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Highlights The neutral rate of interest in the US is 3%-to-4% in nominal terms or 1%-to-2% in real terms, which is substantially higher than the Fed believes and the market is discounting. The end of the household deleveraging cycle, rising wealth, stronger capital spending and homebuilding, and a structurally looser fiscal stance have all increased aggregate demand. In addition, deglobalization and population aging are depleting global savings, raising the neutral rate in the process. A higher neutral rate implies that monetary policy is currently more stimulative than widely perceived. This is good news for stocks, as it reduces the near-term odds of a recession. The longer-term risk is that monetary policy will stay too loose for too long, causing the US economy to overheat. This could prompt the Fed to raise rates well above neutral, an outcome that would certainly spell the end of the secular equity bull market. Investors should overweight stocks in 2022 but look to turn more defensive in late 2023. We are taking partial profits on our long December-2022 Brent futures trade, which is up 17.3% since inception. We are also closing our short meme stocks trade. AMC and GME are down 53% and 47%, respectively, since we initiated it.  The Neutral Rate Matters At first glance, the neutral rate of interest – the interest rate consistent with full employment and stable inflation – seems like a concept only an egghead economist would care about. After all, unlike actual interest rates, the neutral rate cannot be observed in real time. The best one can do is deduce it after the fact, something that does not seem very relevant for investment decisions. While this perspective is understandable, it is misguided. The yield on a long-term bond is largely a function of what investors expect short-term rates to be over the life of the bond. Today, investors expect the Fed to raise rates to only 1.75% during this tightening cycle, a far cry from previous peaks in interest rates (Chart 1). Chart 2Investor Worries That The Fed Will Tighten Too Much Has Led To A Flattening Of The Yield Curve Investor Worries That The Fed Will Tighten Too Much Has Led To A Flattening Of The Yield Curve Investor Worries That The Fed Will Tighten Too Much Has Led To A Flattening Of The Yield Curve Chart 1Expected Rate Hikes Are A Far Cry From Previous Peaks In Interest Rates Expected Rate Hikes Are A Far Cry From Previous Peaks In Interest Rates Expected Rate Hikes Are A Far Cry From Previous Peaks In Interest Rates     Far from worrying that the Fed will keep rates too low for too long in the face of high inflation, investors are worried that the Fed will tighten too much. This is the main reason why the yield curve has flattened over the past three months and the 20-year/30-year portion of the yield curve has inverted (Chart 2). Secular Stagnation Remains The Consensus View Why are so many investors convinced that the Fed will be unable to raise rates all that much over the next few years? The answer is that most investors have bought into the secular stagnation thesis, which posits that the neutral rate of interest has fallen dramatically over time. The secular stagnation thesis comes in two versions: The first or “strong form” describes an economy that needs a deeply negative – and hence unattainable – nominal interest rate to reach full employment. Japan comes to mind as an example. The country has had near-zero interest rates since the mid-1990s; and yet it continues to suffer from deflation. The second or "weak form" describes the case where a country needs a low, but still positive, interest rate to reach full employment. Such an interest rate is attainable by the central bank, and hence creates a goldilocks outlook for investors where profits return to normal, but asset prices continue to get propped up by an ultra-low discount rate. The “weak form” version of the secular stagnation thesis arguably describes the United States. Post-GFC Deleveraging Pushed Down The Neutral Rate Chart 3 One can think of the neutral rate as the interest rate that equates aggregate demand with aggregate supply at full employment. If something causes the aggregate demand curve to shift inwards, a lower real interest rate would be required to bring demand back up (Chart 3). Like many other countries, the US experienced a prolonged deleveraging cycle following the Global Financial Crisis. The ratio of household debt-to-GDP has declined by 23 percentage points since 2008. The need for households to repair their balance sheets weighed on spending, thus necessitating a lower interest rate. Admittedly, corporate debt has risen over the past decade, with the result that overall private debt has remained broadly stable as a share of GDP (Chart 4). However, the drag on aggregate demand from declining household debt was not offset by the boost to demand from rising corporate debt. Whereas falling household debt curbed consumer spending, rising corporate debt did little to boost investment spending. This is because most of the additional corporate debt went into financial engineering – including share buybacks and M&A activity – rather than capex. In fact, the average age of the private-sector capital stock has increased from 21 years in 2010 to 23.4 years at present (Chart 5). Chart 4Household Debt Has Fallen From Its Highs, While Corporate Debt Has Risen Since The GFC Household Debt Has Fallen From Its Highs, While Corporate Debt Has Risen Since The GFC Household Debt Has Fallen From Its Highs, While Corporate Debt Has Risen Since The GFC Chart 5The Average Age Of Capital Stock Has Been Increasing The Average Age Of Capital Stock Has Been Increasing The Average Age Of Capital Stock Has Been Increasing Buoyant Consumer And Business Spending Will Prop Up The Neutral Rate Today, the US economy finds itself in a far different spot than 12 years ago. Households are borrowing again. Consumer credit rose by $40 billion in November, the largest monthly increase on record, and double the consensus estimate (Chart 6). Banks are easing lending standards across all consumer loan categories (Chart 7). Chart 6Big Jump In Consumer Credit Big Jump In Consumer Credit Big Jump In Consumer Credit Chart 7Banks Are Easing Lending Standards For All Consumer Loans Banks Are Easing Lending Standards For All Consumer Loans Banks Are Easing Lending Standards For All Consumer Loans Chart 8Net Worth Has Soared Over The Past Two Years Net Worth Has Soared Over The Past Two Years Net Worth Has Soared Over The Past Two Years Meanwhile, years of easy money have pushed up asset prices, a dynamic that was only supercharged by the pandemic. We estimate that household wealth rose by 145% of GDP between the end of 2019 and the end of 2021 – the largest two-year increase on record (Chart 8). A back-of-the-envelope calculation suggests that this increase in wealth could boost aggregate demand by 5%.1 Reacting to the prospect of stronger final demand, businesses are ramping up capex (Chart 9). After moving sideways for two decades, capital goods orders have soared. Surveys of capex intentions remain at elevated levels. Against the backdrop of empty shelves and warehouses, inventory investment should also remain robust. Residential investment will increase (Chart 10). The homeowner vacancy rate has dropped to a record low, as have inventories of new and existing homes for sale. Homebuilder sentiment rose to a 10-month high in December. Building permits are 11% above pre-pandemic levels. Amazingly, homebuilders are trading at only 7-times forward earnings. We recommend owning the sector. Chart 9Investment Spending Will Stay Strong Investment Spending Will Stay Strong Investment Spending Will Stay Strong Chart 10US Housing Will Remain Well Supported US Housing Will Remain Well Supported US Housing Will Remain Well Supported Fiscal Policy: Tighter But Not Tight Chart 11Chinese Credit Impulse Seems To Be Bottoming Chinese Credit Impulse Seems To Be Bottoming Chinese Credit Impulse Seems To Be Bottoming As in most other countries, the US budget deficit will decline over the next few years, as pandemic-related measures roll off and tax receipts increase on the back of a strengthening economy. Nevertheless, we expect the structural budget deficit to remain 1%-to-2% of GDP larger in the post-pandemic period, following the passage of the infrastructure bill last November and what is likely to be a slimmed down social spending package focusing on green energy, universal pre-kindergarten, and health insurance subsidies. The shift towards structurally more accommodative fiscal policies will play out in most other major economies. In the euro area, spending under the Next Generation EU recovery fund will accelerate later this year, with southern Europe being the primary beneficiary. In Japan, the government has approved a US$315 billion supplementary budget. Matt Gertken, BCA’s Chief Geopolitical Strategist, expects Prime Minister Kishida to pursue a quasi-populist agenda ahead of the upper house election on July 25th.  China is also set to loosen policy. The Ministry of Finance has indicated that it intends to “proactively” support growth in 2022. For its part, the PBoC cut the reserve requirement ratio by 50 basis points on December 6th. The 6-month credit impulse has already turned up (Chart 11). More Than The Sum Of Their Parts Chart 12The Labor Share Typically Rises When Unemployment Falls The Labor Share Typically Rises When Unemployment Falls The Labor Share Typically Rises When Unemployment Falls As discussed above, the end of the deleveraging cycle, rising household wealth, stronger capital spending and homebuilding, and a structurally looser fiscal stance have all increased aggregate demand in the US. While each of these factors have independently raised the neutral rate of interest, taken together, the impact has been even greater. For example, stronger consumption has undoubtedly incentivized greater investment by firms eager to expand capacity. Strong GDP growth, in turn, has pushed up asset prices, leading to even more spending. Furthermore, a tighter labor market has propped up wage growth, especially among low-wage workers. Historically, labor’s share of overall national income has increased when unemployment has fallen (Chart 12). To the extent that workers spend more of their income than capital owners, a higher labor share raises aggregate demand, thus putting upward pressure on the neutral rate. The Retreat From Globalization Will Push Up The Neutral Rate… Chart 13The Ratio Of Global Trade-To-Output Has Been Flat For Over A Decade The Ratio Of Global Trade-To-Output Has Been Flat For Over A Decade The Ratio Of Global Trade-To-Output Has Been Flat For Over A Decade Globalization lowered the neutral rate of interest both because it shifted the balance of power from workers to businesses; and also because it allowed countries such as the US, which run chronic current account deficits, to import foreign capital rather than relying exclusively on domestic savings.  The era of hyperglobalization has ended, however. The ratio of global trade-to-manufacturing output has been flat for over a decade (Chart 13). Looking out, the ratio could decline as geopolitical tensions between China and the rest of the world continue to simmer, and more companies shift production back home in order to gain greater control over the supply chains of essential goods. … As Will Population Aging Chart 14Most Of The Deceleration In US Potential Real GDP Growth Has Already Taken Place Most Of The Deceleration In US Potential Real GDP Growth Has Already Taken Place Most Of The Deceleration In US Potential Real GDP Growth Has Already Taken Place Aging populations can affect the neutral rate either by dragging down investment demand or by reducing savings. The former would lead to a lower neutral rate, while the latter would lead to a higher rate. As Chart 14 shows, most of the decline in US potential GDP growth has already occurred. According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today, mainly due to slower labor force growth. The CBO expects potential growth to edge down to 1.7% over the next few decades. In contrast, the depletion of national savings from an aging population is just beginning. Baby boomers are leaving the labor force en masse. They hold over half of US household wealth, considerably more than younger generations (Chart 15). As baby boomers transition from net savers to net dissavers, national savings will fall, leading to a higher neutral rate. The pandemic has accelerated this trend insomuch as it has caused about 1.2 million workers to retire earlier than they would have otherwise (Chart 16). Chart 15 Chart 16Number Of Retired People Jumped During The Pandemic Number Of Retired People Jumped During The Pandemic Number Of Retired People Jumped During The Pandemic To What Extent Are Higher Rates Self-Limiting? Some commentators contend that any effort by central banks to bring policy rates towards neutral would reduce aggregate demand by so much that it would undermine the rationale for why the neutral rate had increased in the first place. In particular, they argue that higher rates would drag down asset prices, thus curbing the magnitude of the wealth effect. While there is some truth to this argument, its proponents overstate their case. History suggests that stocks tend to brush off rising bond yields, provided that yields do not rise to prohibitively high levels (Table 1). Table 1As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover The New Neutral The New Neutral Chart 17The Equity Risk Premium Remains High The Equity Risk Premium Remains High The Equity Risk Premium Remains High The last five weeks are a case in point. Both 10-year and 30-year Treasury yields have risen nearly 40 bps since December 3rd. Yet, the S&P 500 has gained 2.7% since then. Keep in mind that the forward earnings yield for US stocks still exceeds the real bond yield by 552 bps, which is quite high by historic standards. The gap between earnings yields and real bond yields is even greater abroad (Chart 17). Thus, stocks have scope to absorb an increase in bond yields without a significant PE multiple contraction. Investment Implications Our analysis suggests that the neutral rate of interest in the US is substantially higher than widely believed. How much higher is difficult to gauge, but our guess is that in real terms, it is between 1% and 2%. This is substantially higher than survey measures of the neutral rate, which peg it at close to 0% in real terms (Chart 18). It is also significantly higher than 10-year and 30-year TIPS yields, which stand at -0.73% and -0.17%, respectively (Chart 19). The neutral rate has also increased in other economies, although not as much as in the US. Chart 18Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Chart 19Long-Term Real Rates Remain Depressed Long-Term Real Rates Remain Depressed Long-Term Real Rates Remain Depressed If the neutral rate turns out to be higher than the consensus view, then monetary policy is currently more stimulative than widely perceived. That is good news for stocks, as it would reduce the near-term odds of a recession. Hence, we remain positive on stocks over a 12-month horizon, with a preference for non-US equities. In terms of sector preferences, we maintain our bias for banks over tech. The longer-term risk is that monetary policy will stay too easy, causing the economy to overheat. This could prompt the Fed to raise rates well above neutral, an outcome that would certainly spell the end of the secular equity bull market. Such a day of reckoning could be reached by late 2023. Two Trade Updates We are taking partial profits on our long December-2022 Brent futures trade by cutting our position by 50%. The trade is up 17.3% since inception. Bob Ryan, BCA’s Chief Commodity Strategist, still sees upside for oil prices, so we are keeping the other half of our position for the time being. We are also closing our short meme stocks trade. AMC and GME are down 53% and 47%, respectively, since we initiated it. While the outlook for both companies remains challenging, there is an outside chance that they will find a way to leverage their meme status to create profitable businesses. This makes us inclined to move to the sidelines.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 In line with published estimates, we assume that households spend 5 cents of every one dollar increase in housing wealth, 2 cents of every dollar increase in equity wealth, 10 cents out of bank deposits, and 2 cents out of other assets. Of the 145% of GDP in increased household net worth between the end of 2019 and the end of 2021, 19% stemmed from higher housing wealth, 52% from higher equity wealth, 12% from higher bank deposits, and 17% from other categories.    View Matrix Image Special Trade Recommendations Current MacroQuant Model Scores Image

Highlights Our three strategic themes over the long run: (1) great power rivalry (2) hypo-globalization (3) populism and nationalism. The implications are inflationary over the long run. Nations that gear up for potential conflict and expand the social safety net to appease popular discontent will consume a lot of resources. Our three key views for 2022: (1) China’s reversion to autocracy (2) America’s policy insularity (3) petro-state leverage. The implications are mostly but not entirely inflationary: China will ease policy, the US will pass more stimulus, and energy supply may suffer major disruptions. Stay long gold, neutral US dollar, short renminbi, and short Taiwanese dollar. Stay tactically long global large caps and defensives. Buy aerospace/defense and cyber-security stocks. Go long Japanese and Mexican equities – both are tied to the US in an era of great power rivalry. Feature Chart 1US Resilience US Resilience US Resilience Global investors have not yet found a substitute for the United States. Despite a bout of exuberance around cyclical non-US assets at the beginning of 2021, the year draws to a close with King Dollar rallying, US equities rising to 61% of global equity capitalization, and the US 30-year Treasury yield unfazed by inflation fears (Chart 1). American outperformance is only partly explained by its handling of the lingering Covid-19 pandemic. The US population was clearly less restricted by the virus (Chart 2). But more to the point, the US stimulated its economy by 25% of GDP over the course of the crisis, while the average across major countries was 13% of GDP. Americans are still more eager to go outdoors and the government has been less stringent in preventing them (Chart 3). Chart 2 ​​​​​ Chart 3Social Restrictions Short Of Lockdown Social Restrictions Short Of Lockdown Social Restrictions Short Of Lockdown ​​​​​​ Going forward, the pandemic should decline in relevance, though it is still possible that a vaccine-resistant mutation will arise that is deadlier for younger people, causing a new round of the crisis. The rotation into assets outside the US will be cautious. Across the world, monetary and credit growth peaked and rolled over this year, after the extraordinary effusion of stimulus to offset the social lockdowns of 2020 (Chart 4). Government budget deficits started to normalize while central banks began winding down emergency lending and bond-buying. More widespread and significant policy normalization will get under way in 2022 in the face of high core inflation. Tightening will favor the US dollar, especially if global growth disappoints expectations. Chart 4Waning Monetary And Credit Stimulus Waning Monetary And Credit Stimulus Waning Monetary And Credit Stimulus Chart 5Global Growth Stabilization Global Growth Stabilization Global Growth Stabilization Global manufacturing activity fell off its peak, especially in China, where authorities tightened monetary, fiscal, and regulatory policy aggressively to prevent asset bubbles from blowing up (Chart 5). Now China is easing policy on the margin, which should shore up activity ahead of an important Communist Party reshuffle in fall 2022. The rest of the world’s manufacturing activity is expected to continue expanding in 2022, albeit less rapidly. This trend cuts against US outperformance but still faces a range of hurdles, beginning with China. In this context, we outline three geopolitical themes for the long run as well as three key views for the coming 12 months. Our title, “The Gathering Storm,” refers to the strategic challenge that China and Russia pose to the United States, which is attempting to form a balance-of-power coalition to contain these autocratic rivals. This is the central global geopolitical dynamic in 2022 and it is ultimately inflationary. Three Strategic Themes For The Long Run The international system will remain unstable in the coming years. Global multipolarity – or the existence of multiple, competing poles of political power – is the chief destabilizing factor. This is the first of our three strategic themes that will persist next year and beyond (Table 1). Our key views for 2022, discussed below, flow from these three strategic themes. Table 1Strategic Themes For 2022 And Beyond 2022 Key Views: The Gathering Storm 2022 Key Views: The Gathering Storm 1. Great Power Rivalry Multipolarity – or great power rivalry – can be illustrated by the falling share of US economic clout relative to the rest of the world, including but not limited to strategic rivals like China. The US’s decline is often exaggerated but the picture is clear if one looks at the combined geopolitical influence of the US and its closest allies to that of the EU, China, and Russia (Chart 6). Chart 6 China’s rise is the most destabilizing factor because it comes with economic, military, and technological prowess that could someday rival the US for global supremacy. China’s GDP has surpassed that of the US in purchasing power terms and will do so in nominal terms in around five years (Chart 7). Chart 7 True, China’s potential growth is slowing and Chinese financial instability will be a recurring theme. But that very fact is driving Beijing to try to convert the past 40 years of economic success into broader strategic security. Chart 8America's Global Role Persists (If Lessened) America's Global Role Persists (If Lessened) America's Global Role Persists (If Lessened) ​​​​​ Since China is capable of creating an alternative political order in Asia Pacific, and ultimately globally, the United States is reacting. It is penalizing China’s economy and seeking to refurbish alliances in pursuit of a containment policy. The American reaction to the loss of influence has been unpredictable, contradictory, and occasionally belligerent. New isolationist impulses have emerged among an angry populace in reaction to gratuitous wars abroad and de-industrialization. These impulses appeared in both the Obama and Trump administrations. The Biden administration is attempting to manage these impulses while also reinforcing America’s global role. The pandemic-era stimulus has enabled the US to maintain its massive trade deficit and aggressive defense spending. But US defense spending is declining relative to the US and global economy over time, encouraging rival nations to carve out spheres of influence in their own neighborhoods (Chart 8). Russia’s overall geopolitical power has declined but it punches above its weight in military affairs and energy markets, a fact which is vividly on display in Ukraine as we go to press. The result is to exacerbate differences in the trans-Atlantic alliance between the US and the European Union, particularly Germany. The EU’s attempt to act as an independent great power is another sign of multipolarity, as well as the UK’s decision to distance itself from the continent and strengthen the Anglo-American alliance. If the US and EU do not manage their differences over how to handle Russia, China, and Iran then the trans-Atlantic relationship will weaken and great power rivalry will become even more dangerous. 2. Hypo-Globalization The second strategic theme is hypo-globalization, in which the ancient process of globalization continues but falls short of its twenty-first century potential, given advances in technology and governance that should erode geographic and national boundaries. Hypo-globalization is the opposite of the “hyper-globalization” of the 1990s-2000s, when historic barriers to the free movement of people, goods, and capital seemed to collapse overnight. Chart 9From 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization The volume of global trade relative to industrial production  peaked with the Great Recession in 2008-10 and has declined slowly but surely ever since (Chart 9). Many developed markets suffered the unwinding of private debt bubbles, while emerging economies suffered the unwinding of trade manufacturing. Periods of declining trade intensity – trade relative to global growth – suggest that nations are turning inward, distrustful of interdependency, and that the frictions and costs of trade are rising due to protectionism and mercantilism. Over the past two hundred years globalization intensified when a broad international peace was agreed (such as in 1815) and a leading imperial nation was capable of enforcing law and order on the seas (such as the British empire). Globalization fell back during times of “hegemonic instability,” when the peace settlement decayed while strategic and naval competition eroded the global trading system. Today a similar process is unfolding, with the 1945 peace decaying and the US facing the revival of Russia and China as regional empires capable of denying others access to their coastlines and strategic approaches (Chart 10).1 Chart 10Hypo-Globalization And Hegemonic Instability Hypo-Globalization And Hegemonic Instability Hypo-Globalization And Hegemonic Instability Chart 11Hypo-Globalization: Temporary Trade Rebound Hypo-Globalization: Temporary Trade Rebound Hypo-Globalization: Temporary Trade Rebound No doubt global trade is rebounding amid the stimulus-fueled recovery from Covid-19. But the upside for globalization will be limited by the negative geopolitical environment (Chart 11). Today governments are not behaving as if they will embark on a new era of ever-freer movement and ever-deepening international linkages. They are increasingly fearful of each other’s strategic intentions and using fiscal resources to increase economic self-sufficiency. The result is regionalization rather than globalization. Chinese and Russian attempts to revise the world order, and the US’s attempt to contain them, encourages regionalization. For example, the trade war between the US and China is morphing into a broader competition that limits cooperation to a few select areas, despite a change of administration in the United States. The further consolidation of President Xi Jinping’s strongman rule will exacerbate this dynamic of distrust and economic divorce. Emerging Asia and emerging Europe live on the fault lines of this shift from globalization to regionalism, with various risks and opportunities. Generally we are bullish EM Asia and bearish EM Europe. 3. Populism And Nationalism A third strategic theme consists of populism and nationalism, or anti-establishment political sentiment in general. These forces will flare up in various forms across the world in 2022 and beyond. Even as unemployment declines, the rise in food and fuel inflation will make it difficult for low wage earners to make ends meet. The “misery index,” which combines unemployment and inflation, spiked during the pandemic and today stands at 10.8% in the US and 11.4% in the EMU, up from 5.2% and 8.1% before the pandemic, respectively (Chart 12). Large budget deficits and trade deficits, especially in the US and UK, feed into this inflationary environment. Most of the major developed markets have elected new governments since the pandemic, with the notable exception of France and Spain. Thus they have recapitalized their political systems and allowed voters to vent some frustration. These governments now have some time to try to mitigate inflation before the next election. Hence policy continuity is not immediately in jeopardy, which reduces uncertainty for investors. By contrast, many of the emerging economies face higher inflation, weak growth, and are either coming upon elections or have undemocratic political systems. Either way the result will be a failure to address household grievances promptly. The misery index is trending upward and governments are continually forced to provide larger budget deficits to shore up growth, fanning inflation (Chart 13). Chart 12DM: Political Risk High But New Governments In Place DM: Political Risk High But New Governments In Place DM: Political Risk High But New Governments In Place ​​​​​ Chart 13EM: Political Risk High But Governments Not Recapitalized EM: Political Risk High But Governments Not Recapitalized EM: Political Risk High But Governments Not Recapitalized ​​​​​​ Chart 14EM Populism/Nationalism Threatens Negative Surprises In 2022 EM Populism/Nationalism Threatens Negative Surprises In 2022 EM Populism/Nationalism Threatens Negative Surprises In 2022 Just as social and political unrest erupted after the Great Recession, notably in the so-called “Arab Spring,” so will new movements destabilize various emerging markets in the wake of Covid-19. Regime instability and failure can lead to big changes in policies, large waves of emigration, wars, and other risks that impact markets. The risks are especially high unless and until Chinese imports revive. Investors should be on the lookout for buying opportunities in emerging markets once the bad news is fully priced. National and local elections in Brazil, India, South Korea, the Philippines, and Turkey will serve as market catalysts, with bad news likely to precede good news (Chart 14). Bottom Line: These three themes – great power rivalry, hypo-globalization, and populism/nationalism – are inflationary in theory, though their impact will vary based on specific events. Multipolarity means that governments will boost industrial and defense spending to gear up for international competition. Hypo-globalization means countries will attempt to put growth on a more reliable domestic foundation rather than accept dependency on an unreliable international scene, thus constraining supplies from abroad. Populism and nationalism will lead to a range of unorthodox policies, such as belligerence abroad or extravagant social spending at home. Of course, the inflationary bias of these themes can be upset if they manifest in ways that harm growth and/or inflation expectations, which is possible. But the general drift will be an inflationary policy setting. Inflation may subside in 2022 only to reemerge as a risk later. Three Key Views For 2022 Within this broader context, our three key views for 2022 are as follows: 1. China’s Reversion To Autocracy As President Xi Jinping leads China further down the road of strongman rule and centralization, the country faces a historic confluence of internal and external risks. This was our top view in 2021 and the same dynamic continues in 2022. The difference is that in 2021 the risk was excessive policy tightening whereas this coming year the risk is insufficient policy easing. Chart 15China Eases Fiscal Policy To Secure Recovery In 2022 China Eases Fiscal Policy To Secure Recovery In 2022 China Eases Fiscal Policy To Secure Recovery In 2022 China’s economy is witnessing a secular slowdown, a deterioration in governance, property market turmoil, and a rise in protectionism abroad. The long decline in corporate debt growth points to the structural slowdown. Animal spirits will not improve in 2022 so government spending will be necessary to try to shore up overall growth. The Politburo signaled that it will ease fiscal policy at the Central Economic Work Conference in early December, a vindication of our 2021 view. Neither the combined fiscal-and-credit impulse nor overall activity, indicated by the Li Keqiang Index, have shown the slightest uptick yet (Chart 15). Typically it takes six-to-nine months for policy easing to translate to an improvement in real economic activity. The first half of the year may still bring economic disappointments. But policymakers are adjusting to avoid a crash. Policy will grow increasingly accommodative as necessary in the first half of 2022. The key political constraint is the Communist Party’s all-important political reshuffle, the twentieth national party congress, to be held in fall 2022 (usually October). While Xi may not want the economy to surge in 2022, he cannot afford to let it go bust. The experience of previous party congresses shows that there is often a policy-driven increase in bank loans and fixed investment. Current conditions are so negative as to ensure that the government will provide at least some support, for instance by taking a “moderately proactive approach” to infrastructure investment (Chart 16). Otherwise a collapse of confidence would weaken Xi’s faction and give the opposition faction a chance to shore up its position within the Communist Party. Chart 16China Aims For Stability, Not Rapid Growth, Ahead Of 20th National Party Congress China Aims For Stability, Not Rapid Growth, Ahead Of 20th National Party Congress China Aims For Stability, Not Rapid Growth, Ahead Of 20th National Party Congress Party congresses happen every five years but the ten-year congresses, such as in 2022, are the most important for the country’s overall political leadership. The party congresses in 1992, 2002, and 2012 were instrumental in transferring power from one leader to the next, even though the transfer of power was never formalized. Back in 2017 Xi arranged to stay in power indefinitely but now he needs to clinch the deal, lest any unforeseen threat emerge from at home or abroad. Xi’s success in converting the Communist Party from “consensus rule” to his own “personal rule” will be measurable by his success in stacking the Politburo and Politburo Standing Committee with factional allies. He will also promote his faction across the Central Committee so as to shape the next generations of party leaders and leave his imprint on policy long after his departure. The government will be extremely sensitive to any hint of dissent or resistance and will move aggressively to quash it. Investors should not be surprised to see high-level sackings of public officials or private magnates and a steady stream of scandals and revelations that gain prominence in western media. The environment is also ripe for strange and unexpected incidents that reveal political differences beneath the veneer of unity in China: defections, protests, riots, terrorist acts, or foreign interference. Most incidents will be snuffed out quickly but investors should be wary of “black swans” from China in 2022. Chinese government policies will not be business friendly in 2022 aside from piecemeal fiscal easing. Everything Beijing does will be bent around securing Xi’s supremacy at all levels. Domestic politics will take precedence over economic concerns, especially over the interests of private businesses and foreign investors, as is clear when it comes to managing financial distress in the property sector. Negative regulatory surprises and arbitrary crackdowns on various industrial sectors will continue, though Beijing will do everything in its power to prevent the property bust from triggering contagion across the economic system. This will probably work, though the dam may burst after the party congress. Relations with the US and the West will remain poor, as the democracies cannot afford to endorse what they see as Xi’s power grab, the resurrection of a Maoist cult of personality, and the betrayal of past promises of cooperation and engagement. America’s midterm election politics will not be conducive to any broad thaw in US-China relations. While China will focus on domestic politics, its foreign policy actions will still prove relatively hawkish. Clashes with neighbors may be instigated by China to warn away any interference or by neighbors to try to embarrass Xi Jinping. The South and East China Seas are still ripe for territorial disputes to flare. Border conflicts with India are also possible. Taiwan remains the epicenter of global geopolitical risk. A fourth Taiwan Strait Crisis looms as China increases its military warnings to Taiwan not to attempt anything resembling independence (Chart 17A). China may use saber-rattling, economic sanctions, cyber war, disinformation, and other “gray zone” tactics to undermine the ruling party ahead of Taiwan’s midterm elections in November 2022 and presidential elections in January 2024. A full-scale invasion cannot be ruled out but is unlikely in the short run, as China still has non-military options to try to arrange a change of policy in Taiwan. Chart 17 ​​​​​​ Chart 17BMarket-Based Risk Indicators Say China/Taiwan Risk Has Not Peaked Market-Based Risk Indicators Say China/Taiwan Risk Has Not Peaked Market-Based Risk Indicators Say China/Taiwan Risk Has Not Peaked China has not yet responded to the US’s deployment of a small number of troops in Taiwan or to recent diplomatic overtures or arms sales. It could stage a major show of force against Taiwan to help consolidate power at home. China also has an interest in demonstrating to US allies and partners that their populations and economies will suffer if they side with Washington in any contingency. Given China’s historic confluence of risks, it is too soon for global investors to load up on cheap Chinese equities. Volatility will remain high. Weak animal spirits, limited policy easing, high levels of policy uncertainty, regulatory risk, ongoing trade tensions, and geopolitical risks suggest that investors should remain on the sidelines, and that a large risk premium can persist throughout 2022. Our market-based geopolitical risk indicators for both China and Taiwan are still trending upwards (Chart 17B). Global investors should capitalize on China’s policy easing indirectly by investing in commodities, cyclical equity sectors, and select emerging markets. 2. America’s Policy Insularity Our second view for 2022 centers on the United States, which will focus on domestic politics and will thus react or overreact to the many global challenges it faces. The US faces the first midterm election after the chaotic and contested 2020 presidential election. Political polarization remains at historically high levels, meaning that social unrest could flare up again and major domestic terrorist incidents cannot be ruled out. So far the Biden administration has focused on the domestic scene: mitigating the pandemic and rebooting the economy. Biden’s signature “Build Back Better” bill, $1.75 trillion investment in social programs, has passed the House of Representatives but not the Senate. The spike in inflation has shaken moderate Democratic senators who are now delaying the bill. We expect it to pass, since tax hikes were dropped, but our conviction is low (65% subjective odds), as a single defection would derail the bill. The implication would be inflationary since it would mark a sizable increase in government spending at a time when the output gap is already virtually closed. Spending would likely be much larger than the Congressional Budget Office estimate, shown in Chart 18, because the bill contains various gimmicks and hard-to-implement expiration clauses. Equity markets may not sell if the bill fails, since more fiscal stimulus would put pressure on the Federal Reserve to hike rates faster. Chart 18 Chart 19 Whether the bill passes or fails, Biden’s legislative agenda will be frozen thereafter. He will have to resort to executive powers and foreign policy to lift his approval rating and court the median voter ahead of the midterm elections. Currently Democrats are lined up to lose the House and probably also the Senate, where a single seat would cost them their majority (Chart 19). The Senate is still in play so Biden will be averse to taking big risks. For the same reason, Biden’s foreign policy goal will be to stave off various bubbling crises. Restoring the Iranian nuclear deal was his priority but Russia has now forced its way to the top of the agenda by threatening a partial reinvasion of Ukraine. In this context Biden will not have room for maneuver with China. Congress will be hawkish on China ahead of the midterms, and Xi Jinping will be reviving autocracy, so Biden will not be able to improve relations much. Biden’s domestic policy could fuel inflation, while his domestic-focused foreign policy will embolden strategic rivals, which increases geopolitical risks. 3. Petro-State Leverage A surge in gasoline prices at the pump ahead of the election would be disastrous for a Democratic Party that is already in disarray over inflation (Chart 20). Biden has already demonstrated that he can coordinate an international release of strategic oil reserves this year. Oil and natural gas producers gain leverage when the global economy rebounds, commodity prices rise, and supply/demand balances tighten. The frequency of global conflicts, especially those involving petro-states, tend to rise and fall in line with oil prices (Chart 21). Chart 20Inflation Constrains Biden Ahead Of Midterms Inflation Constrains Biden Ahead Of Midterms Inflation Constrains Biden Ahead Of Midterms Chart 21 Both Russia and Iran are vulnerable to social unrest at home and foreign strategic pressure abroad. Both have long-running conflicts with the US and West that are heating up for fundamental reasons, such as Russia’s fear of western influence in the former Soviet Union and Iran’s nuclear program. Both countries are demanding that the US make strategic concessions to atone for the Trump administration’s aggressive policies: selling lethal weapons to Ukraine and imposing “maximum pressure” sanctions on Iran. Biden is not capable of making credible long-term agreements since he could lose office as soon as 2025 and the next president could reverse whatever he agrees. But he must try to de-escalate these conflicts or else he faces energy shortages or price shocks, which would raise the odds of stagflation ahead of the election. The path of least resistance for Biden is to lift the sanctions on Iran to prevent an escalation of the secret war in the Middle East. If this unilateral concession should convince Iran to pause its nuclear activities before achieving breakout uranium enrichment capability, then Biden would reduce the odds of a military showdown erupting across the region. Opposition Republicans would accuse him of weakness but public opinion polls show that few Americans consider Iran a major threat. The problem is that this logic held throughout 2021 and yet Biden did not ease the sanctions. Given Iran’s nuclear progress and the US’s reliance on sanctions, we see a 40% chance of a military confrontation with Iran over the coming years. With regard to Ukraine, an American failure to give concessions to Russia will probably result in a partial reinvasion of Ukraine (50% subjective odds). This in turn will force the US and EU to impose sanctions on Russia, leading to a squeeze of natural gas prices in Europe and eventually price pressures in global energy markets. If Biden grants Russia’s main demands, he will avoid a larger war or energy shock but will make the US vulnerable to future blackmail. He will also demoralize Taiwan and other US partners who lack mutual defense treaties. But he may gain Russian cooperation on Iran. If Biden gives concessions to both Russia and Iran, his party will face criticism in the midterms but it will be far less vulnerable than if an energy shock occurs. This is the path of least resistance for Biden in 2022. It means that the petro-states may lose their leverage after using it, given that risk premiums would fall on Biden’s concessions. Of course, if energy shocks happen, Europe and China will suffer more than the US, which is relatively energy independent. For this reason Brussels and Beijing will try to keep diplomacy alive as long as possible. Enforcement of US sanctions on Iran may weaken, reducing Iran’s urgency to come into compliance. Germany may prevent a hardline threat of sanctions against Russia, reducing Russia’s fear of consequences. Again, petro-states have the leverage. Therefore investors should guard against geopolitically induced energy price spikes or shocks in 2022. What if other commodity producers, such as Saudi Arabia, crank up production and sink oil prices? This could happen. Yet the Saudis prefer elevated oil prices due to the host of national challenges they face in reforming their economy. If the US eases sanctions on Iran then the Saudis may make this decision. Thus downside energy price shocks are possible too. The takeaway is energy price volatility but for the most part we see the risk as lying to the upside. Investment Takeaways Traditional geopolitical risk, which focuses on war and conflict, is measurable and has slipped since 2015, although it has not broken down from the general uptrend since 2000. We expect the secular trend to be reaffirmed and for geopolitical risk to resume its rise due to the strategic themes and key views outlined above. The correlation of geopolitical risk with financial assets is debatable – namely because some geopolitical risks push up oil and commodity prices at the expense of the dollar, while others cause a safe-haven rally into the dollar (Chart 22).  Global economic policy uncertainty is also measurable. It is in a secular uptrend since the 2008 financial crisis. Here the correlation with the US dollar and relative equity performance is stronger, which makes sense. This trend should also pick up going forward, which is at least not negative for the dollar and relative US equity performance (Chart 23). Chart 22Geopolitical Risk Will Rise, Market Impacts Variable Geopolitical Risk Will Rise, Market Impacts Variable Geopolitical Risk Will Rise, Market Impacts Variable ​​​​​​ Chart 23Economic Policy Uncertainty Will Rise, Not Bad For US Assets Economic Policy Uncertainty Will Rise, Not Bad For US Assets Economic Policy Uncertainty Will Rise, Not Bad For US Assets ​​​​​​ We are neutral on the US dollar versus the euro and recommend holding either versus the Chinese renminbi. We are short the currencies of emerging markets that suffer from great power rivalry, namely the Taiwanese dollar versus the US dollar, the Korean won versus the Japanese yen, the Russian ruble versus the Canadian dollar, and the Czech koruna versus the British pound.     We remain long gold as a hedge against both geopolitical risk and inflation. We recommend staying long global equities. Tactically we prefer large caps and defensives. Within developed markets, we favor the UK and Japan. Japan in particular will benefit from Chinese policy easing yet remains more secure from China-centered geopolitical risks than emerging Asian economies. Within emerging markets, Mexico stands to benefit from US economic strength and divorce from China. We would buy Indian equities on weakness and sell Chinese and Russian equities on strength. We remain long aerospace and defense stocks and cyber-security stocks.   -The GPS Team We Read (And Liked) … Conspiracy U: A Case Study “Crazy, worthless, stupid, made-up tales bring out the demons in susceptible, unthinking people.” Thus the author’s father, a Holocaust survivor translated from Yiddish, on conspiracy theories and the real danger they present in the world. Scott A. Shay, author and chairman of Signature Bank, whose first book was a finalist for the National Jewish Book Award, has written an intriguing new book on the topic and graciously sent it our way.2 Shay is a regular reader of BCA Research’s Geopolitical Strategy and an astute observer of international affairs. He is also a controversialist who has written essays for several of America’s most prominent newspapers. Shay’s latest, Conspiracy U, is a bracing read that we think investors will benefit from. We say this not because of its topical focus, which is too confined, but because of its broader commentary on history, epistemology, the US higher education system – and the very timely and relevant problem of conspiracy theories, which have become a prevalent concern in twenty-first century politics and society. The author and the particular angle of the book will be controversial to some readers but this very quality makes the book well-suited to the problem of the conspiracy theory, since it is not the controversial nature of conspiracy theories but their non-falsifiability that makes them specious. As the title suggests, the book is a polemical broadside. The polemic arises from Shay’s unique set of moral, intellectual, and sociopolitical commitments. This is true of all political books but this one wears its topicality on its sleeve. The term “conspiracy” in the title refers to antisemitic, anti-Israel, and anti-Zionist conspiracy theories, particularly the denial of the Holocaust, coming from tenured academics on both the right and the left wings of American politics. The “U” in the title refers to universities, namely American universities, with a particular focus on the author’s beloved alma mater, Northwestern University in Chicago, Illinois. Clearly the book is a “case study” – one could even say the prosecution of a direct and extended public criticism of Northwestern University – and the polemical perspective is grounded in Shay’s Jewish identity and personal beliefs. Equally clearly Shay makes a series of verifiable observations and arguments about conspiracy theories as a contemporary phenomenon and their presence, as well as the presence of other weak and lazy modes of thought, in “academia writ large.” This generalization of the problem is where most readers will find the value of the book. The book does not expect one to share Shay’s identity, to be a Zionist or support Zionism, or to agree with Israel’s national policies on any issue, least of all Israeli relations with Arabs and Palestinians. Shay’s approach is rigorous and clinical. He is a genuine intellectual in that he considers the gravest matters of concern from various viewpoints, including viewpoints radically different from his own, and relies on close readings of the evidence. In other words, Shay did not write the book merely to convince people that two tenured professors at Northwestern are promoting conspiracy theories. That kind of aberration is sadly to be expected and at least partially the result of the tenure system, which has advantages as well, not within the scope of the book. Rather Shay wrote it to provide a case study for how it is that conspiracy theories can manage to be adopted by those who do not realize what they are and to proliferate even in areas that should be the least hospitable – namely, public universities, which are supposed to be beacons of knowledge, science, openness, and critical thinking, but also other public institutions, including the fourth estate. Shay is meticulous with his sources and terminology. He draws on existing academic literature to set the parameters of his subject, defining conspiracy theories as “improbable hypotheses [or] intentional lies … about powerful and sinister groups conspiring to harm good people, often via a secret cabal.” The definition excludes “unwarranted criticism” and “unfair/prejudiced perspectives,” which are harmful but unavoidable. Many prejudices and false beliefs are “still falsifiable in the minds of their adherents,” which is not the case with conspiracy theories, although deep prejudices can obviously be helpful in spreading such theories. Conspiracy theories often depend on “a stunning amount of uniformity of belief and coordination of action without contingencies.” They also rely excessively on pathos, or emotion, in making their arguments, as opposed to logos (reason) and ethos (credibility, authority). Unfortunately there is no absolute, infallible distinction between conspiracy theories and other improbable theories – say, yet-to-be-confirmed theories about conspiracies that actually occurred. Conspiracy theories differ from other theories “in their relationship to facts, evidence, and logic,” which may sound obvious but is very much to the point. Again, “the key difference is the evidence and how it is evaluated.” There is no ready way to refute the fabrications, myths, and political propaganda that people believe without taking the time to assess the claims and their foundations. This requires an open mind and a grim determination to get to the bottom of rival claims about events even when they are extremely morally or politically sensitive, as is often the case with wars, political conflicts, atrocities, and genocides: Reliable historians, journalists, lawyers, and citizens must first approach the question of the cause or the identity of perpetrators and victims of an event or process with an open mind, not prejudiced to either party, and then evaluate the evidence. The diagnosis may be easy but the treatment is not – it takes time, study, and debate, and one’s interlocutors must be willing to be convinced. This problem of convincing others is critical because it is the part that is so often left out of modern political discourse. Conspiracy theories are often hateful and militant, so there is a powerful urge to censor or repress them. Openly debating with conspiracy theorists runs the risk of legitimizing or appearing to legitimize their views, providing them with a public forum, which seems to grant ethos or authority to arguments that are otherwise conspicuously lacking in it. In some countries censorship is legal, almost everywhere when violence is incited. The problem is that the act of suppression can feed the same conspiracy theories, so there is a need, in the appropriate context, to engage with and refute lies and specious arguments. Clients frequently email us to ask our view of the rise of conspiracy theories and what they entail for the global policy backdrop. We associate them with the broader breakdown in authority and decline of public trust in institutions. Shay’s book is an intervention into this topic that clients will find informative and thought-provoking, even if they disagree with the author’s staunchly pro-Israel viewpoint. It is precisely Shay’s ability to discuss and debate extremely contentious matters in a lucid and empirical manner – antisemitism, the history of Zionism, Holocaust denialism, Arab-Israeli relations, the Rwandan genocide, QAnon, the George Floyd protests, various other controversies – that enables him to defend a controversial position he holds passionately, while also demonstrating that passion alone can produce the most false and malicious arguments. As is often the case, the best parts of the book are the most personal – when Shay tells about his father’s sufferings during the Holocaust, and journey from the German concentration camps to New York City, and about Shay’s own experiences scraping enough money together to go to college at Northwestern. These sequences explain why the author felt moved to stage a public intervention against fringe ideological currents, which he shows to have gained more prominence in the university system than one might think. The book is timely, as American voters are increasingly concerned about the handling of identity, inter-group relations, history, education, and ideology in the classroom, resulting in what looks likely to become a new and ugly episode of the culture and education wars. Let us hope that Shay’s standards of intellectual freedom and moral decency prevail.   Matt Gertken, PhD Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1      The downshift in globalization today is even worse than it appears in Chart 10 because several countries have not yet produced the necessary post-pandemic data, artificially reducing the denominator and making the post-pandemic trade rebound appear more prominent than it is in reality. 2     Scott A. Shay, Conspiracy U: A Case Study (New York: Post Hill Press, 2021), 279 pages. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Appendix: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator United Kingdom UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan Territory: GeoRisk Indicator Taiwan Territory: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator South Africa South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights Japan’s long-term weaknesses – a shrinking population, low productivity growth, excess indebtedness – are very well known. However, it still punches above its weight in the realm of geopolitics. Abenomics – sorry, Kishidanomics – can still deliver some positive surprises every now and then. As the global pandemic wanes, and China faces a historic confluence of internal and external risks, investors should begin buying the yen on weakness. Japanese industrials also are an attractive play in a global portfolio. While the yen will likely fare better than the dollar over the next 6-9 months, it will lag other procyclical currencies. Feature Japan has always been an “earthquake society,”  in which things seem never to change until suddenly everything changes at once. The good news for investors is that that change occurred in 2011 and the latest political events reinforce policy continuity. Why “Abenomics” Remains The Playbook Over ten years have passed since Japan suffered a triple crisis of earthquake, tsunami, and nuclear meltdown. In fact, the Fukushima nuclear crisis merely punctuated a long accumulation of national malaise: the country had suffered two “Lost Decades” and was in the thrall of the Great Recession, a rare period of domestic political change, and a rise in national security fears over a newly assertive China. The nuclear meltdown marked the nadir. The result of all these crises was a miniature policy revolution in 2012 – Prime Minister Shinzo Abe and the Liberal Democratic Party (LDP) returned to power and initiated a range of bolder policies to whip the country’s deflationary mindset and reboot its foreign and trade relations. The new economic program, “Abenomics,” consisted of easy money, soft budgets, and pro-growth reforms. It succeeded in changing Japan. Both private debt and inflation, which had fallen during the lost decades, bottomed after the 2011 crisis and began to rise under Abe (Chart 1). By the 2019 House of Councillors election, however,  Abe was running out of steam. Consumption tax hikes, the US-China trade war, and COVID-19 thwarted his plans of national revival. In particular, Abe hoped to capitalize on excitement over the 2020 Tokyo Olympics to hold a popular referendum on revising the constitution. Constitutional revision is necessary to legitimize the Self-Defense Forces and thus make Japan a “normal” nation again, i.e. one that can maintain armed forces. But the global pandemic interrupted. Until the next heavyweight prime minister comes along, Japan will relapse into its old pattern of a “revolving door” of prime ministers who come and go quickly. For example, the only purpose of Abe’s immediate successor, Yoshihide Suga, was to tie off loose ends and oversee the Olympics before passing the baton (Chart 2). Chart 1Abenomics Was Making Progress Abenomics Was Making Progress Abenomics Was Making Progress Chart 2 The next few Japanese prime ministers will almost inevitably lack Abe’s twin supermajority in parliament, which was exceptional in modern history (Chart 3). It will be hard for the LDP to expand its regional grip given that it holds a majority in all 11 of the regional blocks in which the political parties contend for seats based on their proportion of the popular vote (Table 1). Chart 3 Table 1LDP+ Komeito Regional Performance Japan: Foreign Threats, Domestic Reflation Japan: Foreign Threats, Domestic Reflation Short-lived, traditional prime ministers will not be able to create a superior vision for Japan and will largely follow in Abe’s footsteps.   In September Prime Minister Fumio Kishida replaced Suga – a badly needed facelift for the ruling Liberal Democrats ahead of the October 31 election. The LDP retained its single-party majority in the Diet, so Kishida is off to a tolerable start (Chart 4). But he is far from charismatic and will not last long if he fumbles in the upper house elections in July 2022. This gives him a little more than half a year to make a mark. Chart 4 Kishida will oversee a roughly 30-40 trillion yen stimulus package, or supplemental budget, by the end of this year. Japanese stimulus packages are almost always over-promised and under-delivered. However, given the electoral calendar, he will put together a large package that will not disappoint financial markets. His other goal will be to build on recent American efforts to cobble together a coalition of democracies to counter China and Russia. Japan’s Grand Strategy In Brief Chart 5Japan Exposed To China Trade Japan Exposed To China Trade Japan Exposed To China Trade Japan’s grand strategy over centuries consists of maintaining its independence from foreign powers, controlling its strategic geographic approaches to prevent invasion, and stopping any single power from dominating the eastern side of the Eurasian landmass. Originally the hardest part of this grand strategy was that it required establishing unitary political control over the far-flung Japanese archipelago. However, since the Meiji Restoration, Tokyo has maintained centralized government. Since then Japan has focused on controlling its strategic approaches and maintaining a balance among the Asian powers. During the imperialist period it tried to achieve these objectives on its own. After World War II, the United States became critical to Japan’s grand strategy. Through its broad alliance with Washington, Tokyo can maintain independence, make sure critical territories are not hostile (e.g. Taiwan and South Korea), and deter neighboring threats (North Korea, China, Russia). It can at least try to maintain a balance of power in Eurasia. Yet these constant national interests underscore Japan’s growing vulnerabilities today: China’s economy is now two-times larger than Japan’s and Japan is more dependent on China’s trade than vice versa (Chart 5). Under Xi Jinping, Beijing is actively converting its wealth into military and strategic capabilities that threaten Japan’s security. Rising tensions across the Taiwan Strait are fueling nationalism and re-armament in Japan.  Russia’s post-Soviet resurgence entails an ever-closer Russo-Chinese partnership. It also entails Russian conflicts with the US that periodically upset any attempts at Russo-Japanese détente. North Korea’s asymmetric war capabilities and nuclearization pose another security threat. South Korea’s attempts to engage with the North and China, and compete with Japan, are unhelpful.    All of these realities drive Japan closer to the United States. Even the US is increasingly unpredictable, though not yet to the point of causing serious doubts about the alliance. If the US were fundamentally weakened, or abandoned the alliance, Japan would either have to adopt nuclear weapons or accommodate itself to Chinese hegemony to meet its grand strategy. Nuclearization would be the more likely avenue. The stability of Asia depends greatly on American arbitration. Japan’s Strategy Since 1990 Beneath this grand strategy Japan’s ruling elites must pursue a more particular strategy suited to its immediate time and place. Ever since Japan’s working population and property bubble peaked in the early 1990s, the country’s relative economic heft has declined. To maintain stability and security, the central government in Tokyo has had to take on a very active role in the economy and society. The first step was to stabilize the domestic economy despite collapsing potential growth. This has been achieved through a public debt supercycle (Chart 6). Unorthodox monetary and fiscal policy largely stabilized demand, at the cost of the world’s highest net debt-to-GDP ratio. The economic adjustment was spread out over a long period of time so as to prevent a massive social and political backlash. Unemployment peaked in 2009 at 5.5% and never rose above this level. The ruling elite and the Liberal Democrats maintained control of institutions and government. The second step was to ensure continued alliance with the United States. Japan could deal with its economic problems – and the rise of China – if it maintained access to US consumers and protection from the US military. To maintain the alliance required making investments in the American economy, in US-led global institutions, and cooperating with the US on various initiatives, including controversial foreign policies. As in the 1950s-60s, Japan would bulk up its Self-Defense Forces to share the burden of global security with the United States, despite the US-written constitution’s prohibition on keeping armed forces. The third step was to invest abroad and put Japan’s excess savings to work, developing materials and export markets abroad while employing foreign workers and factories to become Japan’s new industrial base in lieu of the shrinking Japanese workforce (Chart 7).  Chart 6Japan's Public Debt Supercycle Japan's Public Debt Supercycle Japan's Public Debt Supercycle Chart 7 Japan’s post-1990 strategy has staying power because of the massive pressures on Japan listed above: China’s rise, Russo-Chinese partnership, North Korean threats, and American distractions. Investors tend to underrate the impact of these trends on Japan. Unless they fundamentally change, Japan’s strategy will remain intact regardless of prime minister or even ruling party. Russia’s role is less clear and could serve as a harbinger of any future change. President Vladimir Putin and Abe had the best chance in modern memory to resolve the two countries’ territorial disputes, build on mutual interests, and maybe even sign a peace treaty. But Russia’s clash with the West  proved an insurmountable obstacle. New opportunities could emerge at some later juncture, as Japan’s interest in preventing China from dominating Eurasia gives it a strong reason to normalize ties with Russia. Russia will at some point worry about overdependency on China. But this change is not on the immediate horizon.  Japan’s Tactics Since 2011 Chart 8 Japan is nearly a one-party state. Brief spells of opposition rule, in 1993 and 2009-11, are exceptions that prove the rule. The Liberal Democrats did not fall from power so much as suffer a short “time out” to reflect on their mistakes before voters put them right back into power. However, these timeouts have been important in forcing the ruling party to adjust its tactics for changing times, as with Abenomics. Kishida will not have enough political capital to change direction. The emphasis will still be on defeating deflation and rekindling animal spirits and corporate borrowing (as opposed to relying exclusively on public debt). Kishida has talked about a new type of capitalism and a more active redistribution of wealth, in keeping with the current zeitgeist among the global elite. However, Japan lacks the impetus for dramatic change. Wealth inequality is not extreme and political polarization is non-existent (Chart 8). The LDP is wary of losing votes to the populist Japan Innovation Party, or other regional movements, but populism does not have as fertile ground in countries with low inequality.  The desire to boost wages was a central plank of Abenomics (Chart 9) and an area of success. It will come through in Kishida’s policies as well. But the ultimate outcome will depend on how tight the labor market gets in the upcoming economic cycle. Similarly Kishida can be expected to encourage, or at least not roll back, women’s participation in the labor force, as labor markets tighten (Chart 10). As the pandemic wanes it is also likely that he will reignite Abe’s loose immigration policy, which saw the number of foreign workers triple between 2010 and 2020. This inflow is perhaps the surest sign of any that insular and xenophobic Japan is changing with the times to meet its economic needs.  Chart 9Kishidanomics To Build On Abe's Wage Growth Kishidanomics To Build On Abe's Wage Growth Kishidanomics To Build On Abe's Wage Growth Chart 10Women Off To Work But Fertility ##br##Relapsed Women Off To Work But Fertility Relapsed Women Off To Work But Fertility Relapsed The only substantial difference between Kishidanomics and Abenomics is that Abe compromised his reflationary fiscal efforts by insisting on going forward with periodic hikes to the consumption tax. Kishida is under no such expectation. Instead he is operating in a global political and geopolitical context in which ambitious public investments are positively encouraged even at the expense of larger budget deficits (Chart 11). Yet interest rates are still low enough to make such investments cheaply. The stage is set for fiscal largesse. Chart 11Fiscal Largesse To Continue Fiscal Largesse To Continue Fiscal Largesse To Continue Kishida can be expected to promote large new investments in supply-chain resilience, renewable energy, and military rearmament. The US and EU may exempt climate policies from traditional budget accounting – Japan may do the same. Even more so than China and Europe, Japan has a national interest in renewable energy since it is almost entirely dependent on foreign imports for its fossil fuels. The green transition in Japan is lagging that of Germany but the Japanese shift away from nuclear power has gone even faster, creating an import dependency that needs to be addressed for strategic reasons (Chart 12). Monetary-fiscal coordination began under Abe and can increase under Kishida. What is clear is that public investment is the top priority while fiscal consolidation is not. Military spending is finally starting to edge up as a share of GDP, as noted above. For many years Japanese leaders talked about military spending but it remained steady at 1% of GDP. Now, at the onset of the US-China cold war, the Japanese are spending more and say the ratio will rise to 2% of GDP (Chart 13). Tensions with China, especially over Taiwan, will continue to drive this shift, though North Korea’s weapons progress is not negligible. Chart 12 Chart 13 The Biden administration is prioritizing US allies and the competition with China, which makes the Japanese alliance top of mind. Tokyo’s various attempts to talk with Beijing in recent years have amounted to nothing, with the exception of the Regional Comprehensive Economic Partnership, which is far from ratification and implementation. Japan’s relations with China are driven by interests, not passing attitudes and emotions. If Biden proves too dovish toward China – a big “if” – then it will be Japan pushing the US to take a more hawkish line rather than vice versa. Japan will take various strategic, economic, technological, and military actions to defend itself from the range of external threats it faces. These actions will intimidate and provoke China and other neighbors, which will help to entrench the “security dilemma” between the US and China and their allies. For example, Japan will eagerly participate in US efforts to upgrade its military and its regional alliances and partnerships, including via the Quadrilateral Security Dialogue with India and Australia. The Biden administration might force Japan to play nice with South Korea and patch up their trade war. But that is a price Japan can pay since American involvement also precludes any shift by South Korea fully into China’s camp. If China should invade Taiwan – which we cannot rule out over the long run – Japan’s vital supply lines and national security would fall under permanent jeopardy. Japan would have an interest in defending Taiwan but its willingness to war with China may depend on the US response. However, both Japan and the US would have to draw a stark line in defense of Japanese territory, not least Okinawa, where US troops are based. Both powers would mobilize and seek to impose a strategic containment policy around China at that point. Until The Next Earthquake … For Japan to abandon its post-1990 strategy, it would need to see a series of shocks to domestic and international politics. If China’s economy collapsed, Korea unified, or the US abandoned the Asia Pacific region, then Tokyo would have to reassess its strategy. Until then the status quo will prevail. At home Japan would need to see a split within the Liberal Democrats, or a permanent break between the LDP and their junior partner Komeito, combined with a single, consolidated, and electorally viable opposition party and a charismatic opposition leader. This kind of change would follow from major exogenous shocks. Today it is nowhere in sight – the last two shocks, in 2011 and 2020, reinforced the LDP regime. Theoretically some future Japanese government could adopt a socialist platform that relies entirely on public debt rather than trying to reboot private debt. It could openly embrace debt monetization and modern monetary theory  rather than trying to raise taxes periodically to maintain the appearance of fiscal rectitude. But if it tried to distance itself from the United States and improve relations with Russia and China, such a strategy would not go very far. It would jeopardize Japan’s grand strategy. For the foreseeable future, Japan’s economic security and national security lie in maintaining the American alliance and continuing an outward investment strategy focused on emerging markets other than China. Macroeconomic Developments The key message from an economic context is that fiscal stimulus is likely to be larger in Japan than the market currently expects. The IMF is penciling in a fiscal deficit of around 2% of potential GDP next year, which will be a drag on growth (Chart 14). More likely, Kishida will cobble together a slightly larger package to implement most of the initiatives he has proposed on the campaign trail. Meanwhile, a large share of JGBs are about to mature over the next couple of years, providing room for more issuance, which the BoJ will be happy to assimilate (Chart 15). Chart 14More Fiscal Stimulus In Japan Likely More Fiscal Stimulus In Japan Likely More Fiscal Stimulus In Japan Likely Chart 15Lots Of JGBs Mature In The Next Few Years Lots Of JGBs Mature In The Next Few Years Lots Of JGBs Mature In The Next Few Years Real numbers on the size of the fiscal package have been scarce, but it should be around 30-40 trillion yen, spread over a few years. With Japan’s net interest expense at record lows (Chart 16), and a lot of the spending slated for worthwhile productivity-enhancing projects such as supply chains, green energy, education and some boost to the financial sector in the form of digital innovation and consolidation, we expect fiscal policy in Japan will remain moderately loose, with the BoJ staying accommodative. The timing of more fiscal stimulus is appropriate as Japan has managed to finally put the pandemic behind it. The number of new Covid-19 cases is at the lowest recorded level per capita, and Japan now  has more of its population vaccinated than the US. As a result, the manufacturing and services PMIs, which have been the lowest in the developed world, could stage a coiled-spring rebound. This will be a welcome fillip for Japanese assets (Chart 17). Chart 16Little Cost To Issuing More Debt Little Cost To Issuing More Debt Little Cost To Issuing More Debt Chart 17The Japanese Recovery Has Lagged The Japanese Recovery Has Lagged The Japanese Recovery Has Lagged Consumption could also surprise to the upside in Japan. With the consumption tax hike of 2019 and the 2020 pandemic now behind us, pent-up demand could finally be unleashed in the coming quarters. Rising wages and high savings underscore that Japan could see a vigorous rebound in consumption, as was witnessed in other developed economies. This will be particularly the case as inflation stays low. The big risk for Japan from a macro perspective is an external slowdown, driven by China. A boom in foreign demand has been a much welcome cushion for Japanese growth, especially amidst weak domestic demand. The risk is that this tailwind becomes a headwind as Chinese growth slows, especially as a big share of Japanese exports go to China. Our view has been that policy makers in China will be able to ring-fire the property crisis, preventing a “Lehman” moment. As such, while China’s slowdown is a reality and downside risks warrant monitoring, we also expect China to avoid a hard landing. Meanwhile, Japanese exports are also diversified, with other developed and emerging markets accounting for the lion’s share of total exports. For example, exports to the US account for 19% of sales while EU exports account for 9%. Both exports and foreign machinery orders remain quite robust, suggesting that the slowdown in China will not crush all external demand (globally, export growth remains very strong).  It is noteworthy that many countries now have “carte blanche” to boost infrastructure spending, especially in areas like renewable energy and supply chain resiliency. Japan continues to remain a big supplier of capital goods globally. This will ensure that an economic recovery around the world will buffer foreign machinery orders. Market Implications Japanese equities have underperformed the US over the last decade, and Kishidanomics is unlikely to change this trend. But to the extent that more fiscal stimulus helps lift aggregate demand, a few sectors could begin to see short-term outperformance. More importantly, the underperformance of certain Japanese equity sectors have not been fully justified by the improving earnings picture (Chart 18). This suggests some room for catch-up. Banks in particular could benefit from a steeper yield curve in Japan, rising global yields and proposed reform in the sector (Chart 19). We will view this as a tactical opportunity however, than a strategic call. Our colleagues in the Global Asset Allocation service have clearly outlined key reasons against overweighting Japan, and are currently neutral.  More importantly, industrials also look poised to see some pickup in relative EPS growth, as global industrial demand stays robust. An improvement in domestic demand should also favor small caps over large caps. Chart 18ADismal Earnings Explain Some Underperformance Of Japanese Equities Dismal Earnings Explain Some Underperformance Of Japanese Equities Dismal Earnings Explain Some Underperformance Of Japanese Equities Chart 18BDismal Earnings Explain Some Underperformance Of Japanese Equities Dismal Earnings Explain Some Underperformance Of Japanese Equities Dismal Earnings Explain Some Underperformance Of Japanese Equities Chart 19Japanese Banks Will Benefit From A Steeper Yield Curve Japanese Banks Will Benefit From A Steeper Yield Curve Japanese Banks Will Benefit From A Steeper Yield Curve Foreigners have huge sway over the performance of Japanese assets, especially equities. Foreign holders account for nearly 30% of the Japanese equity float. This is important not only for the equity call but for currency performance as well since portfolio flows dominate currency movements. Historically, the yen and the Japanese equity market have been negatively correlated. This was due to positive profit translation effects from a lower currency. However, it is possible that Japanese domestic profits are no longer driven only by translation effects, but rather by underlying productivity gains. This could result in less yen hedging by foreign equity investors, which would restore a positive relationship between the relative share price performance and the currency. As for the yen, the best environment for any currency is when the economy can generate non-inflationary growth. Japan may well be entering this paradigm. Historically, now has been the exact environment where the yen tends to do well, as the economy exits deflation and enters non-inflationary growth (Chart 20). Chart 20The Yen And Japanese Growth The Yen And Japanese Growth The Yen And Japanese Growth Markets have been wrongly focusing on nominal rather than real yields in Japan and the implication for the yen. Therefore the risk to a long yen view is that the Bank of Japan keeps rates low as global yields are rising. However, in an environment where global inflationary pressures normalize (say in the next 6-9 months) and temper the increase in global yields, this could provide room for short covering on the yen. In our view, the yen is already the most underappreciated currency in the G10, as rising global yields have led to a massive accumulation of short positions. Finally, from a valuation standpoint, the yen is the cheapest G10 currency according to our PPP models, and is also quite cheap according to our intermediate-term timing model (Chart 21). With the yen being a risk-off currency, it also tends to rise versus the dollar not only during recessions, but also during most episodes of broad-based dollar weakness. This low-beta nature of the currency makes it a good portfolio hedge in an uncertain world. Chart 21The Yen Is Undervalued The Yen Is Undervalued The Yen Is Undervalued Given the historic return of geopolitical risk to Japan’s neighborhood, as the US and Japan engage in active great power competition with China, the yen is an underrated hedge. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Chester Ntonifor Vice President Foreign Exchange Strategy chestern@bcaresearch.com

Highlights Faced with large excesses in the housing market, we contend that Beijing’s goal is to achieve flat property prices in the coming years. Stable property prices would allow for improved housing affordability over the coming years while precluding debt deflation. However, when authorities fix/control prices, they lose control of volumes/activity. The housing market will not clear. Property sales and construction activity will hit an air pocket. Shrinking construction activity will weigh on China’s economy and China-plays around the world. Feature The recent struggles of several Chinese property developers to service their debt have put the mainland’s real estate market on the radar of global investors. What is the outlook for the Chinese property market and what will be its impact on the mainland and global economies? What does it mean for global financial markets? In contrast to the US housing debacle in 2008, the central pressure point in China’s property market adjustment will not be home prices and mortgage defaults but retrenchment by property developers and a downsizing in construction activity. That is why we are maintaining our negative view on Chinese demand for raw materials and machinery. This will have implications for emerging Asia, developing countries that produce raw materials and machinery stocks worldwide. How Important Is The Property Market? Chart 1Land Sales Revenue And Property Developers Funding Are Sizable Land Sales Revenue And Property Developers Funding Are Sizable Land Sales Revenue And Property Developers Funding Are Sizable In a 2020 paper,1 Kenneth Rogoff and Yuanchen Yang estimate that real estate investment accounted for 12-15% of GDP in China between 2011 and 2018. This compares with a 7% share of GDP in the US at the peak of the housing boom in 2005. Hence, the sheer size of real estate construction in China – which does not include infrastructure investment – implies that real estate investment is very important for the mainland economy. The above numbers do not capture secondary effects from fluctuations in real estate investment. Thereby, the impact of property construction is greater than what is implied by its share of GDP. Further, local governments derive more than 40% of their aggregate revenues – budgetary and off budgetary (managed funds) – from land sales (Chart 1, top panel). As land sales dry up, local government revenues will plummet, undermining their ability to finance infrastructure spending – which is also a major part of the economy. Property developers’ annual funding makes up a very large 20% of GDP, which attests to their importance to the economy and the financial system (Chart 1, bottom panel).  Critically, construction activity drives demand for raw materials and machinery. Granted, Chinese imports of raw materials and machinery used in real estate construction and infrastructure building are non-trivial, the shockwaves from the downturn will spill over to the rest of the world in general and to developing economies in particular. Excesses  The Chinese property market’s vulnerability stems from its excesses. These excesses are apparent on multiple fronts. Table 1Chinese Housing Is Expensive / Unaffordable China: Is The Property Carry Trade Over? China: Is The Property Carry Trade Over? 1. Extreme Overvaluation: Compared to most countries around the world, housing in China is very expensive. The house price-to-household income ratio is 19 in tier-1 cities, 10 in tier-2 and 7 in tier-3 cities (Table 1). For comparison, even after the recent surge in property prices, the house price-to-income ratio is 4 in the US nationwide. Importantly, the mortgage rate in China – currently at 5.4% – is considerably higher than mortgage rates in the US or in other developed economies. The high house price-to-income ratio and relatively high mortgage rate entail that mortgage interest payments account for a larger share of household income in China than in any advanced economy. For new buyers, assuming a 30% down-payment, mortgage interest payments alone make up 28% of household income on average nationwide (Table 1). Chart 2Chinese Households Are As Leveraged As Their US Peers Chinese Households Are As Leveraged As Their US Peers Chinese Households Are As Leveraged As Their US Peers Finally, Chinese household indebtedness is much higher than is often presumed by the global investment community – the household disposable income-to-debt ratio is close to 100%, as high as it is in the US (Chart 2). All this does not mean that China will experience a US-style 2008 credit crisis with households defaulting on their mortgages. As we discuss below, the adjustment process will be different in China than it was in the US. 2. Capital misallocation: Property developers have been building the wrong type of housing at the wrong prices and for the wrong type of buyers. They have been building high-end houses and selling them at very high prices to high-income households who have been buying multiple properties as investments. This represents capital misallocation. Widespread home vacancies confirm this thesis. As of 2017, 21.5% of the housing stock was vacant according to the Survey and Research Center for China Household Finance.  As per the same source, only 11.5% of homebuyers in 2018 were first timers. That compares with 70% of first-time buyers in 2008-2010. In 2018, 22.5% of homebuyers already owned two or more dwellings while 66% owned one. Clearly, housing in China has become an object of speculation which has made it unattainable for first-time homebuyers. Chart 3Property Developers Have Accumulated Massive Assets Property Developers Have Accumulated Massive Assets Property Developers Have Accumulated Massive Assets 3. Speculation and the carry trade: There is nothing wrong with individuals investing in real estate. This practice is widespread all around the world. However, contrary to many other countries, multiple home owners in China do not rent out their properties, but instead keep their houses vacant. For those few owners who rent their houses, the current rental yield on properties rarely exceeds 2%. Given that the mortgage rate is currently 5.4%, the carry costs for individual investors is negative. Therefore, property investors in China can only expect to profit from ever rising prices. This strategy has paid off enormously over the last 20 years. Yet, past performance does not guarantee future gains. A stampede into real estate since 2009 has made housing extremely expensive and has instigated socio-political problems that have made Beijing wary. Critically, property speculation has been prevalent not only among households but also among property developers. The latter have been participating in the largest carry trade of the past 12 years. Facing borrowing costs that were lower than the pace of house price appreciation, property developers in China have done what any business would do: they borrowed as much as they could and accumulated real estate assets in the form of land, incomplete construction as well as completed but unsold properties. Chart 4Property Developers Are Very Leveraged Property Developers Are Very Leveraged Property Developers Are Very Leveraged As long as the rate of annual asset price appreciation exceeds the borrowing costs (the carry), carrying these assets on a balance sheet produces lofty profits. The top panel of Chart 3 demonstrates that housing starts have chronically exceeded completions, i.e., developers have been starting but not completing/delivering properties. The gap between starts and completions – unfinished construction – has ballooned (Chart 3, bottom panel). In short, property developers have been holding on to a lot of land and unfinished construction and have been financing it via debt. The asset-to-equity ratio for property developers trading on the A-share market has surged to 9 (Chart 4).  Overall, the primary reason for real estate asset accumulation in China by individuals and companies has been expectations of continuous price appreciation. When an investor purchases an asset that generates little or no recurrent cash flow and the only rationale for holding onto it is expectations for continuous price appreciation, it qualifies as speculation – not investment. This speculation can continue only as long as there is demand from new buyers. Bottom Line: The property market is suffering from numerous excesses such as extreme overvaluation, capital misallocation and widespread speculative activities. Clouds Are Forming Over Real Estate Odds are that the speculative fever that has held the Chinese housing market in its grip is waning. Chart 5Less Funding = Less Completions = Less Commodity Demand Less Funding = Less Completions = Less Commodity Demand Less Funding = Less Completions = Less Commodity Demand First, the three red lines introduced by authorities a year ago limit property developers’ ability to take on more debt. In fact, many property developers are being forced to reduce their indebtedness to meet these regulatory requirements. These rules mean that property developers will have to reduce new construction at best or sell their assets at worst. When many developers try to offload their assets simultaneously, asset prices will deflate, producing a vicious debt deflation cycle. Second, the reluctance of authorities to bail out large property developers – which are struggling to service their debt – is sending a clear message to both onshore and offshore creditors not to lend to property developers. This is especially true for small and medium banks, trust companies, wealth management products and onshore and offshore bondholders. These lenders along with pre-sales account for the lion’s share of financing options for property developers. Chart 5 illustrates that diminishing funding for property developers weighs down on completion, i.e., less construction work and less demand for raw materials and machinery (Chart 5, bottom panel). Third, the property carry trade does not make sense when the rate of real estate asset price appreciation drops below property developers’ borrowing costs. A negative carry means incurring losses, necessitating the sale of assets, including land and completed properties. A rush to offload assets amid a buyer strike could prompt classic debt deflation. Chart 6Households’ House Buying Intentions Have Plummeted Households' House Buying Intentions Have Plummeted Households' House Buying Intentions Have Plummeted Finally, the upcoming pilot program for a real estate tax and a broader public campaign by Beijing against buying houses as an investment has discouraged individuals from purchasing properties. The proportion of households planning to buy a house has dropped to only 7.7% in Q3 2021 from 11.6% in Q4 2020 (Chart 6). House sales contracted by 16% in September from a year ago and initial reports point to further deterioration in October.     Bottom Line: Central authorities in China are attempting to tackle the property market because they reckon that an expensive and speculative property market could either create socio-political problems down the road or get out of control and crumble of its own accord. Beijing’s objective is to achieve a soft landing by acting preemptively and managing it.  The Role Of Policy Why is Beijing obsessed with taming the property market? We suspect the current hawkish stance is due to the following: Chart 7Housing Prices Correlate With Starts Housing Prices Correlate With Starts Housing Prices Correlate With Starts Housing is becoming unaffordable for low- and some middle-income residents in China. This may give rise to a sense of injustice/inequality and goes against president Xi’s common prosperity goals. This is also negatively affecting family formation and demographics and, ultimately, the nation’s potential growth rate. Beijing believes that the 2019 protests in Hong Kong were to a certain extent due to housing unaffordability. The latter fanned young people’s rage toward authorities and the political system. The Communist party leadership wants to avoid a similar uprising in the mainland. Anytime policymakers have stimulated in the past 12 years, property prices have surged widening the gap between the poor and the rich and making housing even more unaffordable. Presently, they are reluctant to do the same. Also, authorities are clamping down on property developers because historically there was a strong positive correlation between property starts and house prices (Chart 7). The basis for this positive correlation is that whenever property developers start new projects, they raise expectations of higher future prices via aggressive marketing. As a result, people become more inclined to buy houses. In fact, over the years more supply has not precluded property prices from surging and vice versa, as shown in Chart 7. Finally, the central government has learned from its own experience in 2015 and from the US case in 2008 that when a bubble bursts, it is difficult to stop it. Chinese economic policymakers prefer to be proactive than reactive. All of the above does not mean that authorities are planning to instigate a property market crash and will stand by and not stimulate. If and when broad economic conditions deteriorate to the point that income growth and employment are jeopardized, authorities will rachet up their stimulus. Presently, the unemployment rate for the 25-59 age group is very low and the urban labor market is tight (Chart 8). In addition, the nation’s exports are booming, so it is a good time to undertake some deleveraging. In brief, there is now no urgency to stimulate aggressively. Bottom Line: Considering the size of the real estate market and how dire its fundamentals are, we expect economic conditions to get much worse in China. That will ultimately force policymakers to stimulate more aggressively. The End Of The Property Carry Trade Conditions have fallen into place for the property carry trade by developers to unravel: Faced with limited access to funding, a diminished willingness on the part of creditors to rollover their debt as well as plummeting home sales, property developers have already dramatically cut back on land purchases (Chart 9, top panel). Chart 8China's Labor Market Is Strong China's Labor Market Is Strong China's Labor Market Is Strong Chart 9China's Construction Cycle In Perspective China's Construction Cycle In Perspective China's Construction Cycle In Perspective   However, they have so far been completing and delivering pre-sold homes to buyers who had paid in advance. In the last couple of years 90% of homes have been pre-sold. Hence, these completions do not generate new cash inflows for real estate developers. Yet, this completion work has supported construction activity and demand for materials over the past 12 months (Chart 9, bottom panel). Looking forward, reduced funding entails shrinking completions with negative ramifications for the economy (Chart 5 above). Real estate deflation, lack of new sales and restricted financing could turn property developers’ liquidity troubles into a solvency issue. This is how typical financial/credit crises develop – they start with liquidity strains and then turn into solvency problems as the value of collaterals drop, becoming insufficient to cover debt obligation. Defaults ensue. Property development is an extremely fragmented industry in China. There are officially around 100 000 property developers in China. Even the largest ones like Evergrande have a very small share of the market. Therefore, authorities cannot ensure that the sector will function properly by ring fencing or bailing out several large developers. In sum, authorities have very little control over real estate construction because it is quite spread out across the country and involves many private small- and medium-sized developers. We think that Beijing’s goal is to achieve flat property prices in the coming years. Authorities realize that property deflation could be devastating but are also less tolerant of growing excesses and imbalances in this area. Flat home prices and rising incomes will lead to a lower house price-to-income ratio, i.e., will make home ownership more affordable. In short, policymakers are attempting to fix property prices to achive a soft landing. Yet, there is a caveat: when authorities fix/control prices, they lose control of volumes/activity. This will likely be the case in China. Without meaningful drop in house prices, low-and middle-income first-time homebuyers will not become buyers right away and healthy property developers will be unwilling to snap up the assets of their troubled competitors. Hence, the market will not clear and the property sales and construction activity will hit an air pocket. Bottom Line: After more than a decade of speculative excesses, policymakers have embarked on the very difficult task of controlling house prices. They can control house prices via administrative measures. Yet, as expectations of rapidly rising property prices vanish, land sales, home purchases and property construction will likely shrink substantially for a period of time. Investment Recommendations A few market-relevant observations: Chinese non-TMT stocks and China-related plays globally are at risk from shrinking construction activity on the mainland. Critically, EM non-TMT stocks have not priced in the slowdown. Chart 10 illustrates that China’s credit and fiscal spending impulse is back to its previous low, but EM non-TMT stocks have not corrected much. In the past, Chinese onshore property stocks correlated with global material stocks (Chart 11). The basis is that China’s construction accounts for a considerable share of global raw materials consumption. Hence, the bear market in Chinese property stocks is raising a red flag for global material stocks. Chart 10EM Ex-TMT Stocks Are Not Pricing China's Slowdown EM Ex-TMT Stocks Are Not Pricing China's Slowdown EM Ex-TMT Stocks Are Not Pricing China's Slowdown Chart 11A Red Flag For Global Materials A Red Flag For Global Materials A Red Flag For Global Materials   EMs are most vulnerable, and the US is the least exposed to China’s construction and infrastructure investment segments. The basis is that the US is a closed economy and trades very little with China. That is why we believe that the US dollar has more upside and US equities will continue outperforming the global stock index as China’s slowdown persists. Putting it all together, we recommend the following strategies: Avoid EM stocks and underweight EM versus DM in a global equity portfolio. Continue shorting select EM currencies versus the US dollar. Avoid local currency bonds and favor US credit over EM credit markets. Avoid bottom fishing in Chinese offshore corporate bonds, including high-yield ones. As for Chinese equities, investors should stay with the long onshore A shares / short investable index strategy. We also reiterate a strategy we have been recommending for both onshore and offshore stocks since May 9, 2019: short property stocks relative to the benchmark. This has been a very profitable trade. Today, we recommend closing the long position in Chinese insurance stocks given that credit woes will worsen before they improve. One way for global investors to bet on China’s slowdown while hedging the risk of stronger growth in DM is via the following trade: short global materials / long global industrials. Our report from July 30 elaborated the bullish case for global industrials beyond China’s slowdown. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Footnotes 1 See Kenneth S. Rogoff and Yuanchen Yang, "Peak China Housing," National Bureau of Economic Research, August 2020. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights As US and China’s grand strategies collide, expect major and minor geopolitical earthquakes whose epicenter will now lie in South Asia and the Indian Ocean basin. Another tectonic change will drive South Asia’s emergence as a new geopolitical battle ground - South Asia is now heavily weaponized. All key players operating in this theater are nuclear powers. South Asia’s democratic traditions are well-known but notable institutional and social fault lines exist. These could trigger major geopolitical events in Afghanistan, Pakistan and in pockets of India too. We are bullish on India strategically but bearish tactically. Dangerous transitions are underway to India’s east and west. Within India, key elections are approaching, and it is possible that growth may disappoint. For reasons of geopolitics, we are strategically bullish on Bangladesh but strategically bearish on Pakistan and Sri Lanka. We are booking gains of 9% on our long rare earths basket and 1% on our long GBP-CZK trade. Feature Over the 1900s, East Asia and the Middle East emerged as two key geopolitical focal points on the world map. Global hegemons flexed their muscles and clashed in these two theaters. Meanwhile South Asia was a geopolitical backstage at best. The majority of South Asia was a British colony until the second half of the twentieth century. After WWII it struggled with the difficulties of independence and mostly missed out on the prosperity of East Asia and the Pacific. But will the twenty-first century be any different? Absolutely so. We expect the current century to be marked by major and minor geopolitical earthquakes in which South Asia and the Indian Ocean basin will play a major part. This seismic change is likely to be the result of several tectonic forces: Population: A quarter of the world’s people live in South Asia today and this share will keep growing for the next four decades. India will be the most populous country in the world by 2027 and will account for about a fifth of global population. Supply: China’s growth model has left it heavily dependent on imports of raw materials from abroad. It is clashing with the West over markets and supply chains. Beijing is building supply lines overland while developing a navy to try to secure its maritime interests. These interests increasingly overlap with India’s, creating economic competition and security concerns over vital sea lines of communication. Access: Whilst the Himalayas and Tibetan plateau have historically prevented China from expanding its influence in South Asia, China’s alliance with Pakistan is strengthening. Physical channels like the China Pakistan Economic Corridor (CPEC), and other linkages under the Belt and Road Initiative, now provide China a foot in the South Asian door like never before (Map 1). Weapons: The second half of the twentieth century saw China, India, and Pakistan acquire nuclear arms. Consequently, South Asia today is one of the most weaponized geographies globally (Map 1). Map 1South Asia To Emerge As A Key Geopolitical Theater In The 21st Century South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater With the South Asian economy ever developing, and US-China confrontation here to stay, we expect China to make its presence felt in South Asia over the coming decades. The US’s recent withdrawal from Afghanistan, and the failure of democratization in Myanmar, are but two symptoms of a grand strategic change by which China seeks to prevent US encirclement and Indo-American cooperation develops to counter China. Throw in the abiding interests of all these powers in the Middle East and it becomes clear that South Asia and the Indian Ocean basin writ large will become increasingly important over the coming decades. The Lay Of The Land - India Is The Center Of Gravity Chart 1South Asia Managed Rare Feat Of ‘Steady’ Growth South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater South Asia stands out amongst developing regions of the world for its large and young population. In recent decades, South Asia has also managed to grow its economy steadily, surpassing Sub-Saharan Africa and rivaling the Middle East (Chart 1). While South Asia’s growth rates have not been as miraculous as East Asia post World War II, its growth engine has managed to hum slowly but surely. India and Bangladesh have been the star performers on the economic growth front (Chart 2). Despite decent growth rates, the South Asian region is characterized by very low per capita incomes due to large population. On per capita incomes, Sri Lanka leads whilst Pakistan finds itself at the other end of the spectrum (Chart 3). Chart 2India And Bangladesh Have Been Star Performers South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 3Per Capita Incomes In South Asia Have Grown, But Remain Low South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 4India Accounts For About 80% Of South Asia’s GDP South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater South Asia constitutes eight nations. However only four are material from an investment perspective: India, Pakistan, Sri Lanka, and Bangladesh. India is the center of gravity as it offers the most liquid scrips and accounts for 80% of the region’s GDP (Chart 4). In addition: India accounts for 101 of the 110 companies from South Asia listed on MSCI’s equity indices. MSCI India’s market capitalization is about $1 trillion. In fact, India’s equity market could soon become larger than that of the UK and join the world’s top-five club.1 The combined market cap of MSCI Bangladesh, Sri Lanka, and Pakistan amounts to only about $6 billion. Liquidity is a constraint that investors must contend with whilst investing in these three countries in South Asia. Pakistan is the home of 220 million – set to grow to 300 million by 2040. It lags its neighbors on economic growth and governance but has nuclear weapons and a 650,000-strong military. Bottom Line: India is the center of gravity for the regional economy and financial markets in South Asia. Sri Lanka and Bangladesh are small but are developing. Pakistan is the laggard, but is militarily strong, which raises political and geopolitical risks. South Asia: Major Consumer, Minor Producer Chart 5Manufacturing Capabilities Of South Asian Economies Are Weak South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater South Asia’s defining economic characteristic is that it is a major consumer. This feature contrasts with the region’s East Asian cousins, which worked up economic miracles based on their manufacturing capabilities. South Asia’s appetite to consume is partly driven by population and partly driven by the fact that this region’s economies have an unusually underdeveloped manufacturing base (Chart 5). It’s no surprise that all countries in South Asia (with the sole exception of Afghanistan) are set to have a current account deficit over the next five years (Charts 6A and 6B). Chart 6ASouth Asian Economies Tend To Be Net Importers South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 6BSouth Asian Economies Tend To Be Net Importers South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater India is set to become the third largest global importer of goods and services (after the US and UK) over the next five years. Its rise as a large client state of the world will be both a blessing and a curse, as increased business leverage will coincide with geopolitical insecurity. Structurally, Sino-Indian tensions are rising and growing bilateral trade will not be enough to prevent them. Meanwhile dependency on the volatile Middle East is a geopolitical vulnerability. Either way, India and its region become more important to the rest of the world over time. Whilst the structure of South Asia’s economy is relatively rudimentary, it is worth noting that Bangladesh and Sri Lanka present an exception. Bangladesh has embarked on a path of manufacturing-oriented development via labor-intensive production. Sri Lanka has a well-developed services sector (Chart 7). In particular: Bangladesh: Within South Asia, Bangladesh’s manufacturing sector stands out as being better developed than regional peers. More than 95% of Bangladesh’s exports are manufactured goods –a level that is comparable to China (Chart 8). China’s share in the global apparel and footwear market has been systematically declining and Bangladesh is one of the countries that has benefited most from this shift. Bangladesh’s share in global apparel and footwear exports to the US as well as EU has been rising steadily and today stands at 4.5% and 13% respectively.2 Chart 7Bangladesh’s And Sri Lanka’s Economies Are Relatively Modern South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 8Bangladesh Has The Most Developed Exports Franchise In South Asia South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Sri Lanka: Whilst Sri Lanka social complexities are lower and per capita incomes are higher as compared to peers in South Asia, its transition from a long civil war to a focus on economic development recently suffered a body blow, first owing to terrorist attacks in 2019 and then owing to the pandemic. The economic predicament was then worsened by its government’s hasty transition to organic farming which hit domestic food production. Geopolitically it is worth noting that China is one of the largest lenders to Sri Lanka. Whilst Sri Lanka’s central bank may be able to convince markets of the nation’s ability to meet debt obligations for now, its foreign exchange reserves position remains precarious and public debt levels remain high. Sri Lanka’s vulnerable finances are likely to only increase Sri Lanka’s reliance on capital-rich China. Despite Democracy, South Asia Has Political Tinderboxes Another factor that sets South Asia apart from developing regions like Africa, the Middle East, and Central Asia is the region’s democratic moorings. India and Sri Lanka lead the region on this front, although the last decade may have seen minor setbacks to the quality of democracy in both countries (Chart 9). Pockets of South Asia are socially and politically unstable, characterized by religious or communal strife, terrorist activity, and even the occasional coup d'état. Risk Of Social Conflict Most Elevated In Pakistan And Afghanistan India’s demographic dividend is real, but its benefits should not be overstated. For instance, India’s northern region is a demographic tinderbox. It is younger than the rest of the country, yet per capita incomes are lower, youth underemployment is higher, and society is more heterogeneous. The rise of nationalism in India is an important consequence and could engender potential social unrest. Chart 9India’s Democracy Strongest, But May Have Had Some Setbacks South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 10South Asia Is Young And Will Age Slowly South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater   Chart 11Social Complexities Are High In Afghanistan & Pakistan South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater A similar problem confronts South Asia as a whole. Pakistan and Afghanistan are younger than India by a wide margin (Chart 10). But both countries are economically backward and have either poor or non-existent democratic traditions. Lots of poor youths and inadequate political valves to release social tensions make for an explosive combination. These countries are highly vulnerable to social conflict that could cause political instability at home or across the region via terrorism (Chart 11). The Gatsby Effect Most Prominent In Pakistan While various regions struggle with inequality, South Asia has less of a problem that way (Chart 12). However South Asia is characterized by very low levels of social mobility as compared to peer regions. This can partially be attributed to two centuries of colonial rule as well as to endemic traditions of social stratification. Chart 12Gatsby Effect: Social Mobility Is Lowest In Pakistan South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Within South Asia it is worth noting that social mobility is the lowest in Pakistan and highest in Sri Lanka. Chart 13Military’s Influence Most Elevated In Pakistan And Nepal Too South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Military Influential In Pakistan (And Nepal) Events that transpired over January 2020 in the US showed that even the oldest constitutional democracy in the world is not immune to a breakdown of civil-military relations. South Asia has seen the occasional coup d'état, one reason for the political tinderboxes highlighted above. Obviously, Myanmar is the worst – it saw its nascent democratization snuffed out just last year. But other countries in the region could also struggle to maintain civilian order in the coming decades. The military’s influence is outsized in Pakistan as well as Nepal (Chart 13). India maintains high levels of defense spending but has a strong tradition of civilian control (Chart 14). Chart 14Pakistan’s Military Budget Is Most Generous, India A Close Second South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater South Asia: A New Global Battle Ground Historically global hegemons have sought to assert their dominance by staking claim over coastal regions in Europe and Asia. Over the past two centuries Asia has emerged as a geopolitical theater second only to Europe. Naval and coastal conflicts have emerged from the rise of Japan (the Russo-Japanese War) and the Cold War (the Korean War & the Vietnam War). Today the rise of China is the destabilizing factor. The “frozen conflicts” of the Cold War are thawing in Taiwan, South Korea, and elsewhere. China is pursuing territorial disputes around its entire periphery, including notably in the East and South China Seas but also South Asia. Meanwhile the US, fearful of China, is struggling to strike a deal with Iran and shift its focus from the Middle East to reviving its Pacific strategic presence. A budding US-China competition is creating conditions for a new cold war or a series of “proxy battles” in Asia. Over the next few decades, we expect disputes to continue. But the focal points are likely to cover South Asia too. In specific, landlocked regions in South Asia are likely to see rising tensions in the twenty-first century (Map 2). Also as mentioned above, China’s naval expansion and the US’s attempt to form a “quadrilateral” alliance with India, Japan, and Australia will generate tensions and potentially conflict. European allies are also becoming more active in Asia as a result of US alliances as well as owing to Europe’s independent need for secure supply lines. Map 2China’s Interest In Landlocked Regions Of South Asia Is Rising South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater While border clashes between India and China will ebb and flow, Indo-Chinese confrontations along India’s eastern border will become a structural theme. Arguably, Sino-Indian rivalries pre-date the twenty-first century. But in a world in which the Asian giants are increasingly economically and technologically developed, Sino-Indian confrontations are likely to persist and result in major geopolitical events. Consider: China is adopting nationalism and an assertive foreign policy to cope with rising socioeconomic pressures on the Communist Party as potential GDP growth slows. China is developing a navy as well as a stronger alliance with Pakistan, which includes greater lines of communication. North India is a key constituency for the political party in power in India today (i.e., the Bhartiya Janata Party or BJP) and this geography harbors especially unfavorable views of Pakistan (Chart 15). Thus, there is a risk that the India of today could respond far more decisively or aggressively to threats or even minor disputes. More broadly, nationalism is rising in India as well as China. India is shedding its historical stance of neutrality and aligning with the US, which fuels China’s distrust (Chart 16). Chart 15Northern India Views Pakistan Even More Unfavorably Than Rest Of India South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 16India Has Aligned With The QUAD To Counter The Sino-Pak Alliance South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Turning attention to India’s western border, clashes between India and Pakistan relating to landlocked areas in Kashmir will also be a recurring theme. Whilst India currently has a ceasefire agreement in place with Pakistan, peace between the two countries cannot possibly be expected to last. This is mainly because: Kashmir: Core problems between the two countries, like India’s control over Kashmir and Pakistan’s use of militant proxies, remain unaddressed. India’s unexpected decision in 2019 to abrogate article 370 of the Indian constitution has reinforced Pakistan’s attention on Kashmir. Sino-Pak Alliance: Pakistan accounted for 38% of China’s arms exports over 2016-20. Pakistan accounts for the lion’s share of Chinese investments made in South Asia (Chart 17). Sino-India rivalries will spill into the Indo-Pak relationship (and vice versa). Revival Of Taliban: The US withdrawal from Afghanistan has revived Taliban rule in that country. Taliban’s rise will resuscitate a range of dormant terrorist movements in Afghanistan as well as in Pakistan. India has a long history of being targeted. South Asia today is very different from what it looked like for most of the post-WWII era: it is heavily weaponized. India, Pakistan, and China became nuclear powers in the second half of the twentieth century and have been steadily building their nuclear stockpiles ever since (Chart 18). North Korea’s growing arsenal is theoretically able to target India, while Iran (more friendly toward India) may also obtain nuclear weapons. Chart 17China And Pakistan: Joined At The Hip? South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Chart 18South Asia: The New Epicenter For Nuclear Activity South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater While nuclear arms create a powerful incentive for nations to avoid total war, they can also create unmitigated fear and uncertainty during incidents of major strategic tension. This is especially true when countries have not yet worked out a mode of living with each other, as with the US and USSR in the early days of the Cold War. Investment Takeaways For investors with an investment horizon exceeding 12 months, we highlight that India presents a long-term buying opportunity for two key reasons: China’s Internal And External Troubles Will Benefit India: As long as US and China do not reengage in a major way, global corporations will fall under pressure to diversify from China and the US will pursue closer relations with India. China faces an array of challenges across its periphery, whereas India need only focus on the South Asian sphere. India Is Rising As A Global Consumer: As long as a major Middle East war and oil shock is avoided (not a negligible risk), India should see more benefits than costs from its growing importance as a client of the world. However, over the next 12 months we worry that India is priced for perfection. India currently trades at a punchy premium relative to emerging markets (Table 1) at a time of when both geopolitical and macroeconomic headwinds are at play. In particular: Table 1We Are Bearish On India Tactically, But Bullish On India & Bangladesh Strategically South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Major Transitions Are Dangerous: Recent developments in South Asia have added to geopolitical risks for India. The assumption of power by Taliban in Afghanistan will activate latent terrorist forces that could target India. Pakistan’s chronic instability combined with the change of power in Afghanistan could set off an escalation in Indo-Pakistani tensions, sooner rather than later. On India’s eastern front, China’s need to distract its population from a souring economy could trigger a clash between China and India. Down south, China’s rising influence over crisis-hit Sri Lanka is notable and could potentially engender security risks for India. Chart 19Politics Can Trump Economics In Run Up To General Elections South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Growth Slowing, Elections Approaching: We worry that India’s growth engine may throw up a downside surprise over the next 12 months owing to poor jobs growth and poor investment growth. History suggests that politics often trumps economics in the run up to general elections (Chart 19). Hence there is a real risk that policy decisions will be voter-friendly but not market-friendly over 2022. As both India and Pakistan are gearing up for elections in the coming years, major military showdown or saber rattling should not be ruled out. Both countries may engineer a rally around the flag effect to bump up their pandemic-battered approval. Tension with China may escalate as Xi Jinping extends his term in power next year and seeks to enforce red lines in China’s eastern and western borders. Globally what are the key geopolitical factors that could lead to India’s underperformance in the short run? We highlight a checklist here: China Stimulates: The near-term clash between markets and policymakers in China should eventually give way to meaningful fiscal stimulus by Chinese authorities. This buoys China as well as emerging markets that depend on China for their growth. However, even if China flounders, India may not continue to outperform. The correlation between MSCI India and China equities has been positive. Fed Tightens Quickly: A faster-than-expected taper and tightening guidance could cause those emerging markets that are richly priced like India to correct. A Crisis Over Iran’s Nuclear Program: If the US is unable to return to diplomacy, tensions in the Middle East will rise and stoke oil prices. This will affect India adversely, given global price pressures and India’s high dependence on oil imports. Conversely, if these developments fail to materialize then that would lower our conviction regarding India’s underperformance in the short run. In summary, we are bullish India strategically but bearish tactically. As regards the three other investable markets in South Asia: We are bearish on Pakistan and Sri Lanka on a strategic time horizon. Whilst both nations’ rising alignment with China could be an advantage ceteris paribus, ironically their deteriorating finances are driving their proximity to capital-rich China (Chart 20). To boot, Sri Lanka’s ability to pay its way out of its economic crisis on its own steam is worsening. This is evident from its rising debt to GDP ratio (Chart 21). Chart 20Pakistan And Sri Lanka Running Low On Reserves South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater Pakistan faces elevated risks of internal social conflict, must deal with a rapidly changing external environment, has a weak democracy and an unusually influential military. Sri Lanka’s social risks are low, but its economic crisis appears likely to persist. The fact that both markets have been characterized by a high degree of volatility in earnings in the recent past implies that even a cyclical “Buy” case for either of these markets is fraught with risks (Table 1). The outlook for Bangladesh is better. Exports account for 15% of GDP and the US and Europe account for around 70% of its exports. Strong fiscal stimulus in these developed markets should augur well for this frontier market. Additionally, Bangladesh is characterized by moderate social risks, reasonably strong democracy scores and low levels of influence from the military. Its healthy public finances (Chart 21) and the fact that it shares no border with China creates the potential to leverage a symbiotic relationship with China. Chart 21Sri Lanka’s Debt Now Exceeds Its GDP South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater But there is a catch. Bangladesh as a market has a low market cap and hence offers low levels of liquidity (Table 1). We thus urge investors to avoid making cyclical investment calls on this South Asian market. However, from a long-term perspective we highlight our strategic bullish view on Bangladesh given supportive geopolitical factors. Watch out for an upcoming report from our Emerging Markets Strategy team, that will delve into the macroeconomic aspects of Bangladesh.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 Abhishek Vishnoi and Swetha Gopinath, "India's stock market on track to overtake UK in terms of m-cap: Report" Business Standard, October 2021. 2 Arianna Rossi, Christian Viegelahn, and David Williams, "The post-COVID-19 garment industry in Asia" Research Brief, International Labour Organization, July 2021. Open Trades & Positions South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater South Asia: A New Geopolitical Theater

Highlights The surge in energy prices going into the Northern Hemisphere winter – particularly coal and natgas prices in China and Europe – will push inflation and inflation expectations higher into the end of 1Q22 (Chart of the Week).  Over the medium-term, similar excursions into the far-right tails of price distributions will become more frequent if capex in hydrocarbon-based energy sources continues to be discouraged, and scalable back-up sources of energy are not developed for renewables. It is not clear China will continue selectively relaxing price caps for some large electricity buyers, which came close to bankrupting power utilities this year and contributed to power shortages.  The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF.  We remain long both. Higher energy and metals prices also will work in favor of long-only commodity index exposure over the medium term. Longer-term supply-chain issues will be sorted out. Still, higher costs will be needed to incentivize production of the base metals required to decarbonize electricity production globally, and  to keep sufficient supplies of fossil fuels on hand to back up renewable generation.  This will cause inflation to grind higher over time. Feature Back in February, we were getting increasingly bullish base metals on the back of surging demand from China. Most other analysts were looking for a slowdown.1 The metals rally earlier this year drew attention away from the fact that China had fundamentally altered its energy supply chain, when it unofficially banned imports of Australian thermal coal. It also altered global energy flows and will, over the winter, push inflation higher in the short run. Building new supply chains is difficult under the best of circumstances. But last winter had added dimensions of difficulty: A La Niña drawing arctic weather into the Northern Hemisphere and driving up space-heating demand; flooding in Indonesia, which limited coal shipments to China; and a manufacturing boom that pushed power supplies to the limit. Over the course of this year, Chinese coal inventories fell to rock-bottom levels and set off a scramble for liquified natural gas (LNG) to meet space-heating and manufacturing demand last winter (Chart 2).2 Chart of the WeekEnergy-Price Surge Will Lift Inflation Energy-Price Surge Will Lift Inflation Energy-Price Surge Will Lift Inflation Chart 2Coal Shortage China China Power Outages: Another Source Of Downside Risk Coal Shortage China China Power Outages: Another Source Of Downside Risk Coal Shortage China While this was evolving, the volume of manufactured exports from China was falling (Chart 3), even while the nominal value of these exports was rising in USD terms (Chart 4).  This is a classic inflationary set-up: More money chasing fewer goods.  This is occurring worldwide, as supply-chain bottlenecks, power rationing and shortages, and falling commodity inventories keep supplies of most industrial commodities tight.  China's export volumes peaked in February 2021, and moved lower since then.  This likely persists going forward, given the falloff of orders and orders in hand (Chart 5). Chart 3Volume Of China's Exports Falls … Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher Chart 4… But The Nominal USD Value Rises Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher Chart 5China's Official PMIs, Export And In-Hand Orders Weaken Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher Space-heating and manufacturing in China are both heavily reliant on coal. Space-heating north of the Huai River is provided for free, or is heavily subsidized, from coal-fired boilers that pump heat to households and commercial establishments. This is a practice adopted from the Soviet Union in the 1950s and expanded until the 1980s, according to Fan et al (2020).3 Manufacturing pulls its electricity from a grid that produces 63% of its power from coal. China's coal output had been falling since December 2020, which complicated space heating and electricity markets, where prices were capped until this week. This meant electricity generators could not recover skyrocketing energy costs – coal in particular – and therefore ran the risk of bankruptcy.4 The loosening of price caps is now intended to relieve this pressure. Competition For Fuels Will Continue Europe was also hammered over the past year by a colder-than-normal winter brought on by a La Niña event, which sharply drew natgas inventories. The cold weather lingered into April-May, which slowed efforts to refill storage, and set off a scramble to buy up LNG cargoes (Chart 6). Chart 6The Scramble For Natgas Continues Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher This competition has lifted global LNG prices to record levels, and continues to drive prices higher. Longer-term, the logic of markets – higher prices beget higher supply, and vice versa – virtually assures supply chains will be sorted out. However, the cost of energy generally will have to increase to incentivize production of the base metals needed to pull off the decarbonization of electricity production globally, and to keep sufficient supplies of fossil fuels on hand to back up renewable generation. This will cause inflation to grind higher over time. Decarbonization is a strategic agenda for leading governments, especially China and the European Union. China is fully committed to renewables for fear of pollution causing social unrest at home and import dependency causing national insecurity abroad. In the EU, energy insecurity is also an argument for green policy, which is supported by popular opinion. The US has greater energy security than these two but does not want to be left behind in the renewable technology race – it is increasing government green subsidies. The current set of ruling parties will continue to prioritize decarbonization for the immediate future. Compromises will be necessary on a tactical basis when energy price pressures rise too fast, as with China’s latest measures to restart coal-fired power production. The strategic direction is unlikely to change for some time. Investment Implications Over time, a structural shift in forward price curves for oil, gas and coal – e.g., a parallel shift higher from current levels – will be required to incentivize production increases. This would provide hedging opportunities for the producers of the fuels used to generate electricity, and the metals required to build the infrastructure needed by the low-carbon economies of the future. We continue to expect markets to remain tight on the supply side, which will make backwardation – i.e., prices for prompt-delivery commodities trade higher than those for deferred delivery – a persistent feature of commodities for the foreseeable future.  This is because inventories will remain under pressure, making commodity buyers more willing to pay up for prompt delivery. The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF. We remain long both, given our expectation. Over the short term, inflation will be pushed higher by the rise in coal and gas prices.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish According to the Energy Information Administration (EIA), industrial consumption of natgas in the US is on track to surpass its five-year average this year. Over the January-July period, US natgas consumption average 22.4 BCF/d, putting it 0.2 BCF/d over its five-year average (2016-2020). US industrial consumption of natgas peaked in 2018-19 at just over 23 BCF/d, according to the EIA (Chart 7). The EIA expects full-year 2021 industrial consumption of natgas to be 23.1 BCF/d, which would tie it with the previous peak levels. Base Metals: Bullish Following a sharp increase in refined copper usage in China last year resulting from a surge in imports, the International Copper Study Group (ICSG) is expecting a 5% decline this year on the back of falling imports. Globally, the ICSG expects refined copper consumption to be unchanged this year, and rise 2.4% in 2022. Refined copper production is expected to be 25.9mm MT next year vs. 24.9mm MT this year. Consumption is forecast to grow to 25.6mm MT next year, up to 700k MT from the 24.96mm MT usage expected this year. Precious Metals: Bullish Lower-than-expected job growth in the US pushed gold prices higher at the end of last week on the back of expectations the Fed will continue to keep policy accessible as employment weakened. All the same, gold prices remain constrained by a well-bid USD, which continues to act as a headwind, and only minimal weakening of the 10-year US bond yield, which dipped slightly below the 1.61% level hit earlier in the week (Chart 8). Ags/Softs: Neutral This week's USDA World Agricultural Supply and Demand Estimates (WASDE) were mostly neutral for grains and bearish for soybeans. Global ending bean stocks are expected to rise almost 5.4% in the USDA's latest estimate for ending stocks in the current crop year, finishing at 104.6mm tons. Corn and rice ending stocks were projected to rise 1.4% and less than 1%, ending the crop year at 301.7mm tons and 183.6mm tons, respectively. According to the department, global wheat ending stocks are the lone standout, expected to fall 2.1% to 277.2mm tons, the lowest level since the 2016/17 crop year. Chart 7 Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher Chart 8 Uncertainty Weighs On Gold Uncertainty Weighs On Gold   Footnotes 1     Please see Copper Surge Welcomes Metal Ox Year, which we published on February 11, 2021.  It is available at ces.bcaresearch.com. 2     China’s move to switch to Indonesian coal at the beginning of this year to replace Aussie coal was disruptive to global markets.  As argusmedia.com reported, this was compounded by weather-related disruptions in Indonesian exports earlier this year.  It is worthwhile noting, weather-related delays returned last month, with flooding in Indonesia's coal-producing regions again are disrupting coal shipments.  We expect these new trade flows in coal will take a few more months to sort out, but they will be sorted. 3    Please see Maoyong Fan, Guojun He, and Maigeng Zhou (2020), " The winter choke: Coal-Fired heating, air pollution, and mortality in China," Journal of Health Economics, 71: 1-17.  4    In August and September, the South China Morning Post reported coal-powered electric generators petitioned authorities to relax price caps, because they faced bankruptcy from not being able to recover the skyrocketing cost of coal. Please see China coal-fired power companies on the verge of bankruptcy petition Beijing to raise electricity prices, published by scmp.com on September 10, 2021. This month, Shanxi Province, which provides about a third of China's domestically produced coal, was battered by flooding, which forced authorities to shut dozens of mines, according to the BBC. Please see China floods: Coal price hits fresh high as mines shut published by bbc.co.uk on October 12, 2021. Power supplies also were lean because of the central government's so-called dual-circulation policies to reduce energy consumption and the energy intensity of manufacturing. This is meant to increase self-reliance of the state. Please see What is behind China’s Dual Circulation Strategy? Published by the European think tank Bruegel on September 7, 2021.   Investment Views and Themes Strategic Recommendations

Dear Client, Owing to BCA’s Annual Investment Conference next week, there will be no report on Wednesday, October 20. We will return to our regular publication schedule on Wednesday, October 27. Please note that there will be a China Outlook panel discussion at 9 AM on Thursday, October 21. We hope you will join us for the event. Best regards, Jing Sima China Strategist   Highlights In the next six to nine months, the long-end of the yield curve will likely drop as investors start to price in weaker-than-expected economic growth amid measured stimulus. China’s 10-year government bond yields are set to structurally shift to a lower bound as domestic demand decelerates along with the nation’s total population. Policymakers will favor lower borrowing costs to reduce stress due to high debt levels among companies, central and local governments, and households. National savings are not a constraint for a country to lower domestic bond yields. China will continue to open domestic financial markets to global investors. The country’s large foreign exchange reserves limit the risk to its internal markets from extreme volatility in foreign fund flows. Feature In the past two decades policy rates in advanced economies have been brought close to zero and bond yields have dropped to extremely low levels. The yields on China’s government bonds, however, have remained well above their peers in advanced economies and in neighboring countries (Chart 1). Chart 1China's Government Bond Yields Far Above Other Major Economies China's Government Bond Yields Far Above Other Major Economies China's Government Bond Yields Far Above Other Major Economies Moreover, despite China’s growth slowing from double to mid-single digits, yields on China’s 10-year government bonds have remained at around 2006 levels. China’s working-age population continues to decline and its total population is estimated to start falling in the next five years. China’s demographic headwinds, combined with high leverage in the private sector at around 220% of GDP, will cap the upside in yields. In this report we share our views on China’s short rates and long-term bond yields on a cyclical basis (next six to nine months) and in the next five years. The Cyclical Outlook The yield curve will likely flatten with China’s long-term government bond yields dropping more than short-term rates in next six to nine months. This will occur in the expectation of a further growth slowdown in at least the next two quarters. Meanwhile, the downside is limited on the short-end of the curve, given it is more sensitive to the PBoC’s guidance and monetary authorities will ease policy only gradually. Stimulus in the next two quarters may also disappoint. Credit growth will bottom in Q4 this year, but the rebound will be modest. Stronger issuance in local government bonds in the next two quarters will be offset by sluggish bank loan impulse. Chinese policymakers will refrain from using stimulus for the property market as a counter-cyclical policy tool to revive the economy. Restrictions will be maintained on bank lending to the real estate sector including mortgages and these controls will limit the rebound in credit expansion. Furthermore, infrastructure investment will improve modestly in the next two quarters, but local governments remain under pressure to deleverage, which will limit their incentive and capacity to spend. Chart 2Stimulus In 2018/19 Was Very Measured Stimulus In 2018/19 Was Very Measured Stimulus In 2018/19 Was Very Measured We maintain our view that the current policy backdrop is shaping up to resemble that of H2 2018 and 2019. At that time, even though the central bank maintained an accommodative monetary policy stance and kept liquidity conditions ample, the size of the stimulus was measured and the economy was lackluster (Chart 2). Recent liquidity injections by the PBoC through open market operations should not be viewed as monetary easing because they represent the bank’s efforts to keep policy rates steady, at best (Chart 3). The central bank provided the interbank system with substantial financing to avoid liquidity crunches following the May 2019 Baoshang Bank takeover and the November 2020 Yongcheng Coal company debt default (Chart 4). In both cases, 10-year bond yields did not fall by as much as short rates, reflecting investors’ expectations that the liquidity injections and resulting drop in short rates were not long-lasting. Chart 3Recent PBoC Liquidity Injections Intended To Keep Policy Rates Steady Recent PBoC Liquidity Injections Intended To Keep Policy Rates Steady Recent PBoC Liquidity Injections Intended To Keep Policy Rates Steady Chart 4APBoC Also Injected Liquidity After Previous High-Profile Defaults PBoC Also Injected Liquidity After Previous High-Profile Defaults PBoC Also Injected Liquidity After Previous High-Profile Defaults Chart 4BPBoC Also Injected Liquidity After Previous High-Profile Defaults PBoC Also Injected Liquidity After Previous High-Profile Defaults PBoC Also Injected Liquidity After Previous High-Profile Defaults Our view on China’s bond yields will not change with the liftoff of US Fed policy rates,  even if the Fed hikes rates earlier and by more than anticipated. The Fed’s policy has little bearing on China’s long-dated yields, which are driven by domestic business cycles and monetary policy (Chart 5). Concerning the exchange rate, we believe that the RMB will modestly depreciate in the next six to nine months, given that the China-US nominal and real interest rate differentials will narrow (Chart 6). While some depreciation in the currency is modestly reflationary for China’s exporters, it will not be enough to offset weaknesses in domestic demand. Chart 5Domestic Economic Fundamentals Drive Yields On China's Government Bonds Domestic Economic Fundamentals Drive Yields On China's Government Bonds Domestic Economic Fundamentals Drive Yields On China's Government Bonds Chart 6China-US Rate Differentials Are Set To Narrow China-US Rate Differentials Are Set To Narrow China-US Rate Differentials Are Set To Narrow Chart 7Pipeline Inflationary Pressures in China Remain Elevated Pipeline Inflationary Pressures in China Remain Elevated Pipeline Inflationary Pressures in China Remain Elevated Inflation remains a risk to our cyclical view on the 10-year bond yield. While the economy is weakening, pipeline inflationary pressures remain elevated (Chart 7).  We do not foresee that the PBoC will change its modestly dovish policy stance because of inflationary pressures stemming from supply-side bottlenecks. However, supply constraints will not abate soon and consequently, pipeline inflationary pressures and producer price inflation may not subside in the next six months. Thus, fixed-income investors may start to price in higher inflation, which could prevent long-duration bond yields from declining by much. Bottom Line: In the coming months, the long-end of the yield curve will likely drop as investors start to price in weaker-than-expected economic growth and very measured stimulus. The short-end of the curve will have limited downside potential because there is only a slim chance of aggressive monetary easing. Bond Yields Are On A Structural Downtrend Bond yields in China will likely downshift in the next three to five years. Our secular outlook for government bond yields is based on the country’s demographic trends, inflation, productivity growth and debt levels. While China’s long-term bond yields have persistently averaged below nominal GDP growth, in the past decade the gap has significantly narrowed as economic growth slowed while yields remained within a tight range (Chart 8).  This contrasts with other manufacturing and export-oriented Asian economies where interest rates have moved to a lower range in proportion with economic growth rates (Chart 9). Chart 8China's Economic Growth Has Downshifted But Yields Have Not... China's Economic Growth Has Downshifted But Yields Have Not... China's Economic Growth Has Downshifted But Yields Have Not... Chart 9...In Contrast With Other Asian Manufacturing-Based Economies ...In Contrast With Other Asian Manufacturing-Based Economies ...In Contrast With Other Asian Manufacturing-Based Economies China’s long-dated bond yields will also downshift in the next three to five years given the nation’s declining long-term potential output growth, based on the following: Chart 10Wages Have Risen In China Wages Have Risen In China Wages Have Risen In China A shrinking workforce can be inflationary due to higher labor costs and we expect Chinese workers’ compensation will continue to increase in the next five years (Chart 10). However, wage inflation will likely be offset by labor productivity, which has remained robust. The nation’s unit-labor cost (ULC), measured by the wages paid for each employee to produce one unit of output, has been flat to slightly down in the past decade despite strong wage growth (Chart 11). Similarly, ULC has sagged in Japan and is muted in South Korea (countries with shrinking labor forces) due to fast-growing labor productivity. This contrasts with the US, where ULC has risen even though the labor force has expanded in the past 10 years (Chart 12) China’s labor productivity will not likely undergo a significant decline in the next five years, particularly if China successfully maintains the manufacturing sector’s share in its aggregate economy, because productivity growth in this sector is usually higher than in others. Chart 11ULC Has Been Relatively Flat ULC Has Been Relatively Flat ULC Has Been Relatively Flat Chart 12ULC Muted In Asian Economies Compared With US ULC Muted In Asian Economies Compared With US ULC Muted In Asian Economies Compared With US   Meanwhile, China’s total population will shrink within the next five years, which will likely bring powerful disinflationary forces that will more than offset price increases created by labor shortages. Disinflation will cap the upside in interest rates/bond yields. Chart 13Japan's Household Consumption Share Fell Sharply When Total Population Started Shrinking Japan's Household Consumption Share Fell Sharply When Total Population Started Shrinking Japan's Household Consumption Share Fell Sharply When Total Population Started Shrinking A shrinking total population can significantly reduce demand, as evidenced in Japan in the past two decades. Japan’s working-age population started falling in the early 1990s, but the country’s household consumption share in GDP fell sharply after its total population peaked in 2010 and the urban population growth started contracting (Chart 13). In other words, Japan’s rapidly falling demand more than offset a muted increase in wage growth. China’s housing demand may have already peaked and the decline will gather speed in the next five years (Chart 14). Long-term growth in household consumption moves in tandem with housing and, therefore, will also downshift in the coming years (Chart 15). In the next five years or longer, China’s de-carbonization efforts will require shutting down production of many old economy enterprises.  Policymakers may keep low interest rates to accommodate such a transformation. Furthermore, amid the geopolitical confrontation with the US, Beijing will need lower interest rates to support the manufacturing sector and to undertake an industrial upgrade. Chart 14China's Demand For Housing Is On A Structural Downshift... China's Demand For Housing Is On A Structural Downshift... China's Demand For Housing Is On A Structural Downshift... Chart 15...Along With Consumption ...Along With Consumption ...Along With Consumption The main risk to our view is that China’s total factor productivity1 growth could accelerate to more than offset a declining total population. This would boost real per capita income and result in higher potential growth in the economy. In this scenario, long-duration bond yields could climb.  However, total factor productivity growth will need to outpace the rate of a shrinking labor pool and capital formation to prop up growth in the aggregate economy (Chart 16A and 16B). This is a daunting mission that Japan and South Korea, where productivity growth has been on par with China, have failed to accomplish. Chart 16AChina's Neighbors Have Not Accelerated Their Productivity Gains To Structurally Boost Economic Growth China's Neighbors Have Not Accelerated Their Productivity Gains To Structurally Boost Economic Growth China's Neighbors Have Not Accelerated Their Productivity Gains To Structurally Boost Economic Growth Chart 16BChina's Neighbors Have Not Accelerated Their Productivity Gains To Structurally Boost Economic Growth China's Neighbors Have Not Accelerated Their Productivity Gains To Structurally Boost Economic Growth China's Neighbors Have Not Accelerated Their Productivity Gains To Structurally Boost Economic Growth Chart 17China Cannot Drastically Improve Its Productivity Growth In The Next Five Years China’s Interest Rates: Will They Join The Race To Zero? China’s Interest Rates: Will They Join The Race To Zero? It is unrealistic to expect that China will drastically improve its productivity growth.  Productivity level is much higher now than it was 10-20 years ago when China’s manufacturing sector accounted for more than 40% of GDP (Chart 17). Even though China’s manufacturing share in the economy will stabilize and even increase from the current 27% of the economy, it cannot boost the sector drastically, particularly because its export market share cannot expand much further due to rising geopolitical tensions. In short, sectors of the economy where productivity gains have been most rapid – manufacturing sector including exports that drove China’s productivity in the past 20 years - cannot fully offset the deceleration in other growth drivers going forward. The service sector will grow, but it is much more difficult to achieve fast productivity gains in the service sector. All in all, productivity and economic growth will moderate as China’s growth model shifts from capital-intensive infrastructure and real estate to services. Bottom Line: In the next five years, China’s 10-year government bond yields are more likely to structurally move to a lower bound as final demand falls along with the nation’s total population. Savings, Debt And Interest Rates China’s national savings rate is one of the highest in the world, but it will drop as the population ages. Thus, some economists may argue that a structural decline in the national savings rate will lead to higher interest rates in the long run. Chart 18Lower Savings Rates Do Not Necessarily Herald Higher Interest Rates Lower Savings Rates Do Not Necessarily Herald Higher Interest Rates Lower Savings Rates Do Not Necessarily Herald Higher Interest Rates However, there is no empirical evidence that national savings drive interest rates. There has not been an inverse relationship between national savings rates and government bond yields in either Japan or the US, as illustrated in the middle and bottom panels of Chart 18.  There are more periods of positive rather than negative correlation between savings rates and bond yields. Note that China’s national savings rate and its interest rates also are not inversely related; a rising saving rate does not lead to lower interest rates and vice versa (Chart 18, top panel). This empirical evidence is in line with special reports published by BCA’s Emerging Markets Strategy that concluded the following: Banks cannot and do not lend out or intermediate national or households “savings.” In an economy with banks, one does not need to save in the form of a deposit in a bank in order for a bank to lend money to another entity. In any economy, new money originates by commercial banks “out of thin air” when they lend to or buy assets from non-banks. Hence, there is little relationship between national savings (flow concept in economics) and money supply growth (a flow variable too) (Chart 19). The term “savings” in macroeconomics denotes an increase in the economy’s capital stock, not deposits at banks. China’s banking system has an enormous amount of deposits, created by the banks “out of thin air” and not from households’ savings. The above factors explain why Japan’s government bond yields and national savings rate have been falling since 1990 (Chart 18 on Page 12, bottom panel). A lack of demand for borrowing was not why bond yields fell. A reason why China’s bond yields will likely be in a secular decline is that commercial banks will purchase government and corporate bonds en masse as they have done in the past 10 years (Chart 20). To do so, commercial banks will not use existing deposits, but rather they will create new deposits/money “out of thin air.” Chart 19There Is Little Relationship Between National Savings And Money Growth There Is Little Relationship Between National Savings And Money Growth There Is Little Relationship Between National Savings And Money Growth Chart 20China's Commercial Banks Will Continue To Purchase Government And Corporate Bonds China's Commercial Banks Will Continue To Purchase Government And Corporate Bonds China's Commercial Banks Will Continue To Purchase Government And Corporate Bonds The same is true for the banks’ purchases of corporate bonds. In China, commercial banks own about 75% of government (including local government) bonds and 20% of onshore corporate bonds. To avoid a spike in bond yields, Chinese regulators could relax the limitations on commercial banks to purchase government and corporate bonds. The upshot will be a lack of crowding out and no upward pressure on bond yields despite a large bond issuance. Chart 21China's Debt-To-GDP Ratio And Service Costs Have More Than Doubled In The Past 10 Years China's Debt-To-GDP Ratio And Service Costs Have More Than Doubled In The Past 10 Years China's Debt-To-GDP Ratio And Service Costs Have More Than Doubled In The Past 10 Years What are the implications of high indebtedness on interest rates? China’s domestic debt-to-GDP ratio has jumped from 120% of GDP in 2008 to 260% (Chart 21, top panel). This includes local currency borrowing by/debt of government, enterprises and households. Critically, the debt-service ratio2 for enterprises and households has more than doubled from 10% of disposable income in 2008 to over 20% (Chart 21, bottom panel). China cannot afford much higher interest rates because enterprises and households will struggle and will not be able to service their debts. Mortgage rates in China are at around 5.5%, the one-year prime lending rate for companies is 3.85% and onshore corporate bond yields are 3.7%. These are not particularly low borrowing costs given both high indebtedness and the outlook for structurally slower economic growth. Onshore borrowing costs may be brought down further in the years ahead to rule out debt distress among households, enterprises and local governments. Since 2015 and prior to the pandemic, China’s debt-service ratio has been mostly flat despite a rising debt-to-GDP ratio.3 This has been achieved through declining interest rates. In the next five years policymakers will likely maintain a stable debt-to-GDP ratio. Hence, lower bond yields are all but inevitable to decrease the debt-servicing burden. In addition, China’s “common prosperity” policy means larger government spending/deficits. However, to cap the government debt-to-GDP ratio, bond yields should be kept down. This is another reason why China’s will opt for lower interest rates/bond yields. Bottom Line: The high level of debt among local governments, companies and households means that borrowing costs in China will be reduced in the years ahead. National savings are not a constraint in any country for commercial banks to expand credit and/or to buy bonds. China will encourage its banks to buy government and corporate bonds to trim yields amid continuous heavy bond issuance. Will China’s Financial Opening Continue? In the current environment which geopolitical tensions are rising between China and the West, many global investors are concerned whether China will impose tighter capital controls and even seize foreign assets. Despite these challenges, China has continued to make progress opening its domestic markets. The nation seems to be sticking to its key policy goals of attracting foreign capital and internationalizing the RMB; both aspects require open access and repatriation of foreign capital. In addition, the share of foreign holdings in onshore securities is very low and thus, poses limited risk to China’s onshore financial markets during global economic or geopolitical crises. China’s current exposure to foreign capital flows is much smaller than its Asian neighbors during the 1997 Asian Financial Crisis, as well as Russia during the geopolitical standoff in 2014-2016 following the capture of Crimea.4 Despite years of easing access to financial markets, foreign ownership (mostly concentrated in government bonds) remains at only around 3-4% of China’s entire onshore bond market. Furthermore, unlike other Asian economies in 1997-98, China has large foreign exchange reserves to buffer shocks from foreign fund flows. In recent years its capital control mechanism has also been successful in preventing implicit capital outflows and stabilizing the RMB exchange rate. We expect Chinese policymakers to feel confident in continuing their financial opening because they have the capability and sufficient funds to safeguard the economy against retrenchments by global investors. Bottom Line: China will continue to open its domestic financial markets, albeit gradually, to global investors. The country’s domestic financial markets have limited exposure to the extreme volatility of foreign capital flows. Investment Conclusions Chart 22The RMB Still Has Upside Structurally, But Will Modestly Depreciate On A Cyclical Basis The RMB Still Has Upside Structurally, But Will Modestly Depreciate On A Cyclical Basis The RMB Still Has Upside Structurally, But Will Modestly Depreciate On A Cyclical Basis We are constructive on China’s government bonds, both cyclically and structurally. In the next six to nine months, the yield curve will likely flatten, with long-duration bond yields dropping faster than the short-end. China’s 10-year government bond yield will structurally shift to a lower range in the next five years, driven by the impact of falling population on domestic demand, and the country’s rising debt levels and debt-servicing costs. Although the RMB still has upside structural potential, in the next 6 to 12 months the currency will likely modestly depreciate against the US dollar (Chart 22).   Jing Sima China Strategist jings@bcaresearch.com Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Footnotes 1Total Factor Productivity (TFP) is a measure of productive efficiency,  determining how much output can be produced from a certain amount of inputs. 2Defined by BIS as the ratio of interest payments plus amortizations to income. 3Despite a rising debt load, debt-servicing costs were contained due to (1) LGFV debt swap as new provincial government bonds had lower yields than LGFV bonds and (2) a large decline in the prime lending rate and mortgage rates. 4Foreign investors held more than 40% of local currency bonds in Indonesia, and over 20% in Malaysia. Foreign ownership accounted for 26% of Russia’s local currency bonds in 2014. Market/Sector Recommendations Cyclical Investment Stance

Highlights Electricity shortages in China are largely due to excessive power demand rather than a matter of shrinking electricity production. Chinese electricity consumption has been supercharged by the export sector’s booming demand for electricity. Excessive overseas (mainly US) demand for goods has been the main culprit behind China’s robust electricity demand. Divergence in the mainland economy between booming exports on the one hand and weakening property construction and infrastructure spending on the other hand will reduce the likelihood that policymakers will rush to stimulate. Odds are that Chinese and EM share prices will continue selling off and underperforming DM equities. Feature Contrary to popular perceptions, China’s electricity crisis is not due to drastic supply shortages but rather caused by excessive demand. This has implications for macro policy. Given that electricity shortages stem from strong demand, policymakers will be less aggressive in providing blanket stimulus over the near term. The basis is that unleashing more stimulus to boost the industrial sector – at a time when there are already scarcities of electricity and other inputs – will intensify the shortages and aggravate the situation. Robust Electricity Demand Electricity demand has been outstripping growing electricity output. Hence, shortages are largely due to excessive electricity demand. Charts 1 and 2 demonstrate that both electricity consumption and output have been expanding but demand growth has outpacing supply. Notably, electricity demand has surged above its trend by more than electricity production.  Chart 1Chinese Electricity Production Is Above Its Trend Chinese Electricity Production Is Above Its Trend Chinese Electricity Production Is Above Its Trend Chart 2Chinese Electricity Consumption Is Well Above Its Trend Chinese Electricity Consumption Is Well Above Its Trend Chinese Electricity Consumption Is Well Above Its Trend The mainland’s electricity demand has been strong due to surging manufacturing consumption of electricity. The top panel of Chart 3illustrates that electricity consumption in manufacturing has become overextended. On the other hand, residential demand for electricity has been expanding gradually and has not been excessive (Chart 3, bottom panel). The manufacturing sector has been supercharged by booming exports. Chart 4 reveals that China’s industrial output and exports have expanded briskly – their levels have surged well above their 10-year trend. Chart 3Electricity Demand Growth Is Driven By Manufacturing Not Residential Consumption Electricity Demand Growth Is Driven By Manufacturing Not Residential Consumption Electricity Demand Growth Is Driven By Manufacturing Not Residential Consumption Chart 4Manufacturing And Exports Have Been Very Strong Manufacturing And Exports Have Been Very Strong Manufacturing And Exports Have Been Very Strong Chart 5US Goods Demand: Classic Overheating US Goods Demand: Classic Overheating US Goods Demand: Classic Overheating DM countries’ stimulus has been responsible for this export boom. Specifically, US demand for goods has been running well above its pre-pandemic trend (Chart 5). Bottom Line: Both electricity consumption and production have been rising but demand has outstripped supply, resulting in shortages. On Supply Constraints Not only has total electricity output been rising but electricity produced by thermal coal has also been expanding, albeit gradually (Chart 6). China still generates 71% of its electricity using thermal coal. While electricity output growth from this source has slowed down recently, it has still not contracted (Chart 7). Chart 6China: Sources Of Electricity Production China: Sources Of Electricity Production China: Sources Of Electricity Production Chart 7Electricity Output Has Slowed But Not Contracted Electricity Output Has Slowed But Not Contracted Electricity Output Has Slowed But Not Contracted   Similarly, coal supply has been rising slowly, i.e., it has not shrunk (Chart 8). Coal supply has been capped due to the following reasons: Coal production has decelerated due to decarbonization policies adopted by Beijing. Authorities have also constrained coal mining by strictly enforcing safety protocols in mines following accidents early this year. Moreover, coal imports have been constrained by Beijing's ban on coal from Australia. Beijing’s “dual control” policy – which imposes targets on energy intensity and the level of energy consumption on provinces – has also led several local governments to reduce electricity production in recent weeks to ensure that annual targets are met. Finally, in recent years electricity prices have been flat-to-down while coal prices have surged (Chart 9). Thus, coal-based power generators have recently been incurring losses and some of them have been reluctant to produce more electricity. Chart 8China's Coal Supply Has Been Timid China's Coal Supply Has Been Timid China's Coal Supply Has Been Timid   Chart 9Coal Power Plants Are Operating With Losses Coal Power Plants Are Operating With Losses Coal Power Plants Are Operating With Losses   Authorities have begun tackling these problems. Coal supply will likely rise moderately as will electricity output from thermal coal. Reportedly, some Australian coal has in recent days been offloaded in China, and authorities have eased restriction on coal production and encouraged banks to lend to coal producers and electricity generators. Bottom Line: There has been a slowdown – not a contraction – in electricity produced by thermal coal. Authorities have started addressing these bottlenecks and odds are that electricity output will catch up with electricity demand before year-end, i.e., the power shortages will likely gradually ebb. Implications For Chinese Macro Policy Given that electricity demand has been outstripping supply, clients might wonder about the pace of China’s economic growth. This has ramifications as to whether or not authorities will stimulate aggressively. On the one hand, the manufacturing and especially export-oriented segments have been expanding briskly. As shown in Chart 4 above, manufacturing output in general and exports in particular have been overheating. Further, the labor market has been tightening, as is illustrated in Chart 10. On the other hand, as we have been writing, construction and infrastructure spending have been weakening (Chart 11). Chart 10China: Urban Labor Market Is Tight China: Urban Labor Market Is Tight China: Urban Labor Market Is Tight Chart 11Construction And Infrastructure Have Slowed Construction And Infrastructure Have Slowed Construction And Infrastructure Have Slowed Granted property developers, local governments and LGFVs are facing debt limits and financing constraints, it is safe to assume that they will cut back on their capital spending. China’s construction and infrastructure spending accounts for a large share of industrial metals demand. This is a basis for our argument that industrial metal prices remain at risk of declining. Unlike the current power crunch, industrial metal shortages are not caused by excessive demand but rather are due to shrinking production. Chart 12 shows that China’s steel output has contracted. Hence, the surge in steel prices has been due to production cutbacks. Local governments are probably shutting down metals production in response to decarbonization policies and to divert power to export-oriented companies. The fact that the price of steel’s key ingredient – iron ore – has collapsed is consistent with reduced demand for it (Chart 13). This is in contrast with the current strong demand for coal. Chart 12Lower Steel Production = Higher Steel Prices Lower Steel Production = Higher Steel Prices Lower Steel Production = Higher Steel Prices Chart 13Weak Iron Ore Demand = Lower Prices Weak Iron Ore Demand = Lower Prices Weak Iron Ore Demand = Lower Prices Overall, the bifurcation in the economy characterized by booming exports versus weakening property construction and infrastructure spending reduces the likelihood that policymakers will rush to stimulate. Rather, they will provide targeted support to negatively affected segments of the economy in the form of easier credit access, easing industry regulation and easier decarbonization targets. Bottom Line: Policymakers in Beijing will not rush to provide a blanket stimulus for now. Rather, they will use this period of booming exports to undertake deleveraging in the real estate sector as well as local governments and their affiliated companies. Investment Implications: Barring any large stimulus, construction and infrastructure spending will continue to disappoint, which is bad for industrial metals. This outlook in combination with the ongoing regulatory clampdown on internet companies heralds lower prices for Chinese investable stocks. Chart 14Stay Long A Shares / Short Chinese Investable Stocks Stay Long A Shares / Short Chinese Investable Stocks Stay Long A Shares / Short Chinese Investable Stocks Given that Chinese investable stocks include few export companies, booming exports will not be sufficient to propel China’s MSCI Investable equity index higher. Among the Chinese indexes, we reiterate our long A shares / short China MSCI Investable index strategy, a recommendation made in early March (Chart 14). Reshuffling The EM Portfolio BCA’s Emerging Markets Strategy team is recommending the following changes in country allocation within EM equity and fixed-income portfolios. Equities: We are downgrading Indian stocks from overweight to neutral. The reasons for this portfolio shift are presented in the country report we are publishing today. In its place, dedicated EM equity managers should upgrade Russian and Central European equity markets like Poland, Czech Republic and Hungary from neutral to overweight. The rationale is that high oil prices favor Russian equity outperformance. Barring a major crash in oil prices, we are comfortable maintaining an overweight allocation to Russia in an EM portfolio. ​​​​​​​In turn, rising bond yields in core Europe are positive for bank stocks that have a large weight in Central European bourses.   Fixed Income: We are upgrading Russian local currency bonds from neutral to overweight within an EM domestic bond portfolio. A hawkish central bank is positive for the long end of the Russian yield curve. 10-year yields also offer great value. Further, high energy prices (even if they drop from current very elevated levels but remain above $60 per a barrel) will help the ruble to outperform its EM peers. We maintain a yield curve trade of receiving 10-year/paying 1-year swap rates in Russia. Finally, we continue overweighting Russian sovereign and corporate credit within an EM credit portfolio.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The fourth quarter will be volatile as China still poses a risk of overtightening policy and undermining the global recovery. US political risks are also elevated. A debt default is likely to be averted in the end. Fiscal stimulus could be excessive. There is a 65% chance that taxes will rise in the New Year. A crisis over Iran’s nuclear program is imminent. Oil supply disruptions are likely. A return to diplomacy is still possible but red lines need to be underscored. European political risks are comparatively low, although they cannot go much lower, Russia still poses threats to its neighbors, and China’s economic wobbles will weigh on European assets. Our views still support Mexican equities and EU industrials over the long run but we are booking some gains in the face of higher volatility. Feature Our annual theme for 2021 was “No Return To Normalcy” and events have borne this out. The pandemic has continued to disrupt life while geopolitics has not reverted to pre-Trump norms. Going forward, the pandemic may subside but the geopolitical backdrop will be disruptive. This is primarily due to Chinese policy, unfinished business with Iran, and the struggle among various nations to remain stable in the aftermath of the pandemic. Chart 1Delta Recedes With Vaccinations Delta Recedes With Vaccinations Delta Recedes With Vaccinations Chart 2Global Recovery Marches On Global Recovery Marches On Global Recovery Marches On Chart 3Global Labor Markets On The Mend Global Labor Markets On The Mend Global Labor Markets On The Mend The underlying driver of markets in the fourth quarter will be the fact that the COVID-19 pandemic is waning as vaccination campaigns make progress (Chart 1). New cases of the Delta variant have rolled over in numerous countries and in US states that are skeptical toward vaccines. Global growth will still face crosswinds. US growth rates are unlikely to be downgraded further while Europe’s growth has been upgraded. However, forecasters are likely to downgrade Chinese growth expectations in the face of the government’s regulatory onslaught against various sectors and property sector instability (Chart 2). Barring a Chinese policy mistake, the global composite PMI is likely to stabilize. Labor markets will continue healing (Chart 3). The tug of war between unemployment and inflation will continue to give way in favor of inflation, given that wage pressures will emerge, stimulus-fueled household demand will be strong, and supply shortages will persist. Central banks will try to normalize policy but will not move aggressively in the face of any new setbacks to the recovery. Will China Spoil The Recovery? Maybe. Chinese policy and structural imbalances pose the greatest threat to the global economic recovery both in the short and the long run. The immediate risk to the recovery is clear from our market-based Chinese growth indicator, which has not yet bottomed (Chart 4). The historic confluence of domestic political and geopolitical risks in China is our key view for the year. China is attempting to make the economic transition that other East Asian states have made – away from the “miracle” manufacturing phase of growth toward something more sustainable. But there are two important differences: China is making its political and economic system less open and free (the opposite of Taiwan and South Korea) and it is confronting rather than befriending the United States. The Xi administration is focused on consolidating power ahead of the twentieth national party congress in fall 2022. Xi is attempting to stay in power beyond the ten-year limit that was in place when he took office. On one hand he is presenting a slate of socioeconomic reforms – dubbed “common prosperity” – to curry popular favor. This agenda represents a tilt from capitalism toward socialism within the context of the Communist Party’s overarching idea of socialism with Chinese characteristics. On the other hand, Xi is cracking down on the private sector – Big Tech, property developers – which theoretically provides the base of power for any political opposition. The crackdowns have caused Chinese equities to collapse relative to global and have reaffirmed the long trend of underperformance of cyclical sectors relative to defensives within Chinese investable shares (Chart 5, top panel). Chart 4China Threatens To Spoil The Party China Threatens To Spoil The Party China Threatens To Spoil The Party In terms of financial distress, so far only high-yield corporate bonds have seen spreads explode, not investment grade. But current policies force property developers to liquidate their holdings, pay off debts, and raise cash while forcing banks to cut bank on loans to property developers and homebuyers. (Not to mention curbs on carbon emissions and other policies squeezing industrial and other sectors.) Chart 5Beijing Could Easily Trigger Global Market Riot Beijing Could Easily Trigger Global Market Riot Beijing Could Easily Trigger Global Market Riot If these policies are not relaxed then property developers will continue to struggle, property prices will fall, credit tightening will intensify, and local governments will be starved of revenue and forced to cut back on their own spending. Yet the government’s signals of policy easing are so far gradual and behind the curve. If policy is not relaxed, then onshore equities will sell off (as well as offshore) and credit spreads will widen more generally (Chart 5, bottom panel). Broad financial turmoil cannot be ruled out in the fourth quarter. Ultimately, however, China will be forced to do whatever it takes to try to secure the post-pandemic recovery. Otherwise it will instigate a socioeconomic crisis ahead of the all-important political reshuffle in fall 2022. That would be the opposite of what Xi Jinping needs as he tries to consolidate power. Chinese households have stored their wealth, built up over decades of economic success, in the housing sector (Chart 6). Economic instability could translate to political instability. Chart 6Beijing Will Provide Bailouts And Stimulus … Or Face Political Instability Fourth Quarter Outlook: So Much For Normalcy! Fourth Quarter Outlook: So Much For Normalcy! Investors often ask how the government can ease policy if doing so will further inflate housing prices, which hurts the middle class and is the opposite of the common prosperity agenda. High housing prices are the biggest of the three “mountains” that are said to be crushing the common folks and weighing on Chinese birthrates and fertility (the other two are high education and medical costs). The answer is that while policymakers want to cap housing prices and encourage fertility, they must prevent a general collapse in prices and economic and financial crisis. There is no evidence that suppressing housing prices will increase fertility or birthrates – if anything, falling fertility is hard to reverse and goes hand in hand with falling prices. Rather, evidence from the US, Japan, South Korea, Thailand, and other countries shows that a bursting property bubble certainly does not increase fertility or birthrates (Charts 7A and 7B). Chart 7AEconomic Crash Not A Recipe For Higher Fertility Economic Crash Not A Recipe For Higher Fertility Economic Crash Not A Recipe For Higher Fertility Chart 7BEconomic Crash Not A Recipe For Higher Fertility Economic Crash Not A Recipe For Higher Fertility Economic Crash Not A Recipe For Higher Fertility Bringing it all together, investors should not play down negative news and financial instability emerging from China. There are no checks and balances on autocrats. Our China Investment Strategy has a high conviction view that policy stimulus is not forthcoming and regulatory curbs will not be eased. The implication is that China’s government could make major policy mistakes and trigger financial instability in the near term before changing its mind to try to preserve overall stability. At that point it could be too late. Will Countries Add More Stimulus? Yes. Chart 8Global Monetary Policy Challenges Global Monetary Policy Challenges Global Monetary Policy Challenges With China’s stability in question, investors face a range of crosswinds. Central banks are struggling with a surge in inflation driven by stimulus-fueled demand and supply bottlenecks. The global output gap is still large but rapid economic normalization will push inflation up further if kinks are not removed (Chart 8). A moderating factor in this regard is that budget deficits are contracting in 2022 and coming years – fiscal policy will shift from thrust to drag (Chart 9). However, the fiscal drag is probably overstated as governments are also likely to increase deficit spending on the margin. The US is certainly likely to do so. But before considering US fiscal policy we must address the immediate question: whether the US will default on national debt. Treasury Secretary Janet Yellen has designated October 18 as the “X-date” at which the Treasury will run out of extraordinary measures to make debt payments if Congress does not raise the statutory debt ceiling. There is presumably a few weeks of leeway after this date but markets will grow very jittery and credit rating agencies will start to downgrade the United States, as Standard & Poor’s did in 2011. Chart 9Global Fiscal Drag Rears Its Head Fourth Quarter Outlook: So Much For Normalcy! Fourth Quarter Outlook: So Much For Normalcy! Democrats have full control of Congress and can therefore suspend the debt ceiling through a party-line vote. They can do this through regular legislation, if Republicans avoid raising a filibuster, though that requires Democrats to make concessions in a back-room deal with Republicans. Or they can compromise the filibuster, though that requires convincing moderate Democrats who support the filibuster that they need to make an exception to preserve the faith and credit of the US. Or they can raise the debt ceiling via budget reconciliation, though this would run up against the time limit and so far Senate Leader Chuck Schumer claims to refuse this option. While the odds of a debt default are not zero, the Democrats have the power to avoid it and will also suffer the most in public opinion if it occurs. Therefore the debt limit will likely be suspended at the last minute in late October or early November. Investors should expect volatility but should view it as short-term noise and buy on dips – i.e. the opposite of any volatility that stems from Chinese financial turmoil. Congress is likely to pass Biden’s $550 billion bipartisan infrastructure bill (80% subjective odds). It is also likely to pass a partisan social welfare reconciliation bill over the coming months (65% subjective odds). The full impact on the deficit of both bills should range from $1.1-$1.6 trillion over ten years. This will not be enough to prevent the fiscal drag in 2022 but it will provide for a gradually expanding budget deficit over the course of the decade (Chart 10). Chart 10New Fiscal Stimulus Will Reduce Fiscal Drag On Margin Fourth Quarter Outlook: So Much For Normalcy! Fourth Quarter Outlook: So Much For Normalcy! The reconciliation package will be watered down and late in coming. Investors will likely buy the rumor and sell the news. If reconciliation fails, markets may cheer, as it will also include tax hikes and pose the risk of pushing up inflation and hastening Fed rate hikes. Elsewhere governments are also providing “soft budgets.” The German election results confirmed our forecast that the government will change to left-wing leadership that will be able to boost domestic investment but not raise taxes. This is due to the inclusion of at least one right-leaning party, most likely the Free Democrats. Fiscal deficits will go up. Germany has a national policy consensus on most matters of importance and thus can pass some legislation. But the new coalition will be ideologically split and barely have a majority in the Bundestag, so controversial or sweeping legislation will be unlikely. This outcome is positive for German markets and the euro. Looking at popular opinion toward western leaders and their ruling coalitions since the outbreak of COVID-19, the takeaway is that the Europeans have the strongest political capital (Chart 11). Governments are either supported by leadership changes (Italy, Germany) or likely to be supported in upcoming elections (France). The UK does not face an election until 2024, unless an early election is called. This seems doubtful to us given the government’s strong majority. Chart 11DM Shifts In Popular Opinion Since COVID-19 Fourth Quarter Outlook: So Much For Normalcy! Fourth Quarter Outlook: So Much For Normalcy! Chart 12EM Shifts In Popular Opinion Since COVID-19 Fourth Quarter Outlook: So Much For Normalcy! Fourth Quarter Outlook: So Much For Normalcy! After all, Canada called an early election and it became a much riskier affair than the government intended and did not increase the prime minister’s political capital. Spain is far more likely to see tumult and an early election. Japan’s election in November will not bring any surprises: as we have written, Kishidanomics will be Abenomics by a different name. The implication is that after November, most developed markets will be politically recapitalized and fiscal policy will continue to be accommodative across the board. In emerging markets, popular opinion has been much more damning for leaders, calling attention to our expectation that the aftershocks of the global pandemic will come in the form of social and political instability (Chart 12). Russia has a record of pursuing more aggressive foreign policy to distract from its domestic ills. The next conflict could already be emerging, with allegations that it is deliberately pushing up natural gas prices in Europe to try to force the new German government to certify and operate the NordStream II pipeline. The Americans are already brandishing new sanctions. Chart 13Stary Neutral Dollar For Now Stary Neutral Dollar For Now Stary Neutral Dollar For Now Brazil and Turkey both face extreme social instability in the lead-up to elections in 2022 and 2023. India has been the chief beneficiary of today’s climate but it also faces an increase in political and geopolitical risk due to looming state elections and its increasing alliance with the West against China. Putting it all together, the US is likely to stimulate further and pump up inflation expectations. Europe is politically stable but Russia disrupt it. Other emerging markets, including China, will struggle with economic, political, and social instability. This is an environment in which the US dollar will remain relatively firm and the renminbi will depreciate – with negative effects on EM currencies more broadly (Chart 13). Annual Views On Track Our three key views for 2021 are so far on track but face major tests in the fourth quarter: 1. China’s internal and external headwinds: If China overtightens policy and short-circuits the global economic recovery, then its domestic political risks will have exceeded even our own pessimistic expectations. We expect China to ease fiscal policy and do at least the minimum to secure the recovery. Investors should be neutral on risky assets until China provides clearer signals that it will not overtighten policy (Chart 14). 2. Iran is the crux of the US pivot to Asia: A crisis over Iran is imminent since Biden did not restore the 2015 nuclear deal promptly upon taking office. Any disruption of Middle Eastern energy flows will add to global supply bottlenecks and price pressures. Brent crude oil prices will see upside risks relative both to BCA forecasts and the forward curve (Chart 15). Chart 14Wait For China To Relax Policy Wait For China To Relax Policy Wait For China To Relax Policy Chart 15Expect A Near-Term Crisis Over Iran Expect A Near-Term Crisis Over Iran Expect A Near-Term Crisis Over Iran The reason is that Iran is expected to reach nuclear “breakout” capability by November or December (i.e. obtain enough highly enriched uranium to make a nuclear device). The Biden administration is focused on diplomacy and so far hesitant to impose a credible threat of war to halt Iranian advances. Israel’s new government has belatedly admitted that it would be a good thing for the US and Iran to rejoin the 2015 nuclear deal – if not, it supports a global coalition to impose sanctions, and finally a military option as a last resort. Biden will struggle to put together a global coalition as effective as Obama did, given worse relations with China and Russia. The US and Israel are highly likely to continue using sabotage and cyberattacks to slow Iran’s nuclear and missile progress. Chart 16Pivot To Asia Runs Through Iran Pivot To Asia Runs Through Iran Pivot To Asia Runs Through Iran Chart 17Europe: A Post-Trump Winner? Depends On China Europe: A Post-Trump Winner? Depends On China Europe: A Post-Trump Winner? Depends On China Thus the Iranians are likely to reach breakout capability at which point a crisis could erupt. The market is not priced for the next Middle East crisis (Chart 16). Incidentally, any additional foreign policy humiliation on top of Afghanistan could undermine the Biden administration more broadly, in both domestic and foreign policy. 3. Europe benefits most from a post-pandemic, post-Trump world: Europe is a cyclical economy and is also relatively politically stable in a world of structurally rising policy uncertainty and geopolitical risk. We thought it stood to benefit most from the global recovery and the passing of the Trump administration. However, China’s policy tightening has undermined European assets and will continue to do so. Therefore this view is largely contingent on the first view (Chart 17). Investment Takeaways Strategically we maintain a diversified portfolio of trades based on critical geopolitical themes: long gold, short China/Taiwan, long developed markets, long aerospace/defense, long rare earths, and long value over growth stocks. Taiwanese equities have continued to outperform despite bubbling geopolitical tensions. We maintain our view that Taiwan is overpriced and vulnerable to long-term semiconductor diversification as well as US-China conflict. Our rare earths basket, which focuses on miners outside China, has been volatile and stands to suffer if China’s growth decelerates. But global industrial, energy, and defense policy will continue to support rare earths and metals prices. Russian tensions with the West have been manageable over the course of the year and emerging European stocks have outperformed developed European peers, contrary to our recommendation. However, fundamental conflicts remain unresolved and the dispute over the recently completed Nord Stream II pipeline to Germany could still deal negative surprises. We will reassess this recommendation in a future report. We are booking gains on the following trades: long Mexico (8%), long aerospace and defense in absolute terms (4%), long EU industrials relative to global (4%), and long Italian BTPs relative to bunds (0.2%).   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator United Kingdom UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator Appendix: Geopolitical Calendar