; and 6 for overweight). Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Global Investment Strategy View Matrix Hard Or Soft Landing? BCA Strategists Debate The Question Hard Or Soft Landing? BCA Strategists Debate The Question Special Trade Recommendations Current MacroQuant Model Scores Hard Or Soft Landing? BCA Strategists Debate The Question Hard Or Soft Landing? BCA Strategists Debate The Question