China

Executive Summary The structural downtrend in Chinese bond yields has a lot further to go, because it is helping to let the air out gently of stratospheric valuations in the real estate sector, and thereby preventing a hard landing for the Chinese economy. In the US, flagging mortgage and housing market activity is weighing on an already slowing economy. Buy US T-bonds. The long T-bond yield is close to a peak. Switch equity exposure into long-duration sectors such as healthcare and biotech. Go overweight US homebuilders versus US insurers. The peak in bond yields will also take pressure off US homebuilder shares whose recent collapse has been the mirror-image of the surge in the 30-year mortgage rate. Fractal trading watchlist: Basic resources; Switzerland versus Germany; and USD/EUR. The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate Bottom Line: The global bond yield cannot rise much further before it destabilises the $350 trillion global real estate market and thereby destabilises the global economy. Feature Quietly and largely unnoticed, Chinese long-dated bond yields have been drifting lower (Chart I-1 and Chart I-2). At a time that surging bond yields elsewhere in the world have grabbed all the attention, the largely unnoticed contrarian move in Chinese bond yields through the past year is significant because of something else that has gone largely unnoticed: Chinese real estate has become by far the largest asset-class in the world, worth $100 trillion.1 Chart I-1The Contrarian Downdrift In The Chinese 30-Year Bond Yield The Contrarian Downdrift In The Chinese 30-Year Bond Yield The Contrarian Downdrift In The Chinese 30-Year Bond Yield Chart I-2The Contrarian Downdrift In The Chinese 10-Year Bond Yield The Contrarian Downdrift In The Chinese 10-Year Bond Yield The Contrarian Downdrift In The Chinese 10-Year Bond Yield Chinese Real Estate Is Trading On A Stratospheric Valuation The $100 trillion valuation of Chinese real estate market is greater than the $90 trillion global economy, is more than twice the size of the $45 trillion US real estate market and the $45 trillion US stock market, and dwarfs the $18 trillion Chinese economy. Suffice to say, Chinese real estate’s pre-eminence as the world’s largest asset-class is mostly due to its stratospheric valuation. Prime residential rental yields in Guangzhou, Shanghai, Hangzhou, Shenzhen and Beijing have collapsed to 1.5 percent, the lowest rental yields in the world and less than half the global average of 3 percent. Versus rents therefore, Chinese real estate is now twice as expensive as in the rest of the world (Chart I-3). Chart I-3Versus Rents, Chinese Real Estate Is The Most Expensive In The World $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields To corroborate this point, while the US real asset market is worth around two times US annual GDP, the Chinese real estate market is worth more than five times China’s annual GDP! The structural downtrend in Chinese bond yields has a lot further to go. Crucially, the downward drift in Chinese bond yields is alleviating some of the pressure on the extremely highly valued Chinese real estate market – as it helps to let the air out gently of the stratospheric valuations, and thereby avoid a hard landing for the Chinese economy. Hence, the structural downtrend in Chinese bond yields has a lot further to go. The Surge In US Mortgage Rates Is Taking Its Toll Meanwhile, in the rest of the world, the surge in bond yields poses a major threat to the decade long housing boom. Versus rents, US house prices are the most expensive ever – more expensive even than during the early 2000s so-called ‘housing bubble’. For the first time since 2008, the US 30-year mortgage rate is higher than the prime residential rental yield. Until recently, the historically low rental yield on US real estate was justified by an extremely low bond yield. But the recent surge in the bond yield has changed all that. For the first time since 2008, the US 30-year mortgage rate is higher than the prime residential rental yield2 (Chart I-4). Chart I-4The US 30-Year Mortgage Rate Is Now Higher Than The Prime Residential Rental Yield The US 30-Year Mortgage Rate Is Now Higher Than The Prime Residential Rental Yield The US 30-Year Mortgage Rate Is Now Higher Than The Prime Residential Rental Yield The surge in US mortgage rates is taking its toll. Since the end of January, US mortgage applications for home purchase have fallen by almost a fifth (Chart I-5), and the lower demand for home purchase mortgages is starting to weigh on home construction (Chart I-6). Building permits for new private housing units were already falling in February, but a more up-to-date sign of the pain is the 35 percent collapse in US homebuilder shares. Chart I-5US Mortgage Applications For Home Purchase Have Fallen By Almost A Fifth US Mortgage Applications For Home Purchase Have Fallen By Almost A Fifth US Mortgage Applications For Home Purchase Have Fallen By Almost A Fifth Chart I-6The Lower Demand For Home Purchase Mortgages Is Starting To Weigh On Home Construction The Lower Demand For Home Purchase Mortgages Is Starting To Weigh On Home Construction The Lower Demand For Home Purchase Mortgages Is Starting To Weigh On Home Construction $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields Mortgage rates drive real estate rental yields because of the arbitrage between buying versus renting a similar home. Given a fixed annual budget for housing, I must choose between how much home I can buy – which depends on the mortgage rate, versus how much home I can rent – which depends on the rental yield. The arbitrage should make me indifferent between the two options. As a simple example of this arbitrage, let’s assume my annual budget for housing is $10k, and both the mortgage rate and rental yield are 4 percent. I will be indifferent between spending the $10k on interest on a $250k mortgage loan to buy the home, or spending the $10k to rent a similar $250k home. If the mortgage rate rises to 5 percent, then the maximum loan that my $10k of interest payment will afford me falls to $200k, reducing my maximum bid to buy the home. If I am the marginal bidder, then the home price will fall to $200k, so that the $10k rent on the similar valued home will also equate to a higher rental yield of 5 percent. In practice, the simple arbitrage described above is complicated by several factors: the maximum loan-to-value that a lender will offer on the home; the different transaction costs of buying versus renting; and the fact that people prefer to buy than to rent because buying a home is an investment which also provides a consumption service – shelter, whereas renting a home only provides the consumption service. Nevertheless, these complications do not diminish the overarching connection between mortgage rates and rental yields. The lion’s share of the real estate boom has come from a massive valuation uplift, which in turn has come from structurally lower bond yields. All of which brings us to the decade long global real estate boom that has doubled the value of global real estate market to an eye-watering $350 trillion, four times the size of the $90 trillion global economy. During this unprecedented boom, global rents have risen by 40 percent, tracking world nominal GDP, as they should. This means that the lion’s share of the real estate boom has come from a massive valuation uplift, which in turn has come from structurally lower bond yields (Chart I-7).    Chart I-7The Lion's Share Of The Global Real Estate Boom Has Come From A Massive Uplift In Valuations The Lion's Share Of The Global Real Estate Boom Has Come From A Massive Uplift In Valuations The Lion's Share Of The Global Real Estate Boom Has Come From A Massive Uplift In Valuations Since the global financial crisis, there has been an excellent empirical relationship between the global long-dated bond yield (US/China average) and the global rental yield. The important takeaway is that the global bond yield cannot rise much further before it destabilises the $350 trillion global real estate market and thereby destabilises the global economy (Chart I-8). Chart I-8The Global Bond Yield Cannot Rise Much Further Before It Destabilises The $350 Trillion Global Real Estate Market The Global Bond Yield Cannot Rise Much Further Before It Destabilises The $350 Trillion Global Real Estate Market The Global Bond Yield Cannot Rise Much Further Before It Destabilises The $350 Trillion Global Real Estate Market Some Investment Conclusions The good news is that the recent rise in the global bond yield has been limited by the downdrift in Chinese bond yields. Given the massive overvaluation of Chinese real estate, the structural downtrend in Chinese bond yields has a lot further to go. Meanwhile in the US, unless bond yields back down quickly, flagging mortgage and housing market activity will weigh on an already slowing economy. If US bond yields don’t back down quickly, the feedback from consequent slowdown in the economy will ultimately bring yields down anyway. As I explained last week in Fat-Tailed Inflation Signals A Peak In Bond Yields I do expect the long T-bond yield to back down relatively quickly. The sharp drop in US core inflation to just 0.3 percent month-on-month in March signals that inflation is peaking. Hence, medium to long term investors should be buying US T-bonds, and switching equity exposure into long-duration sectors such as healthcare and biotech. Finally, a peak in bond yields will also take pressure off US homebuilder shares whose recent collapse has been the mirror-image of the surge in the 30-year mortgage rate (Chart I-9). Hence, go overweight US homebuilders versus US insurers. Chart I-9The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate The Collapse In US Homebuilder Shares Is The Mirror-Image Of The Surge In The Mortgage Rate Fractal Trading Watchlist Given that inflation hedging investment demand has driven at least part of the strong rally in basic resources, a peak in inflation and bond yields threatens to unwind the recent outperformance of basic resources shares. This is corroborated by the extremely fragile 130-day fractal structure (Chart I-10). Accordingly, the recommended trade is to short basic resources (GNR) versus the broad market, setting the profit target and symmetrical stop-loss at 11.5 percent. This week we are also adding to our watchlist: Switzerland versus Germany; and USD/EUR. The full list of 20 investments that are experiencing or approaching turning points is available on our website: cpt.bcaresearch.com  Chart I-10The Outperformance Of Basic Resources Is Vulnerable To Reversal The Outperformance Of Basic Resources Is Vulnerable To Reversal The Outperformance Of Basic Resources Is Vulnerable To Reversal Switzerland's Outperformance Vs. Germany Could End Switzerland's Outperformance Vs. Germany Could End Switzerland's Outperformance Vs. Germany Could End The Rally In USD/EUR Could End The Rally In USD/EUR Could End The Rally In USD/EUR Could End Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Canada Versus Japan Is Vulnerable To Reversal Chart 5Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal Chart 7Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Bitcoin's 65-Day Fractal Support Is Holding For Now Chart 8A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 9Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 10CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 11Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 12Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 13Greece's Brief Outperformance To End Greece's Brief Outperformance To End Greece's Brief Outperformance To End Chart 14BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Chart 15The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 16The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal The Outperformance Of Resources Versus Biotech Is Vulnerable To Reversal Chart 17Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Cotton's Outperformance Is Vulnerable To Reversal Chart 18US Homebuilders' Underperformance Is At A Potential Turning Point US Homebuilders' Underperformance Is At A Potential Turning Point US Homebuilders' Underperformance Is At A Potential Turning Point Chart 19Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Chart 20Fractal Trading Watch List Fractal Trading Watch List Fractal Trading Watch List Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 We estimate the value of Chinese real estate at the end of 2021 to be $97 trillion, comprising residential $85 trillion, commercial $6 trillion, and agricultural $6 trillion. The source is: the Savills September 2021 report ‘The total value of global real estate’, which valued the global real estate market to the end of 2020; and the February 2022 report ‘Savills Prime Residential Index: World Cities’ which allowed us to update the valuations to the end of 2021. 2 The US prime residential rental yield is the simple average of the prime residential rental yields in New York, Miami, Los Angeles and San Francisco. Source: Savills. Fractal Trading System Fractal Trades $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields $350 Trillion Of Global Real Estate Can’t Swallow Higher Bond Yields 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-5Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

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

Executive Summary The Ukraine war reinforces our key view that commodity producers will use their geopolitical leverage this year. The market is growing complacent again about Russian risks. Iran is part of the same dynamic. If US-Iran talks fail, as we expect, the Middle East will destabilize and add another energy supply risk on top of the Russian risk. The Ukraine war also interacts with our other two key views for 2022: China’s reversion to autocracy and the US’s policy insularity. Both add policy uncertainty and weigh on risk sentiment. The war also reinforces our strategic themes for the 2020s: Great Power Rivalry, Hypo-Globalization, and Populism/Nationalism. Stagflation Cometh Stagflation Cometh Stagflation Cometh Trade Recommendation Inception Date Return Cyclically Long Global Defensives Versus Cyclicals 2022-01-20 10.8% Bottom Line: Tactically stay long global defensives and large caps. Cyclically stay long gold, US equities, aerospace/defense, and cyber security. Feature In our annual outlook, “The Gathering Storm,” we argued that the post-pandemic world economy would destabilize due to intensifying rivalry among the leading nations. We argued that China’s reversion to autocracy, US domestic divisions, and Russia’s commodity leverage would produce a toxic brew for global investors in 2022. By January 27 it was clear to us that Russia would invade Ukraine, so the storm was arriving sooner than we thought, and we doubled down on our defensive and risk-averse market positioning. We derived these three key views from new cyclical trends and the way they interact with our underlying strategic themes – Great Power Rivalry, Hypo-Globalization, and Populism/Nationalism (Table 1). These themes are mutually reinforcing, rooted in solid evidence over many years, and will not change easily. Table 1Three Geopolitical Strategic Themes Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Related Report  Geopolitical Strategy2022 Key Views: The Gathering Storm The Ukraine war reinforces them: Russia took military action to increase its security relative to the US and NATO; the West imposed sanctions that reduce globalization with Russia and potentially other states; Russian aggression stemmed from nationalism and caused a spike in global prices that will spur more nationalism and populism going forward. In this report we examine how these trends will develop in the second quarter and beyond. We see stagflation taking shape and recommend investors prepare for it by continuing to favor defensive sectors, commodities, and value plays. Checking Up On Our Russia View For 2022 Our third key view for 2022 – that oil producers like Russia and Iran possessed immense geopolitical leverage and would most likely use it – is clearly the dominant geopolitical trend of the year, as manifested in the Russian invasion of Ukraine.1 Russia first invaded Ukraine in 2014 and curtailed operations after commodity prices crashed. It launched a new and larger invasion in 2022 when a new commodity cycle began (Chart 1). Facing tactical setbacks, Russia has begun withdrawing forces from around the Ukrainian capital Kyiv. But it will redouble its efforts to conquer the eastern Donbas region and the southern coastline. The coast is the most strategic territory at stake (Map 1). Chart 1Russia's Commodity-Enabled Aggression Russia's Commodity-Enabled Aggression Russia's Commodity-Enabled Aggression Map 1Russian Invasion Of Ukraine, 2022 Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours The most decisive limitation on Russia’s military effort would come from a collapse of commodity exports or prices, which has not happened yet. Europe continues to buy Russian oil and natural gas, although it is debating a ban on the $4.4 billion worth of coal that it imports. With high energy prices making up for a drop in export volumes, Russian armed forces can still attempt a summer and fall campaign (Chart 2). The aim would be to conquer remaining portions of Donetsk and Luhansk, the “land bridge” to Crimea, and potentially the stretch of land between the Dnieper river and eastern Moldova, where Russian troops are already stationed. Chart 2Russia’s War Financing Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Ukraine’s military neutrality is the core Russian objective. Ukraine is offering neutrality in exchange for security guarantees in the current ceasefire talks. Hence a durable ceasefire is possible if the details of neutrality are agreed – Ukraine forswears joining NATO and hosting foreign military infrastructure while accepting limitations on military exercises and defense systems. The security guarantees that Ukraine demands are mostly symbolic, as the western powers that would be credible guarantors are already unwilling to use military force against Russia (e.g. the US, UK, NATO members). However, Russia’s withdrawal from Kyiv will embolden the Ukrainians, so we do not expect a durable ceasefire in the second quarter. Global investors will be mistaken if they ignore Ukraine in the second quarter, at least until core problems are resolved. What matters most is whether the war expands beyond Ukraine: The likelihood of a broader war is low but not negligible. So far the Russian regime is behaving somewhat rationally: Moscow attacked a non-NATO member to prevent it from joining NATO; it limited the size of the military commitment; and it is now accepting reality and withdrawing from Kyiv while negotiating on Ukrainian neutrality. But a major problem emerges if Russia’s military fails in the Donbas while Ukraine reneges on offers of neutrality. Any ceasefire could fall apart and the war could re-escalate. Russia could redouble its attacks on the country or conduct a limited attack outside of Ukraine to trigger a crisis in the western alliance. Moreover, if sanctions keep rising until Russia’s economy collapses, Moscow could become less rational. Finland and Sweden have seen a shift of public opinion in favor of joining NATO. Any intention to do so would trigger a belligerent reaction from Russia. These governments are well aware of the precarious balance that must be maintained to prevent war, so war is unlikely. But if their stance changes then Russia will threaten to attack. Russia would threaten to bomb these states since it cannot now credibly threaten invasion by land (Charts 3A & 3B). Chart 3ANordic States Joining NATO Would Trigger Larger War Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours ​​​​​ Chart 3BNordic States Joining NATO Would Trigger Larger War Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours ​​​​​​ The Black Sea is vulnerable to “Black Swan” events or military spillovers. Russia is re-concentrating its military efforts in the Donbas and land bridge to Crimea. Russia could expand its offensive to Odessa and the Moldovan border. Or Russia could attempt to create a new norm of naval dominance in the Black Sea. Or ships from third countries could hit mines or become casualties of war. For these and other reasons, investors should not take on additional risk in their portfolios on the basis that a durable ceasefire will be concluded quickly. Russia’s position is far too vulnerable to encourage risk-taking. Moscow could escalate tensions to try to save face. It is also critical to ensure that Russia and Europe maintain their energy trade: Neither side has an interest in total energy cutoff. Russia needs the revenue to finance its war and needs to discourage Europe from fulfilling its pledges to transition rapidly to other sources and substitutes. Europe needs the energy to avoid recession, maintain some tie with Russia, and enable its energy diversification strategy. So far natural gas flows are continuing (Chart 4). Chart 4Natural Gas Flows Continuing (So Far) Natural Gas Flows Continuing (So Far) Natural Gas Flows Continuing (So Far) ​​​​​​ Chart 5Global Oil Supply/Demand Balance Global Oil Supply/Demand Balance Global Oil Supply/Demand Balance ​​​​​​ However, risks to energy trade are rising. Russia is threatening to cut off energy exports if not paid in rubles, while the EU is beginning to entertain sanctions on energy. Russia can reduce oil or gas flows incrementally to keep prices high and prevent Europe from rebuilding stockpiles for fall and winter. Partial energy cutoff is possible. Europe’s diversification makes Russia’s predicament dire. Substantial sanction relief is highly unlikely, as western powers will want to prevent Russia from rebuilding its economy and military. Russia could try to impose significant pain on Europe to try to force a more favorable diplomatic solution. A third factor that matters is whether the US will expand its sanction enforcement to demand strict compliance from other nations, at pain of secondary sanctions: Secondary sanctions are likely in the case of China and other nations that stand at odds with the US and help Russia circumvent sanctions. In China’s case, the US is already interested in imposing sanctions on the financial or technology sector as part of its long-term containment strategy. While the Biden administration’s preference is to control the pace of escalation with China, and thus not to slap sanctions immediately, nevertheless substantial sanctions cannot be ruled out in the second quarter. Secondary sanctions will be limited in the case of US allies and partners, such as EU members, Turkey, and India. Countries that do business with Russia but are critical to US strategy will be given waivers or special treatment. Russia is not the only commodity producer that enjoys outsized geopolitical leverage amid a global commodity squeeze. Iran is the next most critical producer. Iran is also critical for the stability of the Middle East. In particular, the consequential US-Iran talks over whether to rejoin the 2015 nuclear deal are likely to come to a decision in the second quarter. Chart 6Failure Of US-Iran Talks Jeopardizes Middle East Oil Supply Failure Of US-Iran Talks Jeopardizes Middle East Oil Supply Failure Of US-Iran Talks Jeopardizes Middle East Oil Supply If the US and Iran agree to a strategic détente, then regional tensions will briefly subside, reducing global oil disruption risks and supply pressures. Iran could bring 1.3 million barrels per day of oil back online, adding to President Biden’s 1 million per day release of strategic petroleum reserves. The combination would amount to 2.3% of global demand and more than cover the projected quarterly average supply deficit, which ranges from 400k to 900k barrels per day for the rest of 2022 (Chart 5). If the US and Iran fail to agree, then the Middle East will suffer another round of instability, adding a Middle Eastern energy shock on top of the Russian shock. Not only would Iran’s 1.3 million barrels per day be jeopardized but so would Iraq’s 4.4 million, Saudi Arabia’s 10.3 million, the UAE’s 3.0 million, or the Strait of Hormuz’s combined 24 million per day (Chart 6). This gives Iran leverage to pursue nuclear weaponization prior to any change in US government that would strengthen Israel’s ability to stop Iran. We would not bet on an agreement – but we cannot rule it out. The Biden administration can reduce sanctions via executive action to prevent a greater oil shock, while the Iranians can accept sanction relief in exchange for easily reversible moves toward compliance with the 2015 nuclear deal. But this would be a short-term, stop-gap measure, not a long-term strategic détente. Conflict between Iran and its neighbors will revive sooner than expected after the deal is agreed, as Iran’s nuclear ambitions will persist. OPEC states are already producing more oil rapidly, suggesting no quick fix if the US-Iran deal falls apart. While core OPEC states have 3.5 million barrels per day in spare capacity to bring to bear, a serious escalation of tensions with Iran would jeopardize this solution. Finally, if commodity producers have geopolitical leverage, then commodity consumers are lacking in leverage. This is clear from Europe’s inability to prevent Russia’s attack or ban Russian energy. It is clear from the US’s apparent unwillingness to give up on a short-term deal with Iran. It is clear from China’s inability to provide sufficient monetary and fiscal stimulus as it struggles with Covid-19. Turkey, Egypt, and Pakistan are geopolitically significant importers of Russian and Ukrainian grain that are likely to face food insecurity and social unrest. We will address this issue below under our Populism/Nationalism theme. Bottom Line: Investors should not be complacent. Russia’s military standing in Ukraine is weak, but its ability to finance the war has not yet collapsed, which means that it will escalate the conflict to save face. What About Our Other Key Views For 2022? Our other two key views for 2022 are even more relevant in the wake of the Ukraine re-invasion. China’s reversion to autocracy is a factor in China’s domestic and foreign policy: Domestically China needs economic and social stability in the advance of the twentieth national party congress, when President Xi Jinping hopes to clinch 10 more years in power. In pursuit of this goal China is easing monetary and fiscal policy. However, with depressed animal spirits, a weakening property sector, and high debt levels, monetary policy is proving insufficient. Fiscal policy will have to step up. But even here, inflation is likely to impose a limitation on how much stimulus the authorities can utilize (Chart 7). Chart 7China Stimulus Impaired By Inflation China Stimulus Impaired By Inflation China Stimulus Impaired By Inflation ​​​​​​ Chart 8Chinese Supply Kinks To Persist Due To Covid-19 Chinese Supply Kinks To Persist Due To Covid-19 Chinese Supply Kinks To Persist Due To Covid-19 China is also trying but failing to maintain a “Covid Zero” policy. The more contagious Omicron variant of the virus is breaking out and slipping beyond the authorities’ ability to suppress cases of the virus to zero. Shanghai is on lockdown and other cities will follow suit. China will attempt to redouble its containment efforts before it will accept the reality that the virus cannot be contained. Chinese production and shipping will become delayed and obstructed as a result, putting another round of upward pressure on global prices (Chart 8). Stringent pandemic restrictions could trigger social unrest. China is ripe for social unrest, which is why it launched the “Common Prosperity” program last year to convince citizens that quality of life will improve. But this program is a long-term program that will not bring immediate relief. On the contrary, the economy is still suffering and the virus will spread more widely, as well as draconian social restrictions. The result is that the lead up to the national party congress will not be as smooth as the Xi administration had hoped. Global investors will remain pessimistic toward Chinese stocks. In foreign affairs, China’s reversion to autocracy is reinforced by Russia’s clash with the West and the need to coordinate more closely. Xi hosted Putin in Beijing on February 4, prior to the invasion, and the two declared that their strategic partnership ushers in a “new era” of “multipolarity” and that their cooperation has “no limits,” which really means that military cooperation is not forbidden. China agreed to purchase an additional 10 billion cubic meters of Russian natural gas over 30-years. While this amount would only replace 3% of Russian natural gas exports to Europe, it would mark a 26% increase in Russian exports to China. More importantly it acts as a symbol of Chinese willingness to substitute for Europe over time. There is a long way to go for China to replace Europe as a customer (Chart 9). But China knows it needs to convert its US dollar foreign exchange reserves, vulnerable to US sanctions, into hard investments in supply security within the Eurasian continent. Chart 9Long Way To Go For China NatGas Imports To Replace EU Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours China is helping Russia circumvent sanctions. China’s chief interest is to minimize the shock to its domestic economy. This means keeping Russian energy and commodities flowing. China could also offer military equipment for Russia. The US has expressly warned China against taking such an action. China could mitigate the blowback by stipulating that the assistance cannot be used in Ukraine. This would be unenforceable but would provide diplomatic cover. While China is uncomfortable with the disturbance of the Ukraine war – it does not want foreign affairs to cause even larger supply shocks. At the same time, China does not want Russia to lose the war or Putin’s regime to fall from power. If Russia loses, Taiwan and its western allies would be emboldened, while Russia could pursue a détente with the West, leaving China isolated. Since China faces US containment policy regardless of what happens in Russia, it is better for China to have Putin making an example out of Ukraine and keeping the Americans and Europeans preoccupied. Chart 10China Strives To Preserve EU Trade Ties China Strives To Preserve EU Trade Ties China Strives To Preserve EU Trade Ties China must also preserve ties with Europe. Diplomacy will likely succeed in the short run since Europe has no interest or desire to expand sanctions to China. The Biden administration will defer to Europe on the pace of sanctions – it is not willing or able to force Europe to break with China suddenly. Eventually Europe and China may sever relations but not yet – China has a powerful incentive to preserve them (Chart 10). China will also court India and other powers in an attempt to hedge its bets on Russia while weakening any American containment. Beyond the party congress, China will be focused on securing the economic recovery and implementing the common prosperity agenda. The first step is to maintain easy monetary and fiscal policy. The second step is to “let 100 flowers bloom,” i.e. relaxing social and regulatory controls to try to revive entrepreneurship and animal spirits, which are heavily depressed. Xi will have the ability to do this after re-consolidating power. The third step will be to try to stabilize economic relations with Europe and others (conceivably even the US temporarily, though no serious détente is likely). The remaining key view for 2022 is that the Biden administration’s domestic focus will be defensive and will invite foreign policy challenges. The Ukraine war vindicates this view but the question now is whether Biden has or will change tack: The Biden administration is focused on the midterm elections and the huge risk to the Democratic Party’s standing. Biden has not received a boost in opinion polls from the war. He is polling even worse when it comes to handling of the economy (Chart 11). While he should be able to repackage his budget reconciliation bill as an energy security bill, his thin majorities in both houses make passage difficult. Chart 11Biden And Democrats Face Shellacking In Midterm Election Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Biden’s weak standing – with or without a midterm shellacking – raises the prospect that Republicans could take back the White House in 2024, which discourages foreign nations from making any significant concessions to the United States in their negotiations. They must assume that partisanship will continue to contaminate foreign policy and lead to abrupt policy reversals. In foreign policy, the US remains reactive in the face of Russian aggression. If Russia signs a ceasefire, the US will not sabotage it to prolong Russian difficulties. Moreover Biden continues to exempt Europe and other allies and partners from enforcing the US’s most severe sanctions for fear of a larger energy shock. Europe’s avoidance of an energy ban is critical and any change in US policy to try to force the EU to cut off Russian energy is unlikely. China will not agree to structural reform or deep concessions in its trade negotiations, knowing that former President Trump could come back. The Biden administration’s own trade policy toward China is limited in scope, as the US Trade Representative Katherine Tai admitted when she said that the US could no longer aim to change China’s behavior via trade talks. Biden’s only proactive foreign policy initiative, Iran, will not bring him public kudos if it is achieved. But American inconstancy is one of the reasons that Iran may walk away from the 2015 nuclear deal. Why should Iran’s hawkish leaders be expected to constrain their nuclear program and expose their economy to future US sanctions if they can circumvent US sanctions anyway, and Republicans have a fair chance of coming back into power as early as January 2025? Biden’s unprecedented release of strategic petroleum reserves will not be able to prevent gasoline prices from staying high given the underlying supply pressures at home and abroad. This is especially true if the Iran talks fail as we expect. Even if inflation abates before the election, it is unlikely to abate enough to save his party from a shellacking. That in turn will weaken the global impression of his administration’s staying power. Hence Biden will focus on maintaining US alliances, which means allowing Europe, India, and others to proceed at a more pragmatic and dovish pace in their relations with Russia and China. Bottom Line: China’s reversion to autocracy and America’s policy insularity suggest that global investors face considerable policy uncertainty this year even aside from the war in Europe. Checking Up On Our Strategic Themes For The 2020s Russia’s invasion strongly confirmed our three strategic themes of Great Power Rivalry, Hypo-Globalization, and Populism/Nationalism. These themes are mutually reinforcing: insecurity among the leading nation-states encourages regionalization rather than globalization, while populism and nationalism encourage nations to pursue economic and security interests at the expense of their neighbors. First, the Ukraine war confirms and exacerbates Great Power Rivalry: Chart 12China And Russia Both Need To Balance Against US Preponderance Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Russia’s action vindicates the “realist” school of international relations (in which we count ourselves) by forcing the world to wake up to the fact that nations still care primarily about national security defined in material ways, such as armies, resources, and territories. The paradox of realism is that if at least one of the great nations pursues its national self-interest and engages in competition for security, then all other nations will be forced to do the same. If a nation neglects its national security interests in pursuit of global economic engagement and cooperation, then it will suffer, since other nations will take advantage of it to enhance their security. Hence, as a result of Ukraine, nations will give a higher weight to national security relative to economic efficiency. The result will be an acceleration of decisions to use fiscal funds and guide the private economy in pursuit of national interests – i.e. the Return of Big Government. Since actions to increase deterrence will provoke counteractions for the same reason, overall insecurity will rise. For example, the US and China will take extra precautions in case of future sanctions and war. But these precautions will reduce trust and cooperation and increase the probability of war over the long run. For the same reason, China cannot reject Russia’s strategic overture – it cannot afford to alienate and isolate Russia. China and Russia have a shared interest in countering the United States because it is the only nation that could conceivably impose a global empire over all nations (Chart 12). The US could deprive Beijing and Moscow of the regional spheres of influence that they each need to improve their national security. This is true not only in Ukraine and Taiwan but in other peripheral areas such as Belarus, the Caucasus, Central Asia, and Southeast Asia. China has much to gain from Russia. Russia is offering China privileged overland access to Russian, Central Asian, and Middle Eastern resources and markets. This resource base is vital to China’s strategic needs, given its import dependency and vulnerability to US maritime power (Chart 13). Chart 13China’s Maritime Vulnerability Forces Eurasian Strategy, Russian Alliance Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Investors should understand Great Power Rivalry in a multipolar rather than bipolar sense. As Russia breaks from the West, investors are quick to move rapidly to the bipolar Cold War analogy because that is what they are familiar with. But the world today has multiple poles of political power, as it did for centuries prior to the twentieth. While the US is the preponderant power, it is not hegemonic. It faces not one but two revisionist challengers – Russia and China. Meanwhile Europe and India are independent poles of power that are not exclusively aligned with the US or China. For example, China and the EU need to maintain economic ties with each other for the sake of stability, and neither the US nor Russia can prevent them from doing so. The same goes for India and Russia. China will embrace Russia and Europe at the same time, while hardening its economy against US punitive measures. India will preserve ties with Russia and China, while avoiding conflict with the US and its allies (the maritime powers), whom it needs for its long-term strategic security in the Indian Ocean basin. Ultimately bipolarity may be the end-game – e.g. if China takes aggressive action to revise the global order like Russia has done – but the persistence of Sino-European ties and Russo-Indian ties suggest we are not there yet. Second, the Ukraine war reinforces Hypo-Globalization: Since the pandemic we have argued that trade would revive on the global economic snapback but that globalization – the deepening of trade integration – would ultimately fall short of its pre-2020 and pre-2008 trajectory. Instead we would inhabit a new world of “hypo-globalization,” in which trade flows fell short of potential. So far the data support this view (Chart 14). Chart 14Globalization Falling Short Of Potential Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours The Ukraine war has strengthened this thesis not only by concretely reducing Russia’s trajectory of trade with the West – reversing decades of integration since the fall of the Soviet Union – but also by increasing the need for nations to guard against a future Chinese confrontation with the Western world. Trust between China and the West will further erode. China will need to guard against any future sanctions, and thus diversify away from the US dollar and assets, while the US will need to do a better job of deterring China against aggression in Asia, and will thus have to diversify away from Chinese manufacturing and critical resources like rare earths. While China and Europe need each other now, the US and China are firmly set on a long-term path of security competition in East Asia. Eventually either the US or China will take a more aggressive stance and Europe will be forced to react. Since Europe will still need US support against a decaying and aggressive Russia, it will likely be dragged into assisting the US against China. Third, the Ukraine war reflects and amplifies Populism/Nationalism: Populism and nationalism are not the same thing but they both stem from the slowing trend of global income growth, the rise of inequality, the corruption of the elite political establishments, and now the rise in inflation. Nations have to devote more resources to pacifying an angry populace, or distracting that populace through foreign adventures, or both. The Ukraine war reflects the rise in nationalism. First, the collapse of the Soviet Union ushered in a period in which Moscow lost control of its periphery, while the diverse peoples could pursue national self-determination and statehood. The independence and success of the Baltic states depended on economic and military cooperation with the West, which eroded Russian national security and provoked a nationalist backlash in the form of President Putin’s regime. Ukraine became the epicenter of this conflict. Ukraine’s successful military resistance is likely to provoke a dangerous backlash from Moscow until either policy changes or the regime changes. American nationalism has flared repeatedly since the fall of the Soviet Union, namely in the Iraq war. The American state has suffered economically and politically for that imperial overreach. But American nationalism is still a potent force and could trigger a more aggressive shift in US foreign policy in 2024 or beyond. European states have kept nationalism in check and tried to subsume their various nationalist sentiments into a liberal and internationalist project, the European Union. The wave of nationalist forces in the wake of the European debt crisis has subsided, with the exception of the United Kingdom, where it flowered in Brexit. The French election in the second quarter will likely continue this trend with the re-election of President Emmanuel Macron, but even if he should suffer a surprise upset to nationalist Marine Le Pen, Europe’s centripetal forces will prevent her from taking France out of the EU or euro or NATO (Chart 15). Over the coming decade, nationalist forces will revive and will present a new challenge to Europe’s ruling elites – but global great power competition strongly supports the EU’s continued evolution into a single geopolitical entity, since the independent states are extremely vulnerable to Russia, China, and even the US unless they unite and strengthen their superstructure. Chart 15Macron Favored, Le Pen Would Be Ineffective Macron Favored, Le Pen Would Be Ineffective Macron Favored, Le Pen Would Be Ineffective In fact the true base of global nationalism is migrating to Asia. Chinese and Indian nationalism are very potent forces under President Xi Jinping and Prime Minister Narendra Modi. Xi is on the verge of clinching another ten years in power while Modi is still favored for re-election in 2024, so there is no reason to anticipate a change anytime soon. The effects are various but what is most important for investors is to recognize that as China’s potential GDP has fallen over the past decade, the Communist Party has begun to utilize nationalism as a new source of legitimacy, and this is expressed through a more assertive foreign policy. President Xi is the emblem of this shift and it will not change, even if China pursues a lower profile over certain periods to avoid provoking the US and its allies into a more effective coalition to contain China. Chart 16Food Insecurity Will Promote Global Unrest, Populism Food Insecurity Will Promote Global Unrest, Populism Food Insecurity Will Promote Global Unrest, Populism The surge in global prices will destabilize regimes that lack food security and contribute to new bouts of populism and nationalism. Turkey is the most vulnerable due to a confluence of political, economic, and military risks that will unsettle the state. But Egypt is vulnerable to an Arab Spring 2.0 that would have negative security implications for Israel and add powder to the Middle Eastern powder keg. Pakistan is already witnessing political turmoil. Investors may overlook any Indonesian unrest due to its attractiveness in a world where Russia and China are scaring away western investment (Chart 16). All three of these strategic themes are mutually reinforcing – and they tend to be inflationary over the long run. Great powers that redouble the pursuit of national interest – through defense spending and energy security investments – while simultaneously being forced to expand their social safety nets to appease popular discontent, will drive up budget deficits, consume a lot of natural resources, and purchase a lot of capital equipment. They will also more frequently engage in economic or military conflicts that constrain supply (Chart 17). Chart 17War And Preparation For War Are Inflationary War And Preparation For War Are Inflationary War And Preparation For War Are Inflationary Bottom Line: The Ukraine war is a powerful confirmation of our three strategic themes. It is also a confirmation that these themes have inflationary macroeconomic implications. Investment Takeaways Chart 18Global Investors Still Flee To US For Safety Global Investors Still Flee To US For Safety Global Investors Still Flee To US For Safety Now that great power rivalry is intensifying immediately and rapidly, and yet China’s and Europe’s economies are encountering greater difficulties, we expect stagflation to arrive sooner rather than later. High headline and core inflation, the Ukraine war, tacit Chinese support for Russia, persistent Chinese supply kinks, US and EU sanctions, US midterm elections, and a potential US-Iran diplomatic breakdown will all weigh on risk sentiment in the second quarter. In Ukraine, Russia’s position is too weak to give comfort for investors, who should continue to favor defensive over cyclical equities and US stocks over global stocks. Russia’s break with the West, and the West’s use of sanctions to prevent Russia from accessing its foreign exchange reserves, has raised new questions about the global currency reserve system and the dollar’s status within that system. Over the coming years China will redouble the efforts it began in the wake of the Great Recession to reduce its dependency on US dollar assets within its reserve basket, while also recycling new current account surpluses into non-dollar assets. However, the evidence does not suggest that King Dollar will suffer a structural breakdown. First, the world lacks alternative safe-haven assets to US Treasuries – and net foreign purchases of US bonds rose in the face of the Ukraine war (Chart 18). Second, the return of war to Europe will weaken the perceived long-term security of European currency and government bonds relative to US counterparts. Even if the Ukraine war is contained in the short run, as we expect, Russia is in structural decline and will remain a disruptive player for some time. We are not at all bearish on the euro or European bonds but we do not see the Ukraine war as increasing their value proposition, to put it lightly. The same logic extends to Japanese bonds, since China, like Russia, is an autocratic and revisionist state that threatens to shake up the security order in its neighborhood. Japan is relatively secure as a nation and we are bullish on the yen, but China’s de facto alliance with Russia weakens Japan’s security outlook over the very long run, especially relative to the United States. Thus, on a cyclical basis the dollar can depreciate, but on a structural basis the US dollar will remain the dominant reserve currency. The US is not only the wealthiest and most secure country in the world but also the largest oil producer. Meanwhile Chinese potential growth, domestic political stability, and foreign relations are all worsening. The US-Iran talks are the most critical geopolitical dynamic in the second quarter aside from Russia’s clash with the West. The fate of the 2015 nuclear deal will be decided soon and will determine whether an even bigger energy shock begins to emanate from the Middle East. We would not bet on a new US-Iran deal but we cannot rule it out. Any deal would be a short-term, stop-gap deal but would prevent an immediate destabilization of the Middle East this year. As such it would reduce the risk of stagflation. Since we expect the deal to fail, we expect a new energy shock to emerge. We see stagflation as more likely than the BCA House View. It will be difficult to lift productivity in an environment of geopolitical and political uncertainty combined with slowing global growth, rising interest rates, and a worsening commodity shock (Chart 19). We will gladly revise this stance if Biden clinches an Iran deal, China relaxes its Covid Zero policy and stabilizes domestic demand, Russia and Europe maintain energy trade, and commodity prices fall to more sustainable levels for global demand. Chart 19Stagflation Cometh Stagflation Cometh Stagflation Cometh Strategically we remain long gold, overweight US equities, overweight UK equities, long British pound and Japanese yen, long aerospace/defense stocks and cyber security stocks. We remain short Chinese renminbi and Taiwanese dollar and short emerging European assets. Our short Chinese renminbi trade and our short Taiwanese versus Korean equity trade are our worst-performing recommendations. However, the above analysis should highlight – and the Ukraine war should underscore – that these two economies face a fundamentally negative geopolitical dynamic. Both Chinese and Taiwanese stocks have been underperforming global peers since 2021 and our short TWD-USD trade is in the money. While we do not expect war to break out in Taiwan this year, we do expect various crisis events to occur, particularly in the lead up to the crucial Taiwanese and American 2022 midterms and 2024 presidential election. We also expect China to depreciate the renminbi when inflation peaks and commodity prices subside. Cyclically we remain long North American and Latin American oil producers and short Middle Eastern producers, based on our pessimistic read of the Iran situation. The Americas are fundamentally better protected from geopolitical risks than other regions, although they continue to suffer from domestic political risks on a country-by-country basis. Cyclically we continue to take a defensive positioning, overweighting defensive sectors and large cap equities.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1      That the Russian threat fell under our third key view for 2022 implies that we did not get our priorities straight. However, consider the timing: shortly after publishing our annual outlook on December 15, the Russians issued an ultimatum to the western powers demanding that NATO stop expanding toward Russia. Diplomats from Russia and the West met on January 12-13 but Russia’s demands were not met. We upgraded the odds that Russia would invade Ukraine from 50% to 75% on January 27. Shuttle diplomacy ensued but failed. Russia invaded on February 24. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades () Section II: Special (EDIT this Header) Section III: Geopolitical Calendar

Executive Summary Natgas Price Surge Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Russia's invasion of Ukraine and the surge in EU natural gas prices it provoked will accelerate investment in clean-hydrogen technology, which uses renewable energy to separate water into hydrogen and oxygen. This already has pushed the cost of clean – or "green" – hydrogen below the cost of competing forms of the fuel on the continent. Widespread adoption of carbon pricing will further enhance the attractiveness of green hydrogen, making it more competitive in transportation and refining applications. The cost of producing clean hydrogen in China also has fallen, owing to the competition for liquified natural gas (LNG) with the EU. Relatively low US natural gas prices are keeping the cost of green hydrogen above alternatives. The US DOE is prioritizing hydrogen development, and is funding research to reduce its cost from ~ $5/kg to $1/kg over the next 10 years. Falling clean-hydrogen costs raise the risk of stranded investment in natural-gas exploration and production. Bottom Line: The EU's drive to diversify away from Russian natural gas as quickly as possible will keep competition for scarce LNG between the EU and Asian markets high, as both bid for scarce supplies. This will redound to the benefit of clean hydrogen and its supporting technology, but might limit natgas E+P. Feature The war in Ukraine will keep the price of natural gas, particularly in its liquid state (LNG), elevated, as the EU and Asia compete for scarce supplies to refill inventories and prepare for the coming winter, along with keeping their heavy industries operating (Chart 1). In the Europe-Middle East-Africa (EMEA) markets and China, higher natgas prices, including LNG, already have lifted the cost of pulling hydrogen from natgas – so-called blue and grey hydrogen – above that of green (or "clean") hydrogen, which is produced by separating the hydrogen and oxygen in water via electrolysis. With natgas prices remaining elevated this year and next, investment in clean-hydrogen technology and its supporting infrastructure can be expected to increase. Government support for hydrogen as a clean fuel – i.e., research funding and tax support – will allow this technology to reach economies of scale and lower costs over the coming decade. Chart 1Russia's Invasion Of Ukraine Will Boost Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Related Report  Commodity & Energy StrategySurging Metals Prices And The Case For Carbon-Capture Government policy can increase the advantage of green-hydrogen and other clean-energy technologies by adopting carbon-pricing schemes on a large scale, as well. Such schemes would assess actual – and avoidable – costs of pollution to incentivize investment in non-polluting technologies. We have argued in the past that this is best done via taxes that can provide revenues to support and fund the development of renewable energy. Ideally, such schemes would include mechanisms to offset the regressive nature of such taxes. Absent a tax, Carbon Clubs that impose tariffs or duties on states not abiding by carbon-reduction policies seeking to export to states that do employ such policies, as developed by William Nordhaus, would be useful.1 Ukraine War Improves Hydrogen Economics Governments supporting low- or zero-carbon emission technologies in their push to contain the rise in the Earth's temperature are focused on hydrogen, which, when consumed in a fuel cell, emits no pollution. Apart from being a fuel source, hydrogen also can be used to store energy. It can power electric grids when there is intermittent electricity supply, making it ideal as a back-up energy source for renewable-energy technologies – solar and wind, in particular – which, as the UK and Europe discovered last summer, can be extremely variable and unreliable. Based on its method of production, hydrogen is assigned a color – grey, blue, or green (Chart 2). In a nutshell: Chart 2Types of Hydrogen By Color EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Grey hydrogen is produced when steam reacts with a hydrocarbon fuel (typically natural gas) to produce hydrogen via a process known as steam-methane reforming (SMR). The downside of this technology is it can result in CO2 and carbon escaping into the environment. Blue hydrogen is created by the same SMR process as grey hydrogen; however, carbon capture and storage (CCS) technology is added to the process to reduce carbon emissions from the steam and fuel reaction. Green hydrogen – aka "clean hydrogen" – is produced with electricity from renewables like wind or solar – in a process that separates water into oxygen and hydrogen via electrolysis. Electricity is the primary cost driver in the production of green hydrogen, followed by the elctrolyzers used to separate oxygen and hydrogen (Chart 3). For this reason, countries where renewable electricity is abundant will be ideal candidates for so-called clean hydrogen. Among renewables, wind and solar are the most developed, and cheapest sources of electricity (Chart 4). As a result, the International Renewable Energy Agency (IRENA) believes countries in the Middle East, Africa, and Oceania have the highest potential to become green hydrogen exporters.2 A constant electric load is crucial for efficient and cost-effective hydrogen production. Electrolyzers will either underperform or overheat if subjected to a variable electric load, reducing their lifespan, and hence increasing overall capital costs. This is yet another reason why countries with vast quantities of wind and solar energy will be at an advantage producing clean hydrogen. Chart 3Renewables Are Primary Cost For Green Hydrogen EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Chart 4Cheap Wind And Solar Electricity Can Reduce Green Hydrogen Costs EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Until now, deficient electrolyzer investment and production have resulted in high capital costs. Low innovation in the technology is due to a dearth of consumer demand due to the high prices, leading to a vicious cycle (Diagram 1). According to IRENA, increasing the manufacturing intensity of stacks – the primary component of the electrolyzer – could reduce the share of its cost from 45% to 30% of the total.3 Russia's invasion of Ukraine and the surge in EU natural gas prices it provoked will accelerate investment in green-hydrogen technology. The war already has pushed the cost of clean hydrogen below the cost of competing grey and blue forms of the fuel on the continent. We expect this will persist over the next two years, as the EU and Asia compete for scarce natural gas and LNG supplies going into the coming winter to rebuild depleted gas inventories, and to keep base metals smelters and refineries up and running. Diagram 1The Vicious Cycle Plaguing Hydrogen EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects The cost of grey hydrogen from natgas was ~ $6.70/kg last month vs a mid-point estimate of ~ $5.75/kg for green hydrogen in the Europe-Middle East-Africa (EMEA) markets.4 In China, green hydrogen was running at ~ $3.20/kg vs a grey cost of ~ $5.30/kg. The US is the outlier here, given its abundance of natural gas production. Grey hydrogen cost $1.20/kg, while green hydrogen was running at ~ $3.30/kg. It is difficult to determine whether green hydrogen will remain cheaper than blue in the EMEA and China markets. Under normal conditions – absent highly backwardated fuel markets – blue hydrogen is considered a bridge to the green variant, since it only builds on the incumbent grey hydrogen production process and is cheaper (Chart 5). Approximately 90% of total hydrogen produced annually is grey. If the EU is forced to ration natgas – Germany, e.g., is preparing its population for such a contingency in the event Russian supplies are shut off – reduced fuel availability will act as a hard constraint for blue-hydrogen production. This would prolong green-hydrogen's cost advantage. Chart 5Green Hydrogen Typically Most Expensive Hue EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects That being said, green hydrogen has its own geopolitical problems. Procuring the critical minerals and metals required to build electrolyzers can prove to be challenging, given the metals’ locations are highly concentrated in states with stressed electrical infrastructures like South Africa, which produces 85% and 70% of global iridium and platinum supply respectively (Chart 6). Both metals are in commonly used electrolyzers. Metals supply disruptions in China similar to those that occurred this past winter can affect numerous metal supply chains necessary for hydrogen production. Chart 6Concentration Risks In Hydrogen Materials EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Displacing High-Polluting Technology According to the IRENA, hydrogen could cover up to 12% of global energy use by 2050.5 Green hydrogen has numerous potential applications: Backstopping intermittent renewable energy; Performing as a “zero-emissions” fuel for maritime shipping and aviation; An energy source for high-heat industrial processes that cannot otherwise be electrified; A feedstock in some industrial processes, like steel production.6 The adoption of hydrogen for new applications has been slow, with uptake limited to the last decade, when fuel cell electric vehicle (FCEV) deployment started gaining traction. In addition, this energy source can be used to produce commodities such as steel, cement and glass used in construction, and ammonia needed to fertilize crops.7 In terms of size, global hydrogen demand was 90 Mt in 2020, with most of it coming from refining and industrial uses. Governments have committed to greater hydrogen use, but not nearly enough to meet net-zero energy emissions by 2050 (Chart 7).8 IRENA estimates that over 30% of hydrogen could be traded across borders by 2050, a higher share than natural gas today.9 According to the Energy Networks Association, up to a fifth of natural gas consumption currently used could be replaced by hydrogen.10 Countries most able to generate cheap renewable electricity will be best placed to produce competitive green hydrogen.11 Chart 7Hydrogen Contributes To Lower Emissions EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Investment Implications High natgas prices – in its pipeline and liquid forms – will redound to the benefit of clean hydrogen and its supporting technology. The relative cost advantage green hydrogen has over its grey and blue competition will persist this year and most likely in 2023, as the EU and China continue to bid for scarce natgas supplies in the wake of Russia's invasion of Ukraine. This could persist, if markets begin pricing the availability and future reliability of clean hydrogen on par with fossil-fuel availability. However, this will require significant increases in green-hydrogen technology investment, particularly in electrolysers. Government support – e.g., the US DOE's efforts to reduce the cost of green hydrogen to $1/kg over the next 10 years from $5/kg – will be important in this regard. The development of green-hydrogen capacity and its infrastructure could limit the further development of natural gas, which will be increasingly important during the global energy transition. The conventional natgas resource base benefits from a fully developed global infrastructure, which, if augmented with funding and tax support for carbon-capture and storage technology, will provide a necessary bridge to a low-carbon energy grid.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodity Round-Up Industrial bulks (iron ore and steel) and metals are becoming more expensive, increasing the cost of Europe’s effort to diversify away from Russian natural gas. European countries that relied on pipeline natgas from Russia will need to construct import facilities and regasification plants to switch to LNG from other exporters. Cross-border European pipelines also will be required to transport imported natural gas from the Iberian Peninsula and Eastern Europe to inland Europe. The US will be expanding LNG export facilities in the Gulf out to 2025, after which growth in export capacity will level off at ~ 10 Bcf/d. It has a large latent export capacity of ~ 187 million tons of LNG, however 48% of that capacity will come via projects currently under construction or awaiting permits. The build-out and expansion of LNG import and export facilities will be steel- and metals- intensive. Renewables-based energy the EU will look to as another alternative to Russian gas will compete with new LNG facilities’ metal demand, given green energy’s infrastructure requirements (Chart 8). The US and China will compete with the EU for these metals, as the world aims to achieve net-zero carbon emissions by 2050. The downside risk is the current COVID wave in China, and the stringent lockdown accompanying it, which started in end-March. Lockdowns will slow down economic activity and demand for metals. So far, however, copper - widely used in the nation’s large property sector - seems to have been untouched by activity in China. This is likely due to low inventory levels, the Ukraine crisis, and political uncertainty in the copper rich countries of Peru and Chile, which has slowed investment activity in the region. According to BCA’s China Investment Strategy, China’s zero-tolerance COVID policy will lead to frequent lockdowns and outweigh the positive effects of stimulus, given the high transmissibility of the Omicron variant now spreading there. Copper demand growth likely slows in China, but outside China demand for steel and base metals is holding up.. Chart 8 EU Gas Crisis Boosts Hydrogen's Prospects EU Gas Crisis Boosts Hydrogen's Prospects Footnotes 1     Please see Surging Metals Prices And The Case For Carbon-Capture, which we published 13 May 2021. It is available at ces.bcaresearch.com. Nordhaus is the 2018 Nobel Laureate in Economics in 2018. Please see Carbon Market Clubs and the New Paris Regime published by the World Bank in July 2016. The intellectual and computational framework for this technology was developed by Nordhaus. 2     Please see Geopolitics of The Energy Transformation: The Hydrogen Factor, published by IRENA. 3    Please see Green Hydrogen Cost Reduction: Scaling Up Electrolyzers to Meet the 1.5°C Climate Goal, published by IRENA. 4    Please see Ukraine war | Green hydrogen 'now cheaper than grey in Europe, Middle East and China': BNEF, published by rechargenews.com on March 7, 2022.  5    https://www.irena.org/newsroom/pressreleases/2022/Jan/Hydrogen-Economy-… 6    Please see Hydrogen: Future of Clean Energy or a False Solution? published by Sierra Club 5 January 2022. 7     Please see Green hydrogen has long been hyped as a replacement for fossil fuels. Now, one of the industry’s biggest players is preparing its IPO published by Fortune on January 10, 2022. 8    Please see Global Hydrogen Review 2021 published by IEA November 2021. 9    Please see Hydrogen Economy Hints at New Global Power Dynamics published by IRENA on January 15, 2022. 10   Please see Hydrogen could replace 20% of natural gas in the grid from next year published by Institution for Mechanical Engineers 14 January 2022. 11    See footnote #9. Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image  

Executive Summary Shanghai Is Extending Lockdowns Due To Exponentially Rising COVID Cases Shanghai Is Extending Lockdowns Due To Exponentially Rising COVID Cases Shanghai Is Extending Lockdowns Due To Exponentially Rising COVID Cases The economic impact of China’s struggle with another wave of COVID outbreaks is showing up in March’s PMI and high-frequency data. The highly contagious nature of the Omicron variant suggests that Shanghai’s battle against the virus spread may last longer than the market has priced in. Chinese authorities will continue playing whack-a-mole in efforts to eliminate the country’s COVID cases. The zero-COVID approach and the virus’ mutating to more contagious variants mean that the country may have to impose more frequent mobility restrictions going forward than in the past two years. Although Chinese policymakers are determined to stabilize the economy, the ongoing combat with COVID will weigh down the effectiveness of the stimulus. In relative terms, we maintain a neutral position on Chinese onshore stocks. However, downshifting corporate profits and the economic shock from lockdowns remain significant risks to the absolute performance of Chinese stocks. Bottom Line: China’s combat against the current COVID-19 outbreaks may last longer than the market has priced in. In the near term, the lockdowns will weigh down the effectiveness of the stimulus. In the second half of the year, the more contagious virus mutations and China’s sticking to zero-COVID strategy may lead to more frequent disruptions to business activity.     Chart 1China Is Bracing For The Worst COVID Outbreak Since Early 2020 China Is Bracing For The Worst COVID Outbreak Since Early 2020 China Is Bracing For The Worst COVID Outbreak Since Early 2020 China’s efforts to stabilize economic growth are facing new challenges, dampening an already fragile recovery. The current wave of COVID-19 outbreaks — the worst since early 2020 — has infected more than 100,000 (TK) people across the country, and the number of new cases is still rising at an exponential rate (Chart 1). Measures to contain the spread of the virus have led to city lockdowns, halted factory production and have dragged down the tourism and catering industries. In previous reports, we noted that it is challenging for China to reach this year’s 5.5% growth target due to downbeat private-sector sentiment and subdued demand for housing. The outlook for China’s economy is grimmer now. The highly contagious COVID virus mutations, including the emerging Omicron BA.2 variant, will make it more difficult for China to control its domestic outbreaks going forward. We do not expect that China will fundamentally change its zero-COVID policy throughout the rest of this year. Therefore, the country will probably see more frequent regional and city lockdowns this year than in the past two years.  The leadership will calibrate its handling of these lockdowns to minimize damage to the economy, and Beijing will continue stepping up its growth support policies. However, the whack-a-mole strategy to eliminate domestic COVID cases will be disruptive to business activity and dampen the effectiveness of policy easing. A One-Two Punch… Related Report  China Investment StrategyA Choppy Bottom The downside risks to China’s economy stemming from the ongoing domestic COVID outbreaks are adding to the difficulties the country is already facing due to subdued domestic demand. As we have been highlighting in our previous reports, weak private sector sentiment has been weighing down the effectiveness of authorities’ efforts to stimulate the Chinese economy. The sluggish PMI data released last week in part reflects the impact of restrictions imposed to control the latest wave of COVID-19 infections, but also highlights the bleak domestic demand conditions. Notably, the March PMI survey does not capture the full impact of the Shanghai lockdown as the data collection period ended before the restrictions went into effect on March 28. The official composite PMI fell from 51.2 to 48.8 – below the 50 boom-bust threshold and the lowest reading since February 2020. The drop reflects a slump in the manufacturing and – to a greater extent – the non-manufacturing sectors, which both fell into a contractionary territory. The manufacturing PMI slid 0.7 points to 49.5, while the non-manufacturing PMI dropped 3.2 points to 48.4 (Chart 2). The new orders sub-index of the manufacturing PMI lost nearly two percentage points and deteriorated more sharply than the production index (Chart 3). Moreover, the spread between the new orders component and new export orders – a proxy for domestic demand – ticked down in March (Chart 3, bottom panel). This indicates that weak production does not just stem from COVID-related supply-side issues, but also from poor domestic demand conditions. Chart 2Chinese PMIs Slide Into Contractionary Territory Chinese PMIs Slide Into Contractionary Territory Chinese PMIs Slide Into Contractionary Territory Chart 3Economic Shock From Lockdowns Compounds An Already Weak Domestic Demand Economic Shock From Lockdowns Compounds An Already Weak Domestic Demand Economic Shock From Lockdowns Compounds An Already Weak Domestic Demand Chart 4Auto Inventory Index Jumped To Highest Since Early 2020 Auto Inventory Index Jumped To Highest Since Early 2020 Auto Inventory Index Jumped To Highest Since Early 2020 In addition, high-frequency data from the China Automobile Dealers Association shows that the Vehicle Inventory Alert Index (VIAI) – a survey that measures destocking pressures in the automobile industry – jumped to the highest level since the first wave of COVID-19 hit China in early 2020 (Chart 4). A rising VIAI above the 50-percent threshold indicates that auto inventories are cumulating at a faster pace than demand.  Importantly, the cities and regions that have been worst hit by this round of COVID outbreaks are mostly coastal metropolises and business hubs such as Shanghai, Shenzhen and cities in Jiangsu and Zhejiang provinces. These cities and provinces represent more than 20% of China’s aggregate GDP and almost 30% of the country’s total import and export volume. As such, the negative impact on China’s overall economy from the lockdowns will be more substantive than during the previous waves. Measures to contain Shanghai’s worst-ever COVID outbreak are also disrupting operations at the world’s busiest container port, adding strains to the already overstretched global shipping industry (Chart 5). The supplier delivery times subindex of the manufacturing PMI dropped to 46.5 in March, the lowest reading since March 2020 (Chart 6). This suggests that suppliers’ delivery times have lengthened with near-term supply chain pressure, since lower readings reflect longer delivery times. Chart 5Shanghai Lockdowns Will Disrupt The Already Overstretched Global Shipping Industry Shanghai Lockdowns Will Disrupt The Already Overstretched Global Shipping Industry Shanghai Lockdowns Will Disrupt The Already Overstretched Global Shipping Industry Chart 6Chinese Suppliers' Delivery Times Have Lengthened Chinese Suppliers' Delivery Times Have Lengthened Chinese Suppliers' Delivery Times Have Lengthened Bottom Line: The economic shock from the current COVID outbreaks is compounding an already weak domestic demand in China. Since the cities and regions that are affected by this round of lockdowns are some of China’s most developed metropolitan areas, the negative impact will likely be larger than during the past two years. How Long Will The Battle Last? China’s struggle to contain the current round of domestic COVID outbreaks will likely last longer than the market has priced in. There is also a non-trivial risk that during the rest of the year, the country will need to shutter large parts of its economy more frequently to combat the spread of COVID variants, which appear to become more contagious as the mutation continues. The lockdowns in Shanghai have already been extended beyond the originally announced two-phased, eight-day restriction plan (Chart 7). The first phase of the lockdown, for which restrictions were due to be lifted on the morning of April 1, has now been extended to anywhere between 3 to 10 days. It may take Shanghai, a city of 25 million residents, between four to six weeks to bring the number of new cases down to a level that is acceptable to the authorities. Chart 7Shanghai Is Extending Its Two-Phased, Eight-Day Lockdowns Bracing For More Turbulence Bracing For More Turbulence Shenzhen, a dynamic metropolitan city bordering Hong Kong, seems to have successfully contained its COVID outbreaks after only one week of a city-wide lockdown. However, Shenzhen imposed lockdowns at an early stage of the outbreak, when both confirmed and asymptomatic case numbers in the city were in the low double digits. Shanghai, on the other hand, took more stringent measures when the number of asymptomatic cases had already reached nearly a thousand. The Omicron variant is four times more transmissible than the earlier Delta mutation, which means it will generate an explosive rise in cases and make containing the virus spread much more difficult than with Delta. In a fully susceptible (unvaccinated and uninfected) population, one person with Delta would on average infect five other people, while one person with Omicron could transmit the virus to about 20 others. As a result, despite a relatively low number of newly confirmed cases, the surging asymptomatic cases in Shanghai imply that a larger population in the city might have already been infected (Chart 8). China’s struggle with the current wave of COVID outbreaks may be an example of what lies ahead, as continuously mutating variants become more contagious and will pose fresh new challenges to China’s zero-COVID approach. The latest strain of Omicron BA.2 appears to be 40% more contagious than the original Omicron strain and is quickly spreading around the world. The number of cases has spiked across much of Europe, parts of Asia, and has begun to rise in North America (Chart 9). It took only two months from when China reported its first local Omicron BA.1 case in early January to the outbreaks of Omicron BA.2 in March. Chart 8Surging Asymptomatic Patients In Shanghai Imply More Confirmed Cases Still To Come Surging Asymptomatic Patients In Shanghai Imply More Confirmed Cases Still To Come Surging Asymptomatic Patients In Shanghai Imply More Confirmed Cases Still To Come Chart 9Covid Cases Are On The Rise Again Globally Bracing For More Turbulence Bracing For More Turbulence This presents the Chinese authorities with a difficult dilemma: impose severe mobility restrictions when domestic cases pop up, or let the virus run rampant and develop a herd immunity among much of its population. China’s leadership has recently reiterated that the country will stick to its zero-COVID strategy. The success that China has had in suppressing the virus in the past two years has left its population with little natural immunity. Moreover, while China’s overall vaccination rate is high at 85%, less than 50% of people over the age of 80 in the country are fully vaccinated. The authorities have been fine tuning their measures to control the virus spread while sticking to a zero-COVID approach. The recently calibrated measures include allowing residents to take rapid antigen tests at home, quarantining people with asymptomatic COVID cases at dedicated isolation centers rather than hospitals, and monitoring patients for shorter periods than previously required. China has also fast-tracked the approval for the importing and domestic manufacturing of Paxlovid, which is highly effective at preventing hospitalization if taken within five days of the onset of symptoms. In addition, the global production of antiviral drugs is starting to ramp up (Chart 10). Nonetheless, China will probably wait until the antiviral drugs are in sufficient supply before fundamentally relaxing its zero-COVID policy. In the meantime, while the country’s economic growth will rebound when the current wave of COVID cases subsides, disruptive outbreaks and lockdowns may become more frequent as the authorities continue to play whack-a-mole with COVID (Chart 11). As a result, business activity in China will suffer. Chart 10Production Of New COVID Drugs Is Picking Up Production Of New COVID Drugs Is Picking Up Production Of New COVID Drugs Is Picking Up Chart 11China Has The Most Stringent COVID-Control Measures Among Large Economies China Has The Most Stringent COVID-Control Measures Among Large Economies China Has The Most Stringent COVID-Control Measures Among Large Economies Bottom Line: Shanghai’s current battle with COVID outbreaks will likely continue in the coming weeks. Before China can relax its zero-COVID policy, the more contagious COVID virus mutations in the future will see Chinese authorities adopt even harsher quarantine and control measures, which will disrupt economic activity further. Investment Conclusion  Chinese stocks in both onshore and offshore markets have recovered some ground from their deeply oversold conditions in mid-March (Chart 12A). While the risk-reward profile for the A-share market warrants a neutral position in a global portfolio, in absolute terms both on- and offshore Chinese stock prices have probably not reached their bottom (Chart 12B). Chart 12AChinese Stocks Will Likely Fall Further In Q2 Chinese Stocks Will Likely Fall Further In Q2 Chinese Stocks Will Likely Fall Further In Q2 Chart 12BIn Relative Terms, Stay Neutral On Chinese Onshore Stocks In Relative Terms, Stay Neutral On Chinese Onshore Stocks In Relative Terms, Stay Neutral On Chinese Onshore Stocks The private sector’s downbeat sentiment, households’ subdued demand for housing, and the ongoing COVID-19 lockdowns pose significant near-term downside risks to China’s economy and corporate profits. February’s credit impulse shows that corporate and household demand for credit has been weakening. Without a major reversal in corporate credit and the property market, a strong business cycle recovery is unlikely in China. Moreover, the March PMI readings suggest that the lockdowns in China’s business and manufacturing hubs will have substantial negative impacts on the economy. As such, we maintain our neutral stance on Chinese onshore stocks and continue to recommend underweight Chinese offshore stocks in a global portfolio.   Jing Sima China Strategist jings@bcaresearch.com   Strategic Themes Cyclical Recommendations