Manufacturing

Executive Summary China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 The pace of credit creation in January increased sharply over December. However, the jump was less than meets the eye compared with previous easing cycles and adjusted for seasonality. Our calculation suggests that a minimum of approximately RMB35 trillion of new credit, or a credit impulse that accounts for 29% of this year's nominal GDP, will be needed to stabilize the economy. January’s credit expansion falls short of the RMB35 trillion mark on a six-month annualized rate of change basis. Our model will provide a framework for investors to gauge whether the month-over-month credit expansion data is on track to meet our estimate of the required stimulus. Despite an improvement in January's credit growth from December, it is premature to update Chinese stocks (on- and off-shore) to overweight relative to global equities. Bottom Line: Approximately RMB35 trillion in newly increased credit this year will probably be needed to revive China’s domestic demand.  Any stimulus short of this goal would mean that investors should not increase their cyclical asset allocation of Chinese stocks in a global portfolio. Feature January’s credit data for China exceeded the market consensus. The aggregate total social financing (TSF) more than doubled in the first month of 2022 from December last year. However, on a year-over-year basis, the increase in January’s TSF was smaller than in previous easing cycles, such as in 2013, 2016 and 2019. Furthermore, underlying data in the TSF reflects a prolonged weak demand for bank loans from both the corporate and household sectors. While January’s uptick in credit expansion makes us slightly more optimistic about China’s policy support, economic recovery and equity performance in the next 6 to 12 months, we are not yet ready to upgrade our view. An estimated RMB35 trillion in newly increased credit this year will likely be necessary to revive flagging domestic demand. In the absence of seasonally adjusted TSF data in China, our framework will help investors determine whether incoming stimulus is on course to meet this objective. Interpreting January’s Credit Numbers Chart 1A Sharp Increase In Credit Creation In January A Sharp Increase In Credit Creation In January A Sharp Increase In Credit Creation In January January’s credit creation beat the market consensus to reach RMB6.17 trillion, pushed up by a seasonal boost and a frontloading of government bond issuance (Chart 1). However, the composition of the TSF data reflects an extended weakness in business and consumer credit demand. On the plus side, net government bond financing, including local government special purpose bonds, rose to RMB603 billion last month, more than twice the amount from January 2021 (Chart 1, bottom panel). Corporate bond issuance also picked up, reflecting cheaper market rates and more accommodative liquidity conditions (Chart 2). Furthermore, shadow credit (including trust loans, entrust loans and bank acceptance bills) also ticked up in January compared with a year ago. The increase in informal lending sends a tentative signal that policymakers may be willing to ease the regulatory pressure on shadow bank activities (Chart 3). Chart 2Corporate Financing Through Bond Issuance Also Increased Corporate Financing Through Bond Issuance Also Increased Corporate Financing Through Bond Issuance Also Increased Chart 3Shadow Banking Activity Ticked Up For The First Time In A Year Shadow Banking Activity Ticked Up For The First Time In A Year Shadow Banking Activity Ticked Up For The First Time In A Year Meanwhile, several factors suggest that the surge in January’s credit expansion may be less than what it appears to be at first glance. First, credit growth is always abnormally strong in January. Banks typically increase lending at the beginning of a year, seeking to expand their assets rapidly before administrative credit quotas kick in. In recent years loans made during the first month of a year accounted for about 17% - 20% of total bank credit generated for an entire year. Secondly, the credit flow in January, although higher than in January 2021, was weaker than in the first month of previous easing cycles. Credit impulse – measured by the 12-month change in TSF as a percentage of nominal GDP – only inched up by 0.6 percentage points of GDP in January this year from December, much weaker than that during the first month in previous easing cycles (Chart 4). TSF increased by RMB980 billion from January 2021, lower than the RMB1.5 trillion year-on-year jump in 2019 and the RMB1.4 trillion boost in 2016 (Chart 4, bottom panel). Chart 4The Magnitude Of Increase In January’s Credit Impulse Less Than Meets The Eye Takeaways From January’s Credit Data Takeaways From January’s Credit Data Chart 5Corporate Demand For Bank Credit Remains Soft Corporate Demand For Bank Credit Remains Soft Corporate Demand For Bank Credit Remains Soft Furthermore, China’s households and private businesses have significantly lagged in their responses to recent policy easing measures and their demand for credit remained soft in January (Chart 5). Bank credit in both short and longer terms to households were lower than a year earlier due to downbeat consumer sentiment (Chart 6A and 6B). Chart 6AConsumption Was Unseasonably Weak During Chinese New Year Consumption Was Unseasonably Weak During Chinese New Year Consumption Was Unseasonably Weak During Chinese New Year Chart 6BHouseholds' Propensity To Consume Continues Trending Down Households' Propensity To Consume Continues Trending Down Households' Propensity To Consume Continues Trending Down How Much Stimulus Is Necessary? Our calculation suggests that China will probably need to create approximately RMB35 trillion in new credit, or 29% of GDP in credit impulse, over the course of this year to avoid a contraction in corporate earnings. In our previous reports, we argued that the state of the economy today is in a slightly better shape than the deep deflationary period in 2014/15, but the magnitude of the property market contraction is comparable to that seven years ago. Chart 7 illustrates our approach, which uses a model of Chinese investable earnings growth. The model is designed to predict the likelihood of a serious contraction in investable earnings in the coming 12 months. It includes variables on credit, manufacturing new orders and forward earnings momentum. The chart shows that the flow of TSF as a share of GDP needs to reach a minimum of 28.5% in order that the probability of a major earnings contraction falls below 50%. The size of the credit impulse necessary is 2 percentage points higher than that achieved last year, but still lower than the scope of the stimulus rolled out in 2016. Assuming an 8% growth rate in nominal GDP in 2022, the credit flow that should to be originated this year would be about RMB35 trillion, as illustrated in Chart 8. The chart also shows that this amount would exceed a previous high in credit flow reached in late-2020. Chart 7China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession Chart 8China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 Based on a 3-month annualized rate of change, January’s credit growth appears that it will achieve the RMB35 trillion mark. However, the jump in TSF largely reflects a one-month leap in frontloaded local government bond issuance and it is not certain if private credit will accelerate in the months ahead. For now, we contend the stimulus have been insufficiently provided during the past six months (Chart 8, bottom panel). Chance Of A Stimulus Overshoot? We will closely monitor whether the month-to-month pace of credit growth is consistent with the scope of the reflationary policy response required to revive China’s domestic demand. Despite a sharp improvement in January’s headline credit number, we view the policy signal from January’s credit data as neutral. China’s unique cyclical patterns and the lack of official seasonally adjusted data make monthly credit figures difficult to interpret. Charts 9 and 10 represent an approach that we previously introduced to help gauge whether the pace of credit creation is on track to meet the stimulus called for to stabilize the economy. Chart 9Jan Credit Growth Looked To Be Stronger Than A “Half-Strength” Credit Cycle… Takeaways From January’s Credit Data Takeaways From January’s Credit Data Chart 10…But It Is Too Early To Conclude It Is In Line With What Is Needed Takeaways From January’s Credit Data Takeaways From January’s Credit Data The charts show an average cumulative amount of TSF as the year advances, along with a ±0.5 standard deviation, based on data from 2010 to 2021. The thick black line in both charts shows the progress in new credit creation this year, assuming an 8% annual nominal GDP growth rate. Chart 9 shows the cumulative progress in credit, assuming a 27% new credit-to-GDP ratio for the year, whereas Chart 10 assumes 30%. The 27% ratio scenario shown in Chart 9, which is slightly higher than the magnitude of stimulus in 2019, would correspond to a very measured credit expansion. If the thick black line continues to trend within this range, it would suggest that policymakers are reluctant to allow credit growth to surge. Consequently, global investors should continue an underweight stance on Chinese stocks. In contrast, Chart 10 represents a 30% rate of TSF as a share of this year’s GDP; this would be the adequate stimulus needed for a recovery in domestic demand. A cumulative amount of TSF that trends within or above this range would provide more confidence that a credit overshoot similar to 2015/16 and 2020 would occur.   Investment Conclusions It is premature to upgrade Chinese stocks to an overweight cyclical stance (i.e. over 6-12 months) within a global portfolio. For now, we recommend investors stay only tactically overweight in Chinese investable equities versus the global benchmark, given their cheap relative valuations. Meanwhile, the increase in January’s TSF, while registering an improvement relative to previous months, does not signal that the pace of credit growth will be strong enough to overcome the negative ramifications of the ongoing deceleration in housing market activity. Therefore, in view of policymakers’ steadfast desire to avoid another major credit overshoot, our cyclical recommendation to underweight Chinese stocks remains unchanged.   Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The first month of this year continues to see economic growth moderating around the world. However, it remains well above trend. There is a tentative growth rotation from the US to other G10 economies. The market expects five interest rate hikes from the Fed this year, but our bias is that they will underwhelm market expectations. A surge in eurozone inflation suggests that many central banks (including the ECB) will gently catch up to the Fed. We were stopped out of our long AUD/USD trade for a small profit and are reinstating this trade via a limit-buy at 0.70. The Dollar Is Flat In 2022, Despite A Hawkish Fed Month In Review: Another Hawkish Pivot By The Fed Month In Review: Another Hawkish Pivot By The Fed Recommendation Inception Level Inception Date Return Long AUD/NZD  1.05 Aug 4/21 1.72% Long AUD/USD 0.7 Feb 3/22 -     Bottom Line: The US dollar will continue to fight a tug of war between a hawkish Federal Reserve, which will boost interest rate differentials in favor of the US and tightening financial conditions that will sap US growth, and trigger a rotation from US stocks. Feature Chart 1The Dollar Has Been Flat In 2022 Month In Review: Another Hawkish Pivot By The Fed Month In Review: Another Hawkish Pivot By The Fed The dollar was volatile in January. The DXY started the year on a weakening path, surged last week on the back of a hawkish Federal Reserve, and is now relapsing anew. Year to date, the dollar index is flat. Remarkably, emerging market currencies such as the CLP, BRL, and ZAR, which are very sensitive to the greenback and financial conditions in the US, have been outperforming (Chart 1). Incoming economic data continues to be robust, but there has been a slight rotation in favor of non-US growth. The economic surprise index in the US has fallen below zero, while it is surging in other G10 countries (Chart 2). Manufacturing PMIs continue to roll over around the world, but remain robust, even in places like the euro area, which is more afflicted by the energy crisis, and the potential for military conflict in its backyard (Chart 3). Chart 2A Growth Rotation Away From The US A Growth Rotation Away From The US A Growth Rotation Away From The US Chart 3APMIs Are Rolling Over Globally PMIs Are Rolling Over Globally PMIs Are Rolling Over Globally Chart 3BPMIs Are Rolling Over Globally PMIs Are Rolling Over Globally PMIs Are Rolling Over Globally In this week’s report, we go over a few key data releases in the last month and implications for currency markets. Our take is that a growth rotation from the US to other economies is underway, and that will ultimately support a lower greenback (Chart 4). That said, near term risks abound, including geopolitical tensions, the potential for more hawkish surprises from the Federal Reserve, and the potential for a policy mistake in China. Chart 4The IMF Expects A Growth Rotation From The US This Year Month In Review: Another Hawkish Pivot By The Fed Month In Review: Another Hawkish Pivot By The Fed US Dollar: In A Tug Of War The dollar DXY index is flat year to date. Economic growth continues to moderate in the US, from very elevated levels. According to the IMF, the US should see robust growth of 4% this year, from 5.6% last year. This is quite strong by historical standards, and in fact argues for less accommodative monetary policy. The caveat is that financial conditions in the US are tightening quite quickly, which could accentuate the slowdown the IMF expects. There have been a few key data releases over the last month. The payrolls report was underwhelming, with only 199K jobs added in December, versus a consensus of 450K. Friday’s number will likely also be on the weaker side. That said, with the unemployment rate now at 3.9%, average hourly earnings growing at 4.7%, and headline CPI inflation at 7%, the case for curtailing monetary accommodation in the minds of the FOMC remains compelling. Last week, the FOMC opened the window for a faster pace of a rate hikes than the market was anticipating. Fed fund futures now suggest around five interest rate increases this year. In our view, the Fed could underwhelm market expectations for a few reasons. Sentiment has begun to deteriorate. The University of Michigan survey saw its sentiment index fall from 70.6 to 67.2. The expectations component fell from 68.3 to 64.1. These also came in below expectations. Both the Markit and ISM purchasing managers’ indices are rolling over. The services PMI in the US is sitting at 50.9, a nudge above the boom/bust level. The goods trade balance continues to hit a record deficit, at -$101bn in December, suggesting the dollar is too strong for the US external balance. In a nutshell, the economic surprise index in the US has turned firmly negative, at a time when market participants are pricing in a very hawkish pace of interest rate increases. A tighter Fed is what the US needs, but the perfect calibration of monetary policy could prove difficult to achieve. As such, we believe the Fed will slightly underwhelm market expectations of five rate hikes. With speculative positioning in the dollar close to record highs, this will surely deal a blow to the greenback. Chart 5AUS Dollar US Dollar US Dollar Chart 5BUS Dollar US Dollar US Dollar The Euro: War And Inflation The euro is up 0.6% year to date. Economic data in the eurozone has been resilient, despite a surge in the number of new COVID-19 cases, rising energy costs and the potential for military conflict between Ukraine and Russia. On the data front, inflation continues to surge. HICP inflation came in at 5.1% on the headline print and 2.3% on the core measure in January. This followed quite strong prints in both Germany and Spain earlier this week, where the latter is seeing inflation at 6.1%. Meanwhile, the unemployment rate continues to drift lower, falling to 7% in December for the entire eurozone, and as low as 5.1% for Germany. House prices are also surging across the monetary union. This begs the question of how long the ECB can remain on a dovish path and maintain credibility on its inflation mandate. Our favorite forward-looking measures for eurozone activity continue to point towards improvement. The Sentix investor confidence index rose from 13.5 to 14.9 in January, well above expectations. The ZEW expectations survey surged from 26.8 to 49.4 in January. The manufacturing PMI remained at a healthy 58.7 in January.  The ECB continues to maintain a dovish stance, keeping rates on hold and reiterating that inflation should subside in the coming quarters. According to their analysis, inflation is stickier than anticipated, but will ultimately head lower. This could prove wrong in a world where inflation is sticky globally and driven by supply-side factors. Ultimately, if inflation does prove transitory, then the hawkish pivot by other central banks will have to be reversed, in a classic catch-22 for the euro. Most of the above analysis suggests that investors should be buying the euro on weaknesses. However, the potential conflict in Ukraine raises the prospect that energy prices could stay elevated, which will hurt European growth. This will weaken the euro. Also, speculators are only neutral the currency according to CFTC data. As such, we are standing on the sidelines on EUR/USD and playing euro strength via a short cable position.  Chart 6AEuro Euro Euro Chart 6BEuro Euro Euro The Japanese Yen: The Most Undervalued G10 Currency The Japanese yen is flat year to date. The number of new COVID-19 infections continues to surge in Japan, which has led to various restrictions across the region and constrained economic activity. This has split the recovery on the island, where domestic activity remains constrained, but the external environment continues to boom. Inflation remains well below the Bank of Japan’s long-run target, coming in at 0.5% for the core measure, and -0.7% for the core core measure (excluding fresh food and energy) in January. The Jibun Bank composite PMI was at 48.8 in January, below the 50 boom/bust level, even though the manufacturing print is a healthy 55.4. The labor market continues to heal, with the unemployment rate at 2.7% in December, but the jobs-to-applicants ratio at 1.16 remains well below the pre-pandemic high of 1.64. This is 30% lower. As a result, wage growth in Japan has been rather anemic.   The external environment continues to perform well. Machine tool orders rose 40.6% year on year in December, following strong machinery orders of 11.6% year on year in November. Exports also rose 17.5% year on year in December. That said, the surge in energy prices and a weak yen continues to be a tax on Japanese consumers. We have been constructive on the yen, on the back of a wave of pent-up demand that will be unleashed as Omicron peaks. The Bank of Japan seems to share this sentiment. While monetary policy was kept on hold at the January 17-18 meeting, the BoJ significantly upgraded its GDP growth forecasts. 2022 forecasts were upgraded from 2.9% to 3.8%. This dovetailed with the latest IMF release of the World Economic Outlook, where Japan was the only country to see improving growth from 2021 in the G10. In short, bad news out of Japan is well discounted, while any specter of good news is underappreciated. The bull case for the yen remains intact over a longer horizon in our view. From a valuation standpoint, it is the cheapest G10 currency. It is also one of the most shorted. And as we have witnessed recently, it will perform well in a market reset, given year-to-date appreciation. Should the equity market rotation from expensive markets like the US towards cheaper and cyclical markets like Japan continue, the yen will also benefit via the portfolio channel. Chart 7AJapanese Yen Japanese Yen Japanese Yen Chart 7BJapanese Yen Japanese Yen Japanese Yen The British Pound: A Hawkish BoE The pound is up 0.5% year to date. The Bank of England raised interest rates to 0.5% today. According to its projections, inflation will rise to 7.25% in April before peaking. The BoE also announced it will start shrinking its balance sheet, via selling £20bn of corporate bonds and allowing a run-off from maturing government bonds. The Bank of England is the one central bank caught between a rock and a hard place. Inflation in the UK is soaring, prompting the governor to send a letter to the Chancellor of the Exchequer, explaining why monetary policy has allowed inflation to deviate from the BoE’s mandate of 2%. Headline CPI for December was at 5.4% and core CPI at 4.2%. The retail price index rose 7.5% year on year in April. At the same time, the UK is facing an energy crisis that is hitting consumer spending, ahead of a well-telegraphed tax hike in April. The labor market continues to heal. The ILO unemployment rate fell to 4.1% in November. This was better than expectations and below most estimates of NAIRU. As such, the UK runs the risk of a wage-price spiral, that will corner the BoE in the face of tighter fiscal policy. Average weekly earnings rose 4.2% year on year in November, pinning real wages in negative territory. Nationwide house prices also continue to inflect higher, accelerating much faster than incomes. This will lead to demand for much higher wages in the UK, in the coming months. The Sonia curve is currently pricing four or more interest rate hikes this year. This is despite Omicron cases in the UK surging to new highs and tighter fiscal policy. Should the BoE tighten aggressively ahead of a pending economic slowdown, this will hurt the pound. PMIs remain relatively well behaved – the manufacturing PMI was 57.3 in January, above expectations, while the services PMI was a healthy 53.3, but this could turn quickly should financial conditions tighten significantly. The political situation in the UK remains volatile, especially with Prime Minister Boris Johnson facing a scandal domestically, while lingering Brexit tensions continue to hurt the trade balance. As such, portfolio flows are likely to keep the pound volatile in the near term. An equity market correction, especially on the back of heightened tensions in Ukraine, will also pressure cable. That said, more political stability domestically and internationally will allow the pound to continue its mean reversion rally. Given the above dynamics, we are long EUR/GBP in the short term but are buyers of sterling over the longer term.  Chart 8ABritish Pound British Pound British Pound Chart 8BBritish Pound British Pound British Pound Australian Dollar: RBA Watching Inflation And Wages The Australian dollar is down 1.7% year to date. The Reserve Bank of Australia kept rates on hold at its February 1 meeting, even though it ended quantitative easing. The two critical measures that the RBA is focusing on are the outlook for inflation, especially backed by an increase in wages. In our view, a more hawkish outcome is likely to materialize over the course of 2022. On the inflation front, key measures are above the midpoint of the central bank’s target. In Q4, headline inflation was 3.5%, the trimmed mean measure was 2.6%, and the median print was 2.7% year on year. In fact, the increase in Q4 prices took the RBA by surprise and was attributed to rising fuel prices. The RBA expects inflationary pressures to remain persistent in 2022, but to ultimately fall to 2.75% in 2023. This will still be at the upper bound of their 1-3% target range. The employment picture in Australia is robust, barring lackluster wage growth. The unemployment rate fell to 4.2% in December from 4.6%, which, according to most measures, is below NAIRU. The RBA expects this rate to dip towards 3.75% next year. Admittedly, wage growth is still low by historical standards, but it is also true that the behavior of the Phillip’s curve at these low levels of unemployment is uncertain. Ergo, we could see an unexpected surge in wage growth. House prices are rising at a record 32% year-on-year in Sydney. This is a clear indication that monetary policy remains too easy, relative to underlying conditions. In the very near term, COVID-19 continues to ravage Australia, which will keep the next set of economic releases rather underwhelming. Combined with the zero-COVID policy in China (Australia’s biggest export partner), the outlook could remain somber in the very near term. This will keep the RBA dovish. On the flip side, a dovish RBA has softened the currency and allowed the trade balance to recover smartly. Meanwhile, it has also led to a record short positioning on the AUD. Our expectation going forward remains the same – as China eases policy, Australian exports will remain strong. A simultaneous peak in the spread of Omicron will also allow a domestic recovery, nudging the RBA to roll back its dovish rhetoric, relative to other central banks. Ergo, investors will get both a terms-of-trade and interest rate support for the AUD. We are reintroducing our limit but on AUD/USD at 70 cents, after being stopped out for a modest profit. Chart 9AAustralian Dollar Australian Dollar Australian Dollar Chart 9BAustralian Dollar Australian Dollar Australian Dollar New Zealand Dollar: Up Versus USD, But Lower On The Crosses The New Zealand dollar is down 2.3% year to date, the worst performing G10 currency. The Reserve Bank of New Zealand has been among the most hawkish in the G10. This has come on the back of strengthening economic data. In Q4, inflation in New Zealand shot up to a 32-year high of 5.9%. The labor market continues to heal, with the unemployment rate at a post-GFC low of 3.2% in Q4, well below NAIRU. Meanwhile, house prices continue to inflect higher, with dwelling costs in Wellington up over 30%. The trade balance continues to print a deficit but has been improving in recent quarters on the back of rising terms of trade. Meanwhile, given New Zealand currently has the highest G10 10-year government bond yield in the developed world, and bond inflows have been able to finance this deficit. In a nutshell, we expect the RBNZ to stay hawkish, but also acknowledge that is being well priced by bond markets. Overall, the kiwi will appreciate versus the US dollar, but will lag AUD, which is much more shorted and has a better terms-of-trade picture. As such, we are long AUD/NZD. Chart 10ANew Zealand Dollar New Zealand Dollar New Zealand Dollar Chart 10BNew Zealand Dollar New Zealand Dollar New Zealand Dollar Canadian Dollar: A Terms-Of-Trade Boom The CAD is down 0.3% year-to date. The Bank of Canada kept rates on hold at its January 26 meeting. This was a surprising outcome for us, as we expected the BoC to raise interest rates, but was in line with market expectations. Taking a step back, all the conditions for the BoC to raise interest rates are in place. The widely viewed Business Outlook Survey showed improvement in Q4, especially vis-à-vis wage and income growth. This is on the back of very strong inflation numbers out of Canada. The headline, trim and median inflation prints were either at or above the upper bound of the central bank’s target at 4.8%, 3.7% and 3%. On the labor front, employment levels in Canada are back above pre-pandemic levels, with the unemployment rate at 5.3%, close to estimates of NAIRU, while the participation rate has also recovered towards pre-pandemic levels. House price inflation is also prominent across many cities in Canada, which argues that monetary policy is too loose for underlying demand conditions. Longer term, the key driver of the CAD remains the outlook for monetary policy, and the path of energy prices. We remain optimistic on both fronts. On monetary policy, we expect the BoC will continue to monitor underlying conditions but will ultimately have to tighten policy as Omicron peaks. Among the G10 countries, Canada is one of the only countries where infection rates have peaked and are falling dramatically. Oil prices also remain well bid, as the Ukraine/Russia conflict continues to unfold. Should we reach a diplomatic solution in Ukraine, while Omicron also falls to the wayside, travel resumption will bring back a meaningful source of oil demand. From a positioning standpoint, speculators are only neutral the CAD. That said, we are buyers of CAD over a 12–18-month horizon given our analysis of the confluence of macro factors.  Chart 11ACanadian Dollar Canadian Dollar Canadian Dollar Chart 11BCanadian Dollar Canadian Dollar Canadian Dollar Swiss Franc: Sticking To NIRP The Swiss franc is down 0.8% year to date. The Swiss economy continues to hold up amidst surging COVID-19 infections. Economic wise, inflation is inflecting higher, the unemployment rate has dropped to 2.4%, and wages are rising briskly. This is lessening the need for the central bank to maintain ultra-accommodative settings. House price inflation also suggests that monetary conditions remain too easy relative to underlying demand. The Swiss National Bank remains committed to its inflation mandate, and inflation in Switzerland is among the lowest in the G10. As such, it will likely lag the rest of other developed market central banks in raising rates, with currently the lowest benchmark interest rate in the world. On the flip side, Switzerland runs a trade surplus that has been in structural appreciation, underpinning the franc as a core holding in any FX portfolio. In the near term, rising interest rates are negative for the franc. We are long EUR/CHF on this basis, as we believe the ECB will begin to react to rising inflation pressures. That said, we were long CHF/NZD on the prospect of rising volatility in the FX market and took 4.6% profits on January 14. In the near term, this trade could continue to perform well.  Chart 12ASwiss Franc Swiss Franc Swiss Franc Chart 12BSwiss Franc Swiss Franc Swiss Franc Norwegian Krone: Higher Rates Ahead The NOK is up 1.1% year-to-date. The Norges Bank kept the policy rate unchanged at 0.5% at its January meeting and reiterated that rate increases in March are likely. In their view, rising prices, low unemployment, and an easing of Covid-19 restrictions will give way to policy normalization, barring a persistence in Omicron infections. With as many as four rate hikes expected in 2022, the central bank is among the most aggressive in the G10. Headline CPI rose to 5.3% in December, spurred by record high electricity prices, while the core inflation came in at 1.8%. The unemployment rate dropped to 3.4% in Q4, the lowest since 2019. The manufacturing PMI rolled over slightly in January but at 56.5 remains well above the long-term average. Daily Covid-19 cases continue to hit record highs, but hospitalizations remain low, and the government has already scaled back most restrictions after a partial lockdown in December. This will contribute to an economic upswing and aid a recovery in retail sales that were down 3.1% month on month in December.  Norway’s trade balance shot up to record highs in December, driven by surging oil and natural gas export prices. A surging trade surplus supports the krone. Meanwhile, in a rising rate environment, portfolio flows into the cyclical-heavy Norwegian stock market could provide further support for the NOK. In a nutshell, the krone is undervalued according to our PPP models and appears attractive on a tactical and cyclical basis.  Chart 13ANorwegian Krone Norwegian Krone Norwegian Krone Chart 13BNorwegian Krone Norwegian Krone Norwegian Krone Swedish Krona: Lower Now, Strong Later The SEK is down 0.5% year-to-date. The Swedish economy continued to strengthen in Q4 with GDP growth rising 1.4% quarter-on-quarter, exceeding expectations. In December, the unemployment rate fell to 7.3%, the lowest since the onset of the pandemic, and household lending edged higher to 6.8% year on year. In other data, the manufacturing PMI increased to 62.4 in January. Headline inflation adjusted for interest rates rose to 4.1%, highest since 1993, well above the Riksbank’s 2% target. This has raised doubts on whether the central bank will be able to hold off raising rates until 2024 as it had previously announced. However, excluding energy prices the CPI declined slightly to 1.7%. In short, the Riksbank faces the same conundrum as the ECB, on the persistence of higher inflation, driven by high energy costs. The Omicron variant continues to spread at record pace in Sweden, but recent numbers suggest some moderation. This was probably due to stricter measures in Sweden, in contrast to its Scandinavian neighbors. The cost of this stringency has been softer business and consumer confidence, which are down to multi-month lows. Retail sales also fell by 4.4% in December from the previous month. Taking a step back, Sweden is a small open economy very sensitive to global growth conditions. As such, a rebound in global and Chinese economic activity will hold the key to a rebound in SEK. In our models, the SEK is also undervalued. Chart 14ASwedish Krona Swedish Krona Swedish Krona Chart 14BSwedish Krona Swedish Krona Swedish Krona   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Feature Chart 1Weak Economic Fundamentals Undermine Stock Performance Intensified Monetary Policy Easing, Unresponsive Underlying Demand Intensified Monetary Policy Easing, Unresponsive Underlying Demand Monetary policy easing has intensified in the past two months. The PBoC reduced one-year loan prime rate (LPR) by 10 bps and five-year by 5 bps following last week’s 10bps cut in policy rates1 and December’s 50 bps drop in the reserve requirement rate (RRR). Nonetheless, the onshore financial market’s response to the monetary policy actions has been muted. China’s A-share market price index fell by 3% in the past month. Credit growth has bottomed, but there is no sign of a strong rebound despite recent rate decreases (Chart 1, top panel). The impaired monetary policy transmission mechanism will likely delay China’s economic recovery, which normally lags the credit cycle by six to nine months. Moreover, the marginal propensity to spend among both corporates and households continues to decline, highlighting a lack of confidence among real economy participants, and will in turn dampen the positive effects of policy stimulus (Chart 2).  The poor performance of Chinese onshore stocks (in absolute terms) is due to a muted improvement in credit growth and deteriorating economic fundamentals (Chart 1, bottom panel). Our model shows that China’s corporate profits are set to contract in next six months, implying that the risk-reward profile of Chinese stocks in absolute terms is not yet attractive (Chart 3). Therefore, investors should maintain an underweight allocation to Chinese equities for the time being. Chart 2Lack Of Confidence Dampens Corporate Earnings Outlook Lack Of Confidence Dampens Corporate Earnings Outlook Lack Of Confidence Dampens Corporate Earnings Outlook Chart 3China's Corporate Profits Set To Contract In Next Six Months China's Corporate Profits Set To Contract In Next Six Months China's Corporate Profits Set To Contract In Next Six Months   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Improving Liquidity, Weakening Credit Demand The modest uptick in December’s total social financing (TSF) growth largely reflects a significant increase in government bond issuance, while bank loan growth continued on a downward trend (Chart 4). Corporate loan demand remained sluggish, which dragged down aggregate bank credit growth (Chart 5). Downbeat business confidence suggests that corporate demand for credit will take longer to turn around, and therefore will reduce the effectiveness of current easing measures. Chart 4Monetary Easing Since Q3 Has Failed To Boost Credit Growth So Far Monetary Easing Since Q3 Has Failed To Boost Credit Growth So Far Monetary Easing Since Q3 Has Failed To Boost Credit Growth So Far Chart 5Corporate Demand For Loans Weaker Than Suggested By Headline Data Corporate Demand For Loans Weaker Than Suggested By Headline Data Corporate Demand For Loans Weaker Than Suggested By Headline Data Meanwhile, corporate bill financing has risen rapidly in recent months and now accounts for almost 40% of new bank loans, the highest level since 2010 (Chart 5, bottom panel). The high share of short-term lending to the corporate sector highlights the underlying weakness in both loan supply and demand.  Banks are risk averse and reluctant to approve longer-term credit to the corporate sector, while corporates are unwilling to take on more debt.  As a result, banks have had to issue short-term bills in order to meet their lending quota. Proactive Fiscal Policy Will Have A Limited Impact On Infrastructure Investments Chart 6Local Government SPBs Will Be Frontloaded In 2022 Intensified Monetary Policy Easing, Unresponsive Underlying Demand Intensified Monetary Policy Easing, Unresponsive Underlying Demand Fiscal policy will likely be frontloaded in Q1 this year, but the impact of a proactive fiscal policy on boosting infrastructural investment may be limited. According to a statement by the Ministry of Finance last December, around RMB1.46 trillion in the quota for local government special purpose bonds (SPBs) has been frontloaded for 2022. If we assume that all of the SPBs will be issued in Q1, the amount will be higher than SPBs issued during the same period in 2019, 2020 and 2021 (Chart 6). We expect a total SPBs quota of RMB 3.5 trillion for 2022, roughly the same as 2021.  This implies a zero fiscal impulse on SPBs in 2022 compared with 2021. However, there were an estimated 1.2 trillion in SPB proceeds in 2021 that local governments failed to invest and this amount could be deployed in 2022. If we add last year’s SPB carryover to this year’s quota, there may be a 30% increase in the available funds to invest in infrastructure projects in 2022. Chart 7Higher LG Bond Issuance Does Not Mean Substantial Boost In Infrastructure Spending Higher LG Bond Issuance Does Not Mean Substantial Boost In Infrastructure Spending Higher LG Bond Issuance Does Not Mean Substantial Boost In Infrastructure Spending However, a 30% jump in SPB proceeds does not suggest an equal boost in infrastructure spending this year (Chart 7). As noted in previous reports, SPBs issued by local governments only account for around 15% of total funding for infrastructure spending. Bank loans, which remain in the doldrums, are a much more significant driver in supporting the sector’s investment.  Secondly, infrastructure spending has structurally downshifted since 2017 due to a sweeping financial deleveraging campaign to rein in shadow banking activity by local government financing vehicles (LGFVs). Shadow banking activity, which is highly correlated with infrastructure investment growth, is stuck in a deep contraction with no signs of an imminent turnaround (Chart 7, bottom panel). Thirdly, land sales play a prominent role in local government financing, accounting for more than 40% of local government aggregate revenues2 compared with about 15% from SPBs (Chart 8). Local government fiscal spending power will be constrained due to a significant and ongoing slowdown in land sales and regulatory pressures on LGFVs (Chart 8, bottom panel).    Therefore, we expect that infrastructure spending will only moderately rebound in 2022. At best, it will return to its pre-pandemic rate of around 4% (year-over-year) in 2022 (Chart 9, top panel). Notably, onshore infrastructure stocks have priced in the recent favorable news about proactive fiscal policy support in 2022 (Chart 9, bottom panel). Given that infrastructure investment will likely only improve modestly this year, on a cyclical basis the sector’s stock performance upside will be capped and renewed weakness is likely. Chart 8Government Funds Face Headwinds From Falling Land Sales Government Funds Face Headwinds From Falling Land Sales Government Funds Face Headwinds From Falling Land Sales Chart 9Infrastructure Investment Will Likely Recover To Its Pre-Pandemic Growth Rate Infrastructure Investment Will Likely Recover To Its Pre-Pandemic Growth Rate Infrastructure Investment Will Likely Recover To Its Pre-Pandemic Growth Rate More Policy Fine-Tuning Is Underway, But Housing Policy Reversal Remains Doubtful Last week’s 5bp reduction in the 5-year LPR, which serves as a benchmark for mortgage loans, was positive for the housing market. However, the cut is insufficient to revive the demand for housing. Moreover, the asymmetrical rate reductions - a 10bps drop in the 1-year LPR versus a 5bps reduction in the 5-year - signals that the authorities are reluctant to decisively reverse housing policies. Sentiment in the housing sector remains downbeat. A survey conducted by the PBoC shows that the willingness to buy a home has plunged to the lowest level since 2017 (Chart 10). Medium- to long-term household loan growth, which is highly correlated with home sales, decelerated further in December (Chart 10, bottom panel). Given that home prices continue to decline, buyers may be expecting more price discounts and refrain from making purchases despite slightly cheaper mortgage rates. Although there was a modest pickup in medium- to long-term consumer loan growth in November, it was mainly driven by pent-up mortgage applications delayed by the banks in Q3. Moreover, advance payments for real estate developers remained in contraction through end-2021. The prolonged weakness in the demand for mortgages and homes highlights our view that it will take more than a minor mortgage rate cut to revive sentiment (Chart 11). Chart 10Sentiment In Housing Market Has Plummeted To A Multi-Year Low Sentiment In Housing Market Has Plummeted To A Multi-Year Low Sentiment In Housing Market Has Plummeted To A Multi-Year Low Chart 11Funding Among Real Estate Developers Has Not Improved Funding Among Real Estate Developers Has Not Improved Funding Among Real Estate Developers Has Not Improved Without a decisive improvement in home sales, real estate developers will continue to face funding constraints, which will weigh on new investment and housing projects (Chart 12). We expect the contraction in real estate investment and housing starts to be sustained through at least 1H22 (Chart 13). Chart 12Policymakers Will Have To Allow Significant Re-leveraging To Revive Housing Demand Policymakers Will Have To Allow Significant Re-leveraging To Revive Housing Demand Policymakers Will Have To Allow Significant Re-leveraging To Revive Housing Demand Chart 13Real Estate Investment And Housing Starts Will Remain In Contraction Through 1H22 Real Estate Investment And Housing Starts Will Remain In Contraction Through 1H22 Real Estate Investment And Housing Starts Will Remain In Contraction Through 1H22 Chinese Export Growth Will Converge To Long-Term Growth Chart 14Vigorous Exports Provided Crucial Support To China's Economy In 2021 Vigorous Exports Provided Crucial Support To China's Economy In 2021 Vigorous Exports Provided Crucial Support To China's Economy In 2021 China’s exports grew vigorously in 2021, providing critical support to the economy.  Net exports contributed 1.7 percentage points to the 8.1% rate of real GDP growth in 2021, the highest growth contribution since 2006. China’s share of global exports expanded to more than 15%, about 2 percentage points higher than the pre-pandemic average from 2015 to 2019 (Chart 14). The export sector probably will not repeat last year’s strong performance. The widening divergence of exports in value and in volume suggests that the solid aggregate value of exports has been mainly buttressed by soaring export prices since July 2021 (Chart 15). The price effect will likely gradually abate in 2022 due to easing global supply chain constraints, softer global economic growth and a high base factor from 2021. Indeed, export prices from China and other industrialized countries may have already peaked (Chart 16). Chart 15Robust Exports Growth Since 2H21 Driven By Soaring Export Prices Robust Exports Growth Since 2H21 Driven By Soaring Export Prices Robust Exports Growth Since 2H21 Driven By Soaring Export Prices Chart 16Export Prices May Have Peaked Export Prices May Have Peaked Export Prices May Have Peaked Services spending worldwide will likely normalize and lead global demand growth in 2022. Meanwhile, goods spending will moderate, implying weaker demand for China’s manufactured goods (Chart 17). Furthermore, China’s strong exports to emerging markets (EM) since Q2 2021 reflected supply shortages due to production interruptions in the EMs (Chart 18). We expect supply chain disruptions in these economies to ease in 2H22 when Omicron-induced infections subside and antiviral treatments become available worldwide. As such, China’s exports to those regions may gradually return to pre-pandemic levels. Chart 17US Household Consumption Will Likely Rotate From Goods To Services In 2022 US Household Consumption Will Likely Rotate From Goods To Services In 2022 US Household Consumption Will Likely Rotate From Goods To Services In 2022 Chart 18Rising Exports To EMs In 2021 May Not Continue Into 2022 Rising Exports To EMs In 2021 May Not Continue Into 2022 Rising Exports To EMs In 2021 May Not Continue Into 2022 China’s manufacturing utilization capacity reached a historical high in 2021, supported by hardy external demand for goods. However, profit margins in the manufacturing sector have been squeezed due to surging input costs (Chart 19). Manufacturing investment growth has been falling, reflecting the reluctance by manufacturers to expand their business operations amid narrowing profit margins (Chart 20). The profit outlook for the manufacturing sector will be at risk of deterioration when the growth in both export volumes and prices moderate in 2022.  Chart 19Manufacturing Sector's Profit Margins Have Been Squeezed Manufacturing Sector's Profit Margins Have Been Squeezed Manufacturing Sector's Profit Margins Have Been Squeezed Chart 20Manufacturing Investment Growth And Output Volume Both Rolled Over Manufacturing Investment Growth And Output Volume Both Rolled Over Manufacturing Investment Growth And Output Volume Both Rolled Over Rising Import Prices Mask The Weakness In Chinese Domestic Demand Chinese import growth in value remained resilient through December, but has increasingly been driven by rising import prices. Import growth in volume, which is a truer picture of China’s domestic demand, decelerated at a faster rate in 2H21 (Chart 21). Credit impulse, which normally leads import growth by around six months, only ticked up slightly. The minor improvement in the rate of Chinese credit expansion will provide limited support to the country’s imports in 1H 2022 (Chart 22).  Chart 21Rising Import Prices Masked The Weakness In China's Domestic Demand Rising Import Prices Masked The Weakness In China's Domestic Demand Rising Import Prices Masked The Weakness In China's Domestic Demand   Chart 22Modest Rebound In Credit Impulse Will Provide Limited Support To Chinese Imports Modest Rebound In Credit Impulse Will Provide Limited Support To Chinese Imports Modest Rebound In Credit Impulse Will Provide Limited Support To Chinese Imports Chart 23Chinese Imports Of Key Commodities Rebounded Aimed Easing In Production Constraints Chinese Imports Of Key Commodities Rebounded Aimed Easing In Production Constraints Chinese Imports Of Key Commodities Rebounded Aimed Easing In Production Constraints The volume of Chinese-imported key commodities, such as iron ore and steel, rebounded in the past three months, but its growth remains in contraction on a year-on-year basis (Chart 23). The improvement in Chinese commodity imports, in our view, reflects an easing in production constraints rather than escalating demand. Recently released economic data, ranging from manufacturing PMI, industrial production, fixed-asset investment and construction activity, all point to an imbalanced supply-demand picture in China’s economy (discussed in the next section).    Sluggish Quarterly Economic Growth At End Of 2021 China’s economy expanded by 8.1% in 2021 or at a 5.1% average annual rate in the past two years.  However, quarterly GDP growth on a year-over-year basis slowed further to 4% in Q4 from 4.9% in the previous quarter. On a sequential basis, seasonally adjusted GDP growth in Q4 was 1.6 percentage points above that of Q3, but slightly below its historical mean (Chart 24). Chart 24Subdued GDP Growth In Q4 Subdued GDP Growth In Q4 Subdued GDP Growth In Q4 Chart 25Investment And Consumption Have Been Poor Economic Links Investment And Consumption Have Been Poor Economic Links Investment And Consumption Have Been Poor Economic Links Chart 26Softness In Investment And Consumption More Than Offset Robust Exports Softness In Investment And Consumption More Than Offset Robust Exports Softness In Investment And Consumption More Than Offset Robust Exports Although industrial production accelerated somewhat in December, it reflects a catch-up phase following a period of constrained output amid last fall’s energy crisis (Chart 25). On the other hand, lackluster domestic demand and a further slowdown in the housing market significantly dragged down China’s economic expansion in Q4. Both fixed-asset investment and consumption decelerated significantly in 2021 Q4, more than offsetting an improvement in net exports (Chart 26, top panel). Notably, year-over-year growth rates in construction and real estate components of real GDP fell below zero in Q4 (Chart 26, bottom panel). In light of the subdued credit growth through end-2021, China’s economic activity will not regain its footing until mid-2022.  Slow Recovery In Household Consumption Likely Through 1H22 The household consumption recovery was sluggish in 2021 and it will face strong headwinds at least through 1H22. China’s consumption recovery has been hindered by a worsening labor market situation, depressed household sentiment and renewed threats from flareups in domestic COVID-19 cases. China’s labor market situation shows a mixed picture. The urban unemployment rate has dropped to pre-pandemic levels and stabilized at 5.1% in December. It remains well within the government’s 2021 unemployment target of “around 5.5%”. However, urban new job creations plunged sharply and the number of migrant workers returning to the cities remains far below the pre-pandemic trend (Chart 27). China’s imbalanced economic recovery in the past two years led to a substantially slower pace of job creation in labor-intensive service sectors (Chart 28). Moreover, wages have been cut and the unemployment rate among younger workers have climbed rapidly in sectors suffering from last year’s regulatory crackdowns in real estate, education and internet platforms. Even though policies have recently eased at margin, it will take time for labor market dynamics (a lagging indicator) to improve. Chart 27Labor Market Situation Is Worsening Labor Market Situation Is Worsening Labor Market Situation Is Worsening Chart 28Imbalanced Economic Recovery Led To A Mixed Picture In The Labor Market Imbalanced Economic Recovery Led To A Mixed Picture In The Labor Market Imbalanced Economic Recovery Led To A Mixed Picture In The Labor Market Chinese household expenditures have lagged disposable incomes since the outbreak of the pandemic (Chart 29). The propensity to consume has declined since 2018 and the downward trend has been exacerbated by the pandemic since early 2020 along with a soaring preference to save (Chart 30). Chart 29Chinese Household Expenditures Have Lagged Disposable Income Growth Chinese Household Expenditures Have Lagged Disposable Income Growth Chinese Household Expenditures Have Lagged Disposable Income Growth Chart 30Poor Sentiment On Future Income Contributes To Consumers' Unwillingness To Spend Poor Sentiment On Future Income Contributes To Consumers' Unwillingness To Spend Poor Sentiment On Future Income Contributes To Consumers' Unwillingness To Spend Household consumption also faces renewed threats from increases in domestic COVID-19 cases. Since Q3 last year, more frequent city-wide lockdowns and inter-regional travel bans have had profound negative effects on the country’s service sector and retail sales (Chart 31 & 32). Omicron has also spread to China, triggering new waves of stringent countermeasures. China will not abandon its zero-tolerance policy towards COVID anytime soon, thus we expect the stop-and-go economic reopening to continue to weigh on the country’s service sector activity and consumption at least through 1H22. Chart 32Service Sector Activities Struggle To Return To Pre-Pandemic Trends Service Sector Activities Struggle To Return To Pre-Pandemic Trends Service Sector Activities Struggle To Return To Pre-Pandemic Trends Chart 31China's Stringent COVID Countermeasures Will Curb Service Sector Recovery In 2022 China's Stringent COVID Countermeasures Will Curb Service Sector Recovery In 2022 China's Stringent COVID Countermeasures Will Curb Service Sector Recovery In 2022   Table 1China Macro Data Summary Intensified Monetary Policy Easing, Unresponsive Underlying Demand Intensified Monetary Policy Easing, Unresponsive Underlying Demand Table 2China Financial Market Performance Summary Intensified Monetary Policy Easing, Unresponsive Underlying Demand Intensified Monetary Policy Easing, Unresponsive Underlying Demand   Footnotes 1     The 7-day reverse repo and the 1-year Medium-term Lending Facility (MLF) rates. 2     Including local government budgetary and managed funds revenues.   Strategic View Cyclical Recommendations Tactical Recommendations

Highlights Global equities are poised to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Non-US markets are likely to outperform. We examine the four pillars that have historically underpinned stock market performance. Pillar 1: Technically, the outlook for equities is modestly bullish, as investor sentiment is nowhere near as optimistic as it usually gets near market tops. Pillar 2: The outlook for economic growth and corporate earnings is modestly bullish as well. While global growth is slowing, it will remain solidly above trend in 2022. Pillar 3: Monetary and financial conditions are neutral. The Fed and a number of other central banks are set to raise rates and begin unwinding asset purchases this year. However, monetary policy will remain highly accommodative well into 2023. Pillar 4: Valuations are bearish in the US and neutral elsewhere. Investors should avoid tech stocks in 2022, focusing instead on banks and deep cyclicals, which are more attractively priced. The Bedrock For Equities In assessing the outlook for the stock market, our research has focused on four pillars: 1) Sentiment and other technical factors, which are most pertinent for stocks over short-term horizons of about three months; 2) cyclical fluctuations in economic growth and corporate earnings, which tend to dictate the path for stocks over medium-term horizons of about 12 months; 3) monetary and financial conditions, which are also most relevant over medium-term horizons; and finally 4) valuations, which tend to drive stocks over the long run. In this report, we examine all four pillars, concluding that global equities are likely to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Pillar 1: Sentiment And Other Technical Factors (Modestly Bullish)   Chart 1US Equities: Breadth Is A Concern US Equities: Breadth Is A Concern US Equities: Breadth Is A Concern Scaling The Wall Of Worry Stocks started the year on a high note, before tumbling on Wednesday following the release of the Fed minutes. Market breadth going into the year was quite poor. Even as the S&P 500 hit a record high on Tuesday, only 57% of NYSE stocks and 38% of NASDAQ stocks were trading above their 200-day moving averages compared to over 90% at the start of 2021 (Chart 1). The US stock market had become increasingly supported by a handful of mega-cap tech stocks, a potentially dangerous situation in an environment where bond yields are rising and stay-at-home restrictions are apt to ease (more on this later). That said, market tops often occur when sentiment reaches euphoric levels. That was not the case going into 2022 and it is certainly not the case after this week's sell-off. The number of bears exceeded the number of bulls in the AAII survey this week and in six of the past seven weeks (Chart 2). The share of financial advisors registering a bullish bias declined by 25 percentage points over the course of 2021 in the Investors Intelligence poll. Option pricing is far from complacent. The VIX stands at 19.6, above its post-GFC median of 16.7.  According to the Minneapolis Fed’s market-based probabilities model, the market was discounting a slightly negative 12-month return for the S&P 500 as of end-2021, with a 3.6 percentage-point larger chance of a 20% decline in the index than a 20% increase (Chart 3). Chart 3Option Pricing Is Not Pointing To Elevated Complacency Option Pricing Is Not Pointing To Elevated Complacency Option Pricing Is Not Pointing To Elevated Complacency Chart 2Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Equities do best when sentiment is bearish but improving (Chart 4). With bulls in short supply, stocks can continue to climb the proverbial wall of worry.   Whither The January Effect? Historically, stocks have fared better between October and April than between May and September (Chart 5). One caveat is that the January effect, which often saw stocks rally at the start of the year, has disappeared. In fact, the S&P 500 has fallen in January by an average annualized rate of 5.2% since 2000 (Table 1). Other less well-known calendar effects – such as the tendency for stocks to underperform on Mondays but outperform on the first trading day of each month – have persisted, however. Chart 4 Chart 5 Table 1Calendar Effects The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market Bottom Line: January trading may be choppy, but stocks should rise over the next few months as more bears join the bullish camp. Last year’s losers are likely to outperform last year’s winners. Pillar 2: Economic Growth And Corporate Earnings (Modestly Bullish)   Economic Growth And Earnings: Joined At The Hip The business cycle is the most important driver of stocks over medium-term horizons of about 12 months. The reason is evident in Chart 6: Corporate earnings tend to track key business cycle indicators such as the ISM manufacturing index, industrial production, business sales, and global trade. Chart 6The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons Chart 7PMIs Signaling Above-Trend Growth PMIs Signaling Above-Trend Growth PMIs Signaling Above-Trend Growth Global growth peaked in 2021 but should stay solidly above trend in 2022. Both the service and manufacturing PMIs remain in expansionary territory (Chart 7). The forward-looking new orders component of the ISM exceeded 60 for the second straight month in December. The Bloomberg consensus is for real GDP to rise by 3.9% in the G7 in 2022, well above the OECD’s estimate of trend G7 growth of 1.4% (Chart 8). Global earnings are expected to increase by 7.1%, rising 7.5% in the US and 6.7% abroad (Chart 9). Our sense is that both economic growth and earnings will surprise to the upside in 2022. Chart 9Analysts Expect Single-Digit Earnings Growth Analysts Expect Single-Digit Earnings Growth Analysts Expect Single-Digit Earnings Growth Chart 8 Plenty Of Pent-Up Demand For Both Consumer And Capital Goods US households are sitting on $2.3 trillion in excess savings (Chart 10). Around half of these savings will be spent over the next few years, helping to drive demand. Households in the other major advanced economies have also buttressed their balance sheets. Chart 10Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand After two decades of subdued corporate investment, capital goods orders have soared. This bodes well for capex in 2022. Inventories remain at rock-bottom levels, which implies that output will need to exceed spending for the foreseeable future (Chart 11). On the residential housing side, both the US homeowner vacancy rate and the inventory of homes for sale are near multi-decade lows. Building permits are 11% above pre-pandemic levels (Chart 12). Chart 11Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Chart 12Residential Construction Will Remain Well Supported Residential Construction Will Remain Well Supported Residential Construction Will Remain Well Supported Chart 13China's Credit Impulse Has Bottomed China's Credit Impulse Has Bottomed China's Credit Impulse Has Bottomed Chinese Growth To Rebound, Europe To Benefit From Lower Natural Gas Prices Chinese credit growth decelerated last year. However, the 6-month credit impulse has bottomed, and the 12-month impulse is sure to follow (Chart 13). Chinese coal prices have collapsed following the government’s decision to instruct 170 mines to expand capacity (Chart 14). China generates 63% of its electricity from coal. Lower energy prices and increased stimulus should support Chinese industrial activity in 2022. Like China, Europe will benefit from lower energy costs. Natural gas prices have fallen by nearly 50% from their peak on December 21st. A shrinking energy bill will support the euro (Chart 15). Chart 14Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Chart 15A Shrinking Energy Bill Will Support The Euro A Shrinking Energy Bill Will Support The Euro A Shrinking Energy Bill Will Support The Euro Chart 16 Omicron Or Omicold? While the Omicron wave has led to an unprecedented spike in new cases across many countries, the economic fallout will be limited. The new variant is more contagious but significantly less lethal than previous ones. In South Africa, it blew through the population without triggering a major increase in mortality (Chart 16). Preliminary data suggest that exposure to Omicron confers at least partial immunity against Delta. The general tendency is for viral strains to become less lethal over time. After all, a virus that kills its host also kills itself. Given that Omicron is crowding out more dangerous strains such as Delta, any future variant is likely to emanate from Omicron; and odds are this new variant will be even milder than Omicron. Meanwhile, new antiviral drugs are starting to hit the market. Pfizer claims that its new drug, Paxlovid, cuts the risk of hospitalization by almost 90% if taken within five days from the onset of symptoms. Bottom Line: While global growth has peaked and the pandemic remains a risk, growth should stay well above trend in the major economies in 2022, fueling further gains in corporate earnings and equity prices.   Pillar 3: Monetary And Financial Factors (Neutral)   Chart 17The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months Tighter But Not Tight Monetary and financial factors help govern the direction of equity prices both because they influence economic growth and also because they affect the earnings multiple at which stocks trade. There is little doubt that a number of central banks, including the Federal Reserve, are looking to dial back monetary stimulus. However, there is a big difference between tighter monetary policy and tight policy. Even if the FOMC were to raise rates three times in 2022, as the market is currently discounting, the fed funds rate would still be half of what it was on the eve of the pandemic (Chart 17). Likewise, even if the Fed were to allow maturing assets to run off in the middle of this year, as the minutes of the December FOMC meeting suggest is likely, the size of the Fed’s balance sheet will probably not return to pre-pandemic levels until the second half of this decade.   A Higher Neutral Rate We have argued in the past that the neutral rate of interest in the US is higher than widely believed. This implies that the overall stance of monetary policy remains exceptionally stimulative. Historically, stocks have shrugged off rising bond yields, as long as yields did not increase to prohibitively high levels (Table 2). Table 2As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market If the neutral rate ends up being higher than the Fed supposes, the danger is that monetary policy will stay too loose for too long. The question is one of timing. The good news is that inflation should recede in the US in 2022, as supply-chain bottlenecks ease and spending shifts back from goods to services. The bad news is that the respite from inflation will not last. As discussed in Section II of our recently-published 2022 Strategy Outlook, inflation will resume its upward trajectory in mid-2023 on the back of a tightening labor market and a budding price-wage spiral. This second inflationary wave could force the Fed to turn much more aggressive, spelling the end of the equity bull market. Bottom Line: While the Fed is gearing up to raise rates and trim the size of its balance sheet, monetary policy in the US and in other major economies will remain highly accommodative in 2022. US policy could turn more restrictive in 2023 as a second wave of inflation forces a more aggressive response from the Fed.   Pillar 4: Valuations (Bearish In The US; Neutral Elsewhere)   US Stocks Are Looking Pricey… While valuations are a poor timing tool in the short run, they are an excellent forecaster of stock prices in the long run. Chart 18 shows that the Shiller PE ratio has reliably predicted the 10-year return on equities. Today, the Shiller PE is consistent with total real returns of close to zero over the next decade. Chart 18 Investors’ allocation to stocks has also predicted the direction of equity prices (Chart 19). According to the Federal Reserve, US households held a record high 41% of their financial assets in equities as of the third quarter of 2021. If history is any guide, this would also correspond to near-zero long-term returns on stocks. Chart 19Valuations Matter For Long-Term Returns (II) Valuations Matter For Long-Term Returns (II) Valuations Matter For Long-Term Returns (II)   … But There Is More Value Abroad Valuations outside the US are more reasonable. Whereas US stocks trade at a Shiller PE ratio of 37, non-US stocks trade at 20-times their 10-year average earnings. Other valuation measures such as price-to-book, price-to-sales, and dividend yield tell a similar story (Chart 20). Chart 20AUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) Chart 20BUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) Cyclicals And Banks Overrepresented Abroad Our preferred sector skew for 2022 favors non-US equities. Increased capital spending in developed economies and incremental Chinese stimulus should boost industrial stocks and other deep cyclicals, which are overrepresented outside the US (Table 3). Banks are also heavily weighted in overseas markets; they should also do well in response to faster-than-expected growth and rising bond yields (Chart 21). Table 3Deep Cyclicals And Financials Are Overrepresented Outside The US The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market Chart 21Rising Bond Yields Will Help Bank Shares Rising Bond Yields Will Help Bank Shares Rising Bond Yields Will Help Bank Shares Bottom Line: Valuations are more appealing outside the US, and with deep cyclicals and banks set to outperform tech over the coming months, overseas markets are the place to be in 2022. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image

Highlights US economic data remains robust, but economic surprises are rolling over relative to other G10 countries. Meanwhile, the Fed is turning a tad more hawkish, which is positive for the greenback in the short term but could hurt growth over a cyclical horizon.  A hawkish Fed and dovish PBoC could set the stage for an economic recovery outside the US. We are not fighting the Fed (dollar bullish in the near term), and most of our trades are at the crosses. These include long EUR/GBP, long AUD/NZD and long CHF/NZD. We also have a speculative long on AUD/USD. We were stopped out of our short USD/JPY trade at break even and will look to reinstate at more attractive levels. Feature Chart 1 The dollar was the best performing G10 currency last year (Chart 1), which begs the question if this outperformance will be sustained in 2022. In this week’s report, we go over a few key data releases in the last month and implications for currency markets. Most recently, PMI releases across the developed world have remained robust but are peaking (Chart 2). The key question is whether the slowdown proves genuine, and if so, whether the US can maintain economic leadership versus the rest of the G10. Chart 2AGlobal PMIs Are Softening, Especially In The US Global PMIs Are Softening, Especially In The US Global PMIs Are Softening, Especially In The US Chart 2BGlobal PMIs Are Softening, Especially In The US Global PMIs Are Softening, Especially In The US Global PMIs Are Softening, Especially In The US The next key question is what central banks do about inflation. It is becoming clearer that rising prices are not a US-centric phenomenon but a global problem (Chart 3). Our bias is that central banks cannot meaningfully diverge on the inflation front. This will create trading opportunities. Chart 3AInflation Is A Global Problem Inflation Is A Global Problem Inflation Is A Global Problem Chart 3BInflation Is A Global Problem Inflation Is A Global Problem Inflation Is A Global Problem Over the next few pages, we look at the latest data releases and implications for currency strategy. US Dollar: Strong Now, Weaker Later? The dollar DXY index fell 0.4% in December and is up 0.5% year to date. A growth rotation from the US to other economies continues, even though US economic data over the last month remains rather robust. The latest release of the ISM manufacturing index remained strong at 58.7 for December, but this has rolled over from 61.1 in the previous month. More importantly, the prices paid index fell from 82.4 to 68.2. This suggests inflationary pressures are coming in, which could assuage tightening pressure on the Federal Reserve.  In other data, the trade deficit continues to widen, hitting a record -$97.8bn in November. Durable goods orders for November rose 2.5%, the biggest increase in six months. The consumer confidence index from the Conference Board has also rebounded, rising to 115.8 in December. Home prices are also rising, with an increase of almost 20% year on year in October. This suggests monetary conditions in the US remain very easy, relative to underlying demand. A tighter Fed is what the US needs, but the perfect calibration of monetary policy could prove difficult to achieve. The Fed minutes this week highlighted a preference for a faster pace of policy normalization, in the face of a tightening labor market and persistent inflationary pressures. This put the US dollar in a quandary, relative to other developed market currencies. If the US tightens monetary policy, while China eases, it strengthens the dollar in the near term, but tightens US financial conditions that have been the bedrock of US demand. This will suggest peak US demand in the coming months, and a bottoming in demand for countries that are more sensitive to Chinese monetary conditions. Chart 4AUS Dollar US Dollar US Dollar Chart 4BUS Dollar US Dollar US Dollar The Euro: All Bets On China? The euro was up 0.4% in December. Year-to-date, the euro is down 0.5%. Inflation continues to rise in the eurozone, which begs the question of how long the ECB can remain on a dovish path and maintain credibility on its inflation mandate. PPI came out at 23.7% year-on-year, the highest in several decades. Core consumer price index (CPI) in the eurozone is at 4.9%, a whisker below US levels. Economic data remain resilient in the euro area, despite surging Covid-19 cases. The ZEW expectations survey rose to 26.8 in December from 25.9. The trade balance remains in a healthy surplus (though rolling over). In a nutshell, economic surprises in the eurozone have been outpacing those in the US over the last month. The ECB continues to maintain a dovish stance, keeping rates on hold and reiterating that inflation should subside in the coming quarters. According to their forecasts, inflation is headed below 2% by the end of 2022. This could prove wrong in a world where inflation is sticky globally and driven by supply-side factors. In the near term, we expect a policy convergence between the ECB and the BoE. As such, we are long EUR/GBP on this basis. Over the longer term, we expect the ECB to lag the Fed, and thus we will fade any persistent strength in the euro. Chart 5AEuro Euro Euro Chart 5BEuro Euro Euro The Japanese Yen: The Most Hated Currency The Japanese yen was down 2% in December. It is also down 0.6% year-to-date. Overall, the yen was the worst performing G10 currency in 2021. Good news out of Japan continues to be underappreciated, while bad news is well discounted. Industrial production rose 5.4% in November, from a contraction the previous month, and the Jinbun Bank manufacturing PMI edged higher in December to 54.3. Retail sales are inflecting higher, and the national CPI has bottomed, easing pressure on the Bank of Japan to remain ultra-accommodative. The bull case for the yen remains intact. First, as we have witnessed recently, it will perform well in a market reset, given it is the most shorted G10 currency. Second, and related, the yen tends to do well with rising volatility, which we should expect in the coming months. Third, Covid-19 infections in Japan remain low, meaning should global cases rollover, Japan could be quicker in jumpstarting an economic recovery. Finally, an equity market rotation from expensive markets like the US towards cheaper and cyclical markets like Japan, will benefit the yen via the portfolio channel. From a valuation standpoint, the yen is the cheapest G10 currency according to our PPP models. We were long the yen and stopped out at break even (114.40). We will look to re-enter this trade at more attractive levels. Chart 6AJapanese Yen Japanese Yen Japanese Yen Chart 6BJapanese Yen Japanese Yen Japanese Yen British Pound: Near-Term Volatility The pound was up 1.9% in December. Year-to-date, cable is flat. UK data continues to moderate from high levels, similar to the picture in the US. Covid-19 infections continue to surge, but the December manufacturing PMI remains resilient at 57.9. Retail sales and house prices are also robust, and the latest CPI print for November, at 5.1%, justifies the interest rate hike by the Bank of England last month. The near-term path for the pound will be dictated by portfolio flows, and the ability of the BoE to deliver aggressive rate hikes already priced in the market. With the UK running a basic balance deficit, a dry up in foreign capital could hurt the pound. This will also be the case if the BoE does not deliver as many hikes as is discounted by markets. A rollover in energy costs (electricity prices are collapsing), and potentially, inflation could be catalyst. The post-Brexit environment also remains quite volatile.  This short-term hiccup underpins our long EUR/GBP call. Longer term, incoming data continues to strengthen the case for the BoE to tighten policy. At 4.2%, the unemployment rate is at NAIRU. Wages are also inflecting higher. As such, the pound should outperform over the longer-term, as the BoE continues to normalize policy. Chart 7ABritish Pound British Pound British Pound Chart 7BBritish Pound British Pound British Pound Australian Dollar: Top Pick For 2022 The Australian dollar was up 2.2% in December. Year-to-date, the Aussie is down 1.4%. Covid-19 continues to ravage Australia, prompting the government to adopt measures such as threatening to deport superstar athletes who refuse to be vaccinated. Combined with the zero-Covid policy in China (Australia’s biggest export partner), the economic outlook remains grim in the near term. In our view, such pessimism opens a window to be cautiously long AUD. First, speculators are very short the currency. Second, low interest rates are reintroducing froth in the property market that the authorities have fought hard to keep a lid on. Home prices in Sydney and Melbourne are rising close to 20% year-on-year. Most inflation gauges are also above the midpoint of the RBA’s target. Our playbook is as follows: China eases policy, allowing Australian exports to remain strong. This will allow the RBA to roll back its dovish rhetoric, relative to other central banks. This will also trigger a terms of trade recovery and interest rate support for the AUD. We are cautiously long AUD at 70 cents, and recommend investors stick with this position. Chart 8AAustralian Dollar Australian Dollar Australian Dollar Chart 8BAustralia Dollar Australia Dollar Australia Dollar New Zealand Dollar: Up Versus USD, But Lower On The Crosses The New Zealand dollar was up 0.25% in December, while down 1.1% year to date. The Covid-19 situation is much better in New Zealand, compared to its antipodean neighbor, but recent economic developments still have a stagflationary undertone. Headline CPI and house prices are rising at the fastest pace in decades, but wage growth remains very muted. With the RBNZ that now has house price considerations in its mandate, the risk is that further rate hikes hamper the recovery. Data wise, the trade balance continues to print a deficit as domestic demand in China remains tepid. New Zealand currently has the highest G10 10-year government bond yield, suggesting marginally tighter financial conditions. Meanwhile, portfolio flows into New Zealand have turned negative in recent quarters, especially driven by defensive equity outflows. Overall, the kiwi will benefit from a recovery in China but less so than the AUD, which is much shorted and has a better terms of trade picture. As such we are long AUD/NZD. Chart 9ANew Zealand Dollar New Zealand Dollar New Zealand Dollar Chart 9BNew Zealand Dollar New Zealand Dollar New Zealand Dollar Canadian Dollar: Next Up After AUD? The CAD was up 1.4% in December. Year to date, the loonie is down 0.7%. The key driver of the CAD in 2022 remains the outlook for monetary policy, and the path of energy prices. We are optimistic on both fronts. On monetary policy, CPI inflation remains above the central bank’s target, house prices are rising briskly, and the trade balance continues to improve meaningfully. This provides fertile ground for tighter monetary settings. Employment in Canada is already above pre-pandemic levels and has now settled towards trend growth of around 2%. This suggests a print of 30,000 - 40,000 jobs (27,500 in December), is in line with trend. The unemployment rate continues to drop, hitting 6.0%. Oil prices also remain well bid, as outages in Libya offset planned production increases by OPEC. Should Omicron also fall to the wayside, travel resumption will bring back a meaningful source of demand. Net purchases of Canadian securities continue to inflect higher, as the commodity sector benefits from a terms-of-trade boom. We are buyers of CAD over a 12–18-month horizon. Chart 10ACanadian Dollar Canadian Dollar Canadian Dollar Chart 10BCanadian Dollar Canadian Dollar Canadian Dollar Swiss Franc: Line Of Defense The Swiss franc was up 0.8% in December and has fallen by 0.9% year to date. The Swiss economy continues to fare well amidst surging Covid-19 infections. Meanwhile, as a defensive currency, the franc has benefitted from the rise in volatility, especially compared to other currencies like the New Zealand dollar over the course of 2021 (we are long CHF/NZD). Economic wise, the unemployment rate has dropped to 2.5%, inflation is rising briskly, and house prices remain very resilient. This is lessening the need for the central bank to maintain ultra-accommodative settings. It is also interesting that the Swiss franc is well shorted by speculators engaging in various carry trades. Our baseline is that the Swiss National Bank is likely to lag the rest of the G10 in lifting rates from -0.75%, currently the lowest benchmark interest rate in the world. That said, this is well baked in the consensus suggesting any risk-off event or pricing of less monetary accommodation in other markets will help the franc. One area of opportunity is being long EUR/CHF, where the market has priced a very dovish ECB, even relative to the SNB. We are long this cross (which could suffer in the short term) but should rise longer term.  Chart 11ASwiss Franc Swiss Franc Swiss Franc Chart 11BSwiss Franc Swiss Franc Swiss Franc Norwegian Krone: A Beta Play On A Lower Dollar The Norwegian krone was up 2.7% in December and is down 0.9% year to date. Norway was a developed market beacon of how to handle the pandemic until the more contagious Omicron variant started to ravage the economy. The latest data prints suggest core CPI is falling and house price appreciation is rolling over. Headline inflation remains strong, and the latest retail sales release shows 1% growth month on month for November suggesting some resilience amidst the pandemic. The Norges Bank has been the most orthodox in the G10, raising interest rates and promising to continue doing so in the coming quarters. Should Omicron prove transient and oil prices stay resilient, this will be a “carte blanche” for the Norges bank to keep normalizing policy.  Norway’s trade balance and terms of trade remain robust. Meanwhile, portfolio investment in some unloved sectors in Norway could provide underlying support for the NOK. We are buyers of the NOK on weakness. Chart 12ANorwegian Krone Norwegian Krone Norwegian Krone Chart 12BNorwegian Krone Norwegian Krone Norwegian Krone Swedish Krona: A Play On China The SEK was up 0.3% in December and is down 1% year to date. The performance of the Swedish economy continues to strengthen the case for the Riksbank to tighten monetary policy. In recent data, the trade balance remains in a surplus as of November, household lending is rising 6.6% year on year (November), retail sales remain robust, and PPI is inflecting higher. Manufacturing confidence also improved in December, along with improvement in labor market conditions.  The Riksbank will remain data dependent, but it has already ended QE. It remains one of the most dovish G10 central banks and is slated to keep its policy rate flat at 0% at least until 2024. This could change if inflationary pressures remain persistent. A bounce in Chinese demand could be the catalyst that triggers this change.  We have no open positions now in SEK, but will look to go short USD/SEK and EUR/SEK should more evidence of a Swedish recovery materialize. Chart 13ASwedish Krona Swedish Krona Swedish Krona Chart 13BSwedish Krona Swedish Krona Swedish Krona Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Forecast Summary

Highlights Indian stocks need more time to digest and consolidate the significant gains from earlier this year. However, the country’s medium and long-term growth outlook remains positive. Indian firms’ profit margins will likely settle at a higher level than usual. That will also put a floor on its equity multiples. With an imminent topline recovery, the main driver of Indian stocks next year will be profits, in contrast with multiple expansions during the last year and a half. India is beginning a cyclical expansion with a cheap rupee. Stay neutral Indian stocks in an EM equity basket for now. Investors should overweight India in an EM domestic bond portfolio. Feature Chart 1Indian Stocks Are Overbought Indian Stocks Are Overbought Indian Stocks Are Overbought We tactically downgraded Indian stocks from overweight to neutral in EM and emerging Asian equity portfolios in early October this year. This call has worked out well so far as India’s absolute and relative share prices seem to have peaked. The primary reason for our tactical “neutral” call on Indian equities was this market’s vertical rise earlier this year, both in absolute and relative terms. Similar spikes – in terms of magnitude and duration back in 2007 and in 2014 – were followed by a period of underperformance (Chart 1). Yet, we recommended downgrading to only a neutral allocation. The reason is that the country’s cyclical outlook remains constructive, and the profit expansion cycle has further to run. That forbade us from turning too bearish on this bourse. A neutral stance on India also makes sense for the next several months as this bourse digests and consolidates its previous gains. In this report, we detail the various nuances of our analysis. Meanwhile, the Indian currency is cheap versus the greenback and will likely be one of the best performing currencies in the EM world over the next year. A positive currency outlook also makes Indian government bonds attractive for foreign investors, as Indian bonds also offer a high yield amid a benign domestic inflation backdrop. Dedicated EM domestic bond portfolios should stay overweight India. Equity Multiple Compression Ahead? Chart 2India's Profit Margin Expansion Has Led To Its Equity Re-Rating India's Profit Margin Expansion Has Led To Its Equity Re-Rating India's Profit Margin Expansion Has Led To Its Equity Re-Rating An upshot to the steep equity rally earlier this year has been India’s stretched valuations. That made many investors question the sustainability of the outperformance. A pertinent question, therefore, is how overvalued have Indian stocks become? And how much multiple compression can investors expect in this bourse? Before we answer this question, it’s useful to understand what drove the cyclical re-rating of Indian markets in the first place. The solid black line in Chart 2 shows the gross profit margins of all Indian listed non-financial firms. They have risen substantially since spring 2020 to reach decade-high levels. Margin expansions of this magnitude are indicative of material efficiency gains; and are usually rewarded with an equity re-rating. This is indeed what happened since spring 2020: stock multiples rose following the expanding margins. The same can be said if we only consider the major non-financial corporations’ EBITDA margins (Chart 2, bottom panel). If one looks at the cyclically adjusted P/E ratio (CAPE) instead, we see a very similar thing: the CAPE ratio has also risen in line with rising profit margins (Chart 3). Chart 3Profit Margins Have A Bearing On Equity Valuations Profit Margins Have A Bearing On Equity Valuations Profit Margins Have A Bearing On Equity Valuations Charts 2 and 3 show that the positive correlations between profit margins and stock multiples held steady over past several cycles. Hence, it will be reasonable to expect that should Indian firms hold on to wide margins, they will not suffer a significant de-rating going forward. Can Margins Stay Wide? Chart 4Indian Firms' Borrowing Costs Will Likely Stay Low Indian Firms' Borrowing Costs Will Likely Stay Low Indian Firms' Borrowing Costs Will Likely Stay Low Before we delve into the question of whether margins can stay wide, we need to understand what caused such a margin expansion in the first place. That cause is cost cutting: wage bills have gone down as businesses slashed employees. Data from Oxford economics show that there had been 9% fewer workers in India as of September 2021 compared to March 2020, just before the pandemic. Interest expense has also gone down – both relative to sales and profits (Chart 4) – as interest rates were cut aggressively. In our view, the latest rollover in profit margins will likely be temporary and limited. It is probably due to hiring back of some employees. Beyond a near-term limited drop in margins, the more relevant question to ask is, can Indian corporations maintain high margins? Our bias is that, to a large extent, they can. The main reason is that firms’ costs are slated to stay under control: Chart 5Indian Companies Do Not Face Any Wage Pressures Indian Companies Do Not Face Any Wage Pressures Firms' Costs Will Likely Stay Low As Wage Pressures Are Muted... Indian Companies Do Not Face Any Wage Pressures Firms' Costs Will Likely Stay Low As Wage Pressures Are Muted... Wage expectations are low. Going forward, as millions of new job seekers and workers temporarily discouraged by the pandemic enter the job market, wages have little chance of much of an increase. The top panel of Chart 5 shows salary expectations from an industrial survey by RBI. Both the assessment for the current quarter and expectations for the next quarter have been a net negative for a while. Rural wages are also similarly timid (Chart 5, bottom panel). Notably, companies’ hiring back of employees is slow. It seems they prefer to substitute labor by capital by investing in new machines and equipment. This will boost productivity and cap wages. Overall, high productivity growth will keep companies’ profit margins wide and excess labor will suppress wages. Higher margins and low inflation are bullish for the stock market. Critically, headline inflation is within the central bank target bands, and our model shows that it will likely remain as such (Chart 6, top panel). Core inflation is also likely to stay flattish (Chart 6, bottom panel). This means the odds are that the central bank will not raise rates anytime soon. Flattish inflation and policy rates mean firms’ borrowing costs, in both nominal and real terms, are slated to stay approximately as low as they are now. Low real borrowing costs are usually a tailwind for stocks (Chart 7). Chart 6 Chart 7Low Borrowing Costs Are Bullish For Stocks Low Borrowing Costs Are Bullish For Stocks Low Borrowing Costs Are Bullish For Stocks     All put together, Indian companies will likely see their costs largely under control. That, in turn, should keep profit margins wider than usual. Wide profit margins should limit multiple compression. Can The Topline Rise Further? Wider margins will boost total profits if and once the topline (revenues) recovers. So, the next question is, how much topline recovery is in the cards? Chart 8Indian Economy Is In A Rapid Expansion Mode Indian Economy Is In A Rapid Expansion Mode Indian Economy Is In A Rapid Expansion Mode There are already signs that sales will likely accelerate in the months to come: PMI indexes for both the manufacturing and services sectors have recovered strongly since the Delta variant-induced lockdowns in spring. They are now hovering around a very high level of close to 60. This indicates that the economy is in a rapid expansion mode (Chart 8). The Industrial Outlook survey (conducted by the RBI) shows that the order books for the September quarter was already at a decade-high level. The expectation for the next few quarters is even more elevated – indicating strong momentum (Chart 9, top panel). In other surveys, such as the PMI and Business Expectation survey (from Dun & Bradstreet), we see similar strong order books (Chart 9, bottom panel). While orders are strong, inventory of finished goods is low. Not surprisingly, businesses are expecting very high-capacity utilization in the next few quarters (Chart 10, top two panels). Chart 9Firms' Order Books Are Quite Robust Firms' Order Books Are Quite Robust Firms' Order Books Are Quite Robust Chart 10Low Inventories Mean Stronger Economic Activity Ahead Low Inventories Mean Stronger Economic Activity Ahead Low Inventories Mean Stronger Economic Activity Ahead They are expecting to hire more people. Companies also believe consumer demand will revive which will enable wider profit margins. In sum, firms are optimistic about accelerating economic activity (Chart 10, bottom two panels). Chart 11A Positive Bank Credit Impulse Is Bullish For Industrial Activity A Positive Bank Credit Impulse Is Bullish For Industrial Activity A Positive Bank Credit Impulse Is Bullish For Industrial Activity This, in turn, is encouraging them to make capital investments. Finally, the commercial banks’ credit impulse has also turned positive. Rising bank credit impulses usually signal stronger industrial production (Chart 11). To summarize, chances are that firms’ top lines are set to rise materially. Coupled with high margins, this will translate into strong profit acceleration in the next several quarters. Put differently, over the past year and a half, Indian firms witnessed rising margins. Going forward, they will likely see rising profits. Higher profits, in turn, will propel Indian share prices cyclically beyond any short-term consolidation. A Sustainable Expansion? In a notable departure from most developed countries, India’s recovery from the pandemic-induced recession has been more capex-led, rather than consumption-led (Chart 12). One reason for that is the Indian government did not supplement the lost household incomes during the lockdowns nearly as much as developed countries did. That, in turn, kept household demand low. And it also contributed to keeping inflation in check – even though India’s supply side was also paralyzed due to strict lockdown measures. On the other hand, firms’ profits soared owing to rigorous cost-cutting. Higher profits in turn have encouraged firms to expand their production capacity. Companies are ramping up capital spending as they expect sales to accelerate in the future (Chart 13). Chart 12A Capex-Led Recovery Will Prolong The Economic Expansion A Capex-Led Recovery Will Prolong The Economic Expansion A Capex-Led Recovery Will Prolong The Economic Expansion Chart 13Strong Profits Are Encouraging Firms To Ramp Up Capital Spending Strong Profits Are Encouraging Firms To Ramp Up Capital Spending Strong Profits Are Encouraging Firms To Ramp Up Capital Spending Notably, the combination of curtailed household demand and robust capital expenditure has set India’s inflation dynamics apart from many other countries in Latin America and EMEA. While India’s inflation remains largely contained, countries in those regions are witnessing accelerating inflation.  Also, over a cyclical horizon, a capex-led expansion is very crucial for India as this will determine the duration and magnitude of the cycle. Strong investment expenditures do not only boost firms’ competitiveness and profitability, but they also help keep inflationary pressures at bay. Lower inflation for a longer period means the central bank need not raise rates as soon and/or as much as otherwise would be the case. That in turn allows the economic and profit expansion to continue for longer. An extended period of expansion is also positive for multiples as investors extrapolate profit growth over many years ahead. India’s current dynamics are a case in point. Given the country is facing no imminent interest rate hikes, stock multiples can stay higher for longer. This is because multiple de-rating commences only after meaningful rate hikes have already been accorded (Chart 14). Since that is quite far off, valuations are not facing any immediate and considerable headwinds. Finally, India is beginning the new cycle with a rather inexpensive currency. Chart 15 shows that the rupee is currently cheaper by about 10% than what would be its “fair value” vis-à-vis the US dollar. The fair value has been derived from a regression analysis of the exchange rate on the relative manufacturing producer prices of India and the US. Chart 14It Takes Several Rate Hikes Before It Hurts Stock Multiples It Takes Several Rate Hikes Before It Hurts Stock Multiples It Takes Several Rate Hikes Before It Hurts Stock Multiples Chart 15India's Cyclical Expansion Has A Tailwind From Cheap Currency India's Cyclical Expansion Has A Tailwind From Cheap Currency India's Cyclical Expansion Has A Tailwind From Cheap Currency   Investment Conclusions Equities: Given the vertical rise earlier this year, Indian stocks would likely need a few more months to digest previous gains and consolidate. Hence, even though the country’s cyclical outlook remains constructive, we recommend that dedicated EM and Asian equity portfolios stay neutral on this market for now. Absolute return investors should stay on the sidelines and wait for a better entry point. Currency and Bonds: The rupee is cheap and could be one of the best performers within the EM world over a cyclical horizon. Indian government bonds also offer a good value with a rather high yield (6.4% for 10-year securities) amid a benign inflation outlook. A positive rupee outlook also makes Indian bonds more appealing for foreign investors. Investors should stay overweight India in an EM local currency bond portfolio. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes

Highlights Financial markets in both mainstream EM and China are undergoing an adjustment that is not yet complete. EM equity and currency valuations are neutral. When valuations are neutral, the profit and liquidity cycles become the key drivers of share prices. Both these factors are currently headwinds to equity prices. Our investment strategy is to remain defensive going into the new year. Yet, the longer-term outlook is brighter. We see with high odds that the first half of the year will present an opportunity to turn positive on EM assets in absolute terms, and upgrade EM versus DM within global equity and fixed-income portfolios. Our checklist of fundamental factors that will cause us to turn bullish on EM and China include: (1) significant stimulus in China leading to a strong recovery in its credit impulse; (2) a rollover in Latin America’s core inflation that will open the door for monetary policy easing in these economies; and (3) the Fed abandoning its plans to hike rates, creating conditions for durable US dollar weakness. Feature Introduction: Beyond Omicron There is low visibility regarding the Omicron variant of the COVID-19 virus’s impact on societies and economies. We do not pretend to be experts in virology and on pandemics. So, in this 2022 outlook, we will focus on the macro fundamentals that go beyond Omicron. If the latter proves to be very disruptive for many economies, EM risk assets will sell off materially in the coming weeks. If Omicron proves to be a non-issue, macro fundamentals will prevail. In this case (and if our analysis is correct) EM risk assets will still fare poorly, at least in the early months of 2022. Chart 1The EM Selloff Has Been Occurring Since February 2021 The EM Selloff Has Been Occurring Since February 2021 The EM Selloff Has Been Occurring Since February 2021 Notably, the cross rate between the Swedish krona and Swiss franc correlates well with EM share prices and both had already been falling well before Omicron arrived (Chart 1). Overall, our investment strategy is to remain defensive going into the new year. Nevertheless, odds are significant that in H1 2022 there will be a buying opportunity in EM assets in absolute terms, and a better entry point to upgrade EM relative to DM within global equity and fixed-income portfolios. China’s Business Cycle And Macro Policy Will China ease policy substantially? It depends on how bad the economy, financial markets and business/consumer sentiment get. Beijing has already initiated piecemeal monetary and fiscal easing. However, if the growth slowdown is gradual and orderly, and financial markets do not panic, then policy easing will be measured. On the contrary, if growth tumbles sharply, business and consumer confidence deteriorate markedly and onshore share prices sell off hard, then policymakers will accelerate the stimulus. In a nutshell, substantial policy easing is not likely unless Chinese onshore stocks experience a meaningful deterioration. In the meantime, the Mainland economy will continue disappointing, and the path of least resistance for China-related plays is down: The annual change in excess reserves – that PBOC injects into the banking system – leads the credit impulse by six months (Chart 2, top panel). The former has stabilized but has not yet turned up. Hence, in the near term, the credit impulse will be stabilizing at very low levels but will not revive materially until spring 2022. This entails more growth disappointments in China’s old economy (Chart 2, bottom panel). In turn, the average of the manufacturing PMI’s new orders and backlog of orders series heralds more downside in EM non-TMT share prices (Chart 3). Chart 2China: An Economic Revival Is Not Imminent China: An Economic Revival Is Not Imminent China: An Economic Revival Is Not Imminent Chart 3EM Non-TMT Stocks Remain At Risk EM Non-TMT Stocks Remain At Risk EM Non-TMT Stocks Remain At Risk Property construction will not recover quickly. Marginal easing of real estate regulations and restrictions will not be sufficient to revive animal spirits among property developers and buyers. As we argued in a recent special report on the property market, real estate in China benefited from the biggest carry trade in the world over the past decade. With borrowing costs below 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 forms of land, incomplete construction, and completed but unsold properties. Chart 4The Carry Trade In China's Real Estate The Carry Trade In China's Real Estate The Carry Trade In China's Real Estate The top panel of Chart 4 illustrates that developers have been starting many more projects than they have been completing. As a result, their unfinished construction has ballooned (Chart 4, bottom panel). Such a business model was profitable since developers’ borrowing costs were below the pace of real estate asset price appreciation. This dynamic will reverse going forward: real estate asset price appreciation will be below developers’ borrowing costs. Thus, property developers have every incentive to shed their assets as quickly as possible. This will discourage new land investment and new construction. In brief, odds are rising that the property market downtrend will be an extended one. In 2015, when property inventories swelled (Chart 4, bottom panel), it took outright monetization of residential properties by the PBOC through the PSL program1 to revive real estate demand and construction. Currently, anything short of aggressive monetization or a very large policy boost will be insufficient to reignite property market sentiment. Thus, the real estate market will continue to struggle. Chart 5 illustrates that real estate developer financing has dried up, heralding a significant contraction in floor space completion, i.e., construction activity. This will weigh on industrial commodities (Chart 5, bottom panel). Even if the government approves a larger special bond quota for local governments, traditional infrastructure spending is unlikely to accelerate meaningfully (Chart 6). The basis is that local governments will continue facing financing constraints from an ongoing slump in their land sales. The RMB 3.65 trillion special bond issuance quota in 2021 accounted for only 18% of local government on- and off-budget revenues. Meanwhile, land sales by local governments account for 40% of their on- and off-budget revenues. As the property market travails continue, local governments will not be able to materially increase traditional infrastructure spending.  Chart 5Less Funding = Less Completions = Less Commodity Demand Less Funding = Less Completions = Less Commodity Demand Less Funding = Less Completions = Less Commodity Demand Chart 6China: Traditional Infrastructure Has Been Weak China: Traditional Infrastructure Has Been Weak China: Traditional Infrastructure Has Been Weak In sum, the Chinese economy has developed formidable downward momentum that will not be easy to reverse. That said, authorities will likely begin injecting more stimulus in 2022 to secure a stable economy and financial markets in the second half of 2022, ahead of the important Party Congress. Bottom Line: The slowdown in the Chinese old economy will continue for now with negative ramifications for China-related financial markets. A buying opportunity for China plays leveraged to its old economy is likely sometime in 2022. Chinese Internet Stocks Chart 7Chinese Internet Stocks Are Not Cheap Chinese Internet Stocks Are Not Cheap Chinese Internet Stocks Are Not Cheap The outlook for Chinese TMT stocks remains uninspiring. We maintain that the regulatory changes affecting Chinese internet stocks are structural rather than cyclical in nature. There could be periods when the pace of regulatory clampdown eases, but these regulations will not be rolled back in any meaningful way. While Chinese platform companies’ equity valuations have already de-rated, these stocks are not cheap: their trailing and forward P/E ratios stand at 35 and 30, respectively (Chart 7). Their multiples will compress further for the following reasons: Their business models have to change because of regulatory requirements. Higher uncertainty about their future business models currently entails a higher equity risk premium. Authorities will cap these companies’ profitability like regulators do with monopolies and oligopolies, which heralds a lower return on equity. In addition, in line with the common prosperity policy, these companies will perform social duties – redistributing profits from shareholders to the society. All these will lower their profitability, warranting permanently lower multiples than those in the past 10 years. Beijing’s involvement in their management and the prioritization of national and geopolitical objectives over shareholder interests will lead foreign investors to dis-invest from these companies. Some large companies face non-trivial risks of delisting from the US. Last week, Beijing reportedly asked Didi to delist from the US due to concerns over its data security. For very different reasons, US and Chinese authorities do not want Chinese companies to be listed in the US. And when Chinese and US authorities do not want to see some of these stocks listed in the US, they will not be. Odds are rising that a few of them might be delisted in the coming years. In such a scenario, US institutional investors will offload their holdings of these companies. Chart 8China: Online Retail Sales Have Slowed Down China: Online Retail Sales Have Slowed Down China: Online Retail Sales Have Slowed Down In addition to the risk to multiples, these internet companies’ profits are also under threat. Chart 8 shows that online retail sales of goods and services have been lackluster compared to their torrid pace in the past 10 years. Bottom Line: The path of least resistance for Chinese internet/platform share prices remains down. Mainstream EM Economies In the majority of EM economies ex-China, Korea and Taiwan (herein referred to as mainstream EM), domestic demand will remain in the doldrums in H1 2022: Monetary policy has tightened in Latin America and Russia while real interest rates are elevated/restrictive in the ASEAN region. In countries where central banks have been hiking rates, domestic demand is bound to decelerate (Chart 9, top panel). In fact, domestic demand remains below pre-pandemic levels in many mainstream EMs (Chart 9, bottom panel). Rate hikes and/or high borrowing costs in real terms will continue to weigh on money and credit growth. The annual growth rates of broad money and bank loans have already reached record lows in both nominal and real terms (Chart 10). These are equity market-weighted aggregates for EM ex-China, Korea and Taiwan. Chart 9Mainstream EM: Domestic Demand Is At Risk Of A Relapse Mainstream EM: Domestic Demand Is At Risk Of A Relapse Mainstream EM: Domestic Demand Is At Risk Of A Relapse Chart 10Mainstream EM: Tepid Money And Credit Growth Mainstream EM: Tepid Money And Credit Growth Mainstream EM: Tepid Money And Credit Growth Chart 11Mainstream EM: No Fiscal Reprieve In 2022 Mainstream EM: No Fiscal Reprieve In 2022 Mainstream EM: No Fiscal Reprieve In 2022 For the same universe, the fiscal thrust in 2022 will be around -1% of GDP (Chart 11). Chart 12 illustrates the 2022 fiscal thrust – defined as the yearly change in the cyclically adjusted budget deficit – for individual countries. Only Turkey is projected to have a small positive fiscal thrust next year. Chart 12 The slowdown in China’s old economy will weigh on Asian economies and commodity producers elsewhere. Table 1 demonstrates that China is the top destination for Asian and commodity producing economies’ exports. Finally, political uncertainty and volatility will remain high in Latin America while geopolitical tensions will linger and escalate from time to time around Russia and Taiwan. We do not think political and geopolitical risks are fully reflected in these financial markets. This leaves these bourses vulnerable to these risks. Bottom Line: Economic growth in mainstream EM economies will disappoint, at least in H1 2022. What We Are Looking To Turn Bullish On EM Assets? Equities: A combination of the following will make us consider issuing a buy recommendation on EM equities: Significant stimulus in China leading to a strong recovery in its credit impulse (shown in Chart 2 above). A rollover in Latin America’s core inflation that will open the door for monetary policy easing in these economies. Regarding indicators, we would need to see all three of the following: EM M1 growth accelerates (Chart 13) Analysts’ net EPS expectations drop to their previous lows (Chart 14) Investor sentiment on EM equities declines to its previous lows (Chart 15). EM equity valuations are neutral in absolute terms. When valuations are neutral, share prices could rise or fall. In these cases, the profit cycle is the key driver of share prices. EM equity market cap-weighted narrow money (M1) growth suggests that EM EPS growth will decelerate well into 2022 (Chart 13 above). Such a profit slump is not yet priced in according to Chart 14. Chart 13An EM Profit Slump Is Imminent An EM Profit Slump Is Imminent An EM Profit Slump Is Imminent Chart 14Analysts Are Not Pricing In An EM Profit Slump Analysts Are Not Pricing In An EM Profit Slump Analysts Are Not Pricing In An EM Profit Slump Chart 15Investor Sentiment On EM Stocks Is Not Downbeat Investor Sentiment On EM Stocks Is Not Downbeat Investor Sentiment On EM Stocks Is Not Downbeat Chart 16Mainstream EM Currencies: Spot And Total Return Indexes Mainstream EM Currencies: Spot And Total Return Indexes Mainstream EM Currencies: Spot And Total Return Indexes Exchange Rates: The mainstream EM equity market cap-weighted currency spot rate versus the US dollar is not far from its 2020 spring lows. On a total return basis – when carry is taken into account – mainstream EM currencies are still above their March 2020 lows (Chart 16). Chart 17Mainstream EM: Real Effective Exchange Rates Mainstream EM: Real Effective Exchange Rates Mainstream EM: Real Effective Exchange Rates Critically, EM currencies are not particularly cheap (Chart 17). Given the lingering headwinds, they are likely to depreciate further. The mainstream EM aggregate real effective exchange rate will likely drop to one or two standard deviations below its mean before these currencies find a bottom (Chart 17). Barring a scenario in which the Omicron variant becomes a major drag on the US economy, the Federal Reserve will maintain its recent hawkish rhetoric due to rising core US inflation. This will support the US dollar and weigh on EM currencies. If Omicron produces a major selloff in financial markets, EM currencies will depreciate. In a nutshell, weak domestic demand and return on capital, political volatility, a slowdown in China and potentially lower commodity prices will all continue depressing EM currencies in the early months of 2022. In the following section about local rates, we list signposts that will make us turn positive on EM currencies Local Rates: EM local rates have gone up a great deal and they offer good value. However, as long as EM currencies do not find a floor, interest rates in high-yield local bond markets will not decline. Critically, US dollar returns on EM local currency bonds are primarily determined by exchange rates. Hence, a buying opportunity for international investors in EM high-yield local bonds will coincide with a bottom in their currencies. We recommend turning positive on mainstream EM currencies versus the US dollar if two out of these three conditions are met: The Fed abandons its intention to hike rates. Significant stimulus in China leading to a strong recovery in its credit impulse Mainstream EM’s aggregate real effective exchange rate drops more than one standard deviation below its mean (Chart 17). Chart 18EM Credit Spreads Are Driven By The EM Business Cycle And Currencies EM Credit Spreads Are Driven By The EM Business Cycle And Currencies EM Credit Spreads Are Driven By The EM Business Cycle And Currencies Credit Markets: As we discussed in a report published earlier this year titled A Primer on EM USD Bonds, the two key drivers of EM sovereign and corporate credit spreads are economic growth and the exchange rate (Chart 18). A positive turn on the EM/China business cycles and their currencies will make us immediately bullish on EM sovereign credit. As for high-yield Chinese USD property developers’ bonds, they are not a buy given their extremely high indebtedness and the dismal outlook for real estate. Investment Strategy Odds are that there will be a buying opportunity in EM equities, fixed income and currencies in 2022. The checklists we highlighted above outline what we will be monitoring to make us turn positive on EM equities, local rates, exchange rates and credit. Our current investment stance is as follows: There is likely to be more downside in EM equities in absolute terms. They will also continue underperforming their DM peers. We downgraded EM equities from neutral to underweight on March 25, 2021 and this strategy remains intact. Within the EM benchmark, our overweights are Korea, Singapore, China (favoring A shares over investable stocks), Vietnam, Russia, central Europe and Mexico. Our equity underweights are Brazil, Chile, Peru, Colombia, South Africa, Turkey and Indonesia. We recommend a neutral allocation to all other bourses in mainstream EM. A word on India, Korea and Mexico is warranted. We will publish a report on India next week. Concerning our overweight in the Korean bourse, lower DRAM prices and China’s slowdown have weighed on its performance in 2021 (Chart 19). However, weakness in semiconductor prices will prove to be short lived as the semiconductor industry is in a structural upswing. Besides, Korea and Mexico are two countries in the EM universe that will benefit from the US industrial boom – one of our major multi-year themes. Chart 20 shows that Korea’s relative equity performance versus the overall EM benchmark closely tracks global industrials relative share prices versus global non-TMT stocks. Chart 19A Soft Spot In The DRAM Industry A Soft Spot In The DRAM Industry A Soft Spot In The DRAM Industry Chart 20Overweight The KOSPI Within The EM Equity Space Overweight The KOSPI Within The EM Equity Space Overweight The KOSPI Within The EM Equity Space The path of least resistance for EM currencies versus the US dollar is presently down. We continue to recommend shorting the following basket of EM currencies versus the US dollar: BRL, CLP, COP, PEN, ZAR, KRW, THB and PHP. Last week, we recommended adding the Indonesian rupiah to this list and today we are booking profits on the short position in TRY. The currencies that we currently favor are CNY, INR, MYR, SGD, TWD, RUB, CZK and MXN. In local rates, we have been betting on the yield curve flattening in Mexico and Russia, have been recommending receiving 10-year swap rates in China and Malaysia as well as paying 10-year rates in the Czech Republic. In the EM credit space, we continue to recommend underweighting EM versus US corporate credit, quality adjusted. As with equities, we downgraded this allocation from neutral to underweight on March 25, 2021. Within the EM credit space, we favor sovereign versus corporate credit, quality adjusted. For EM sovereign credit and domestic bond portfolios, our recommended allocations across various countries are shown in the tables enclosed below. Finally, today we are closing our volatility trades: long EM equity volatility and EM currency volatility. Both positions were initiated on February 4, 2021 and have been profitable.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Footnotes 1Pledged Supplementary Lending was in effect in 2014-2018: The PBOC lent at very low interest rates to the three policy banks who in turn re-lent to local governments and regional property developers (mainly in tier-2 and smaller cities). These entities then bought slums from their owners, putting cash in their hands to purchase new and better properties. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Dear Client, There will be no report next week as we will be working on our Quarterly Strategy Outlook, which will be published the following week. In the meantime, please keep an eye out for BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic and financial market outlook for the year ahead. Best regards, Peter Berezin Chief Global Strategist Highlights Inflation in the US, and to a lesser extent, in other major economies, will follow a “two steps up, one step down” trajectory of higher highs and higher lows.  While inflation will fall in the first half of next year as goods prices stabilize, an overheated labor market will cause inflation to re-accelerate into 2023. The Fed will be slow to respond to high inflation, implying that monetary policy will remain accommodative next year. This should help propel stocks to new highs. Chinese stimulus will offset much of the drag from a weaker domestic property market. The dollar is a high momentum currency, so we wouldn’t bet against the greenback in the near term. Nevertheless, with “long dollar” now a consensus trade, we would position for a weaker dollar over a 12-month horizon. A depreciating dollar next year should help non-US equities, especially beleaguered emerging market stocks. The dollar will strengthen anew in 2023, as the Fed is forced to turn more hawkish, and global equities begin to buckle. From Ice To Fire In past reports, we have contended that inflation in the US, and to a lesser extent, in other major economies, would follow a “two steps up, one step down” trajectory of higher highs and higher lows.  We are currently near the top of those two steps. The pandemic ushered in a major re-allocation of spending from services to goods (Chart 1). US inflation should dip over the next 6-to-9 months as the demand for goods decelerates and supply-chain disruptions abate. Chart 1The Pandemic Caused A Major Shift In Spending From Services To Goods The Pandemic Caused A Major Shift In Spending From Services To Goods The Pandemic Caused A Major Shift In Spending From Services To Goods CHart 2Those With Low Paid Jobs Are Enjoying Stronger Wage Gains Those With Low Paid Jobs Are Enjoying Stronger Wage Gains Those With Low Paid Jobs Are Enjoying Stronger Wage Gains The respite from inflation will not last long, however. The labor market is heating up. So far, most of the wage growth has been at the bottom end of the income distribution (Chart 2). Wage growth will broaden over the course of 2022, setting the scene for a price-wage spiral in 2023. We doubt that either fiscal or monetary policy will tighten fast enough to prevent such a spiral from emerging. As a result, US inflation will surprise meaningfully on the upside. Our view has no shortage of detractors. In this week’s report, we address the main counterarguments in a Q&A format:   Q: What makes you think that service spending will rebound fast enough to offset the drag from weaker goods consumption? Chart 3Inventory Restocking Could Be A Source Of Growth Next Year Inventory Restocking Could Be A Source Of Growth Next Year Inventory Restocking Could Be A Source Of Growth Next Year A: There is still a lot of pent-up demand for goods. Try calling any auto dealership. You will hear the same thing: “We have nothing in stock now, but if you put in an order today, you might get a vehicle in 3-to-6 months.” Thus, durable goods sales are unlikely to weaken quickly. And with inventories near record low levels, firms will need to produce more than they sell (Chart 3). Inventory restocking will support GDP growth. As for services, real spending in the US grew by 7.9% in the third quarter, an impressive feat considering that this coincided with the Delta-variant wave. Service growth will stay strong in the fourth quarter. The ISM non-manufacturing index jumped to a record high of 66.7 in October, up from 61.9 in September. The Atlanta Fed’s GDPNow model is tracking real PCE growth of 9.2% in Q4. Goldman’s Current Activity Indicator has hooked up (Chart 4). Chart 4 Q: Aren’t you worried that spending on services might stall next year? A: Not really. Chart 5 shows the percentage change in real spending for various types of services from January 2020 to September 2021, the last month of available data. Chart 5 Chart 6 The greatest decline in spending occurred in those sectors that were most directly affected by the pandemic. Notably, spending on movie theaters, amusement parks, and live entertainment in September was still down 46% on a seasonally-adjusted basis compared to last January. Hotel spending was down 22%. Spending on public transport was down 26%. Only spending on restaurants was back to normal. The number of Covid cases has once again started to trend higher in the US, so that path to normalization will take time (Chart 6). Nevertheless, with vaccination rates still edging up and new antiviral drugs set to hit the market, it is reasonable to assume that many of the hardest-hit service categories will recover next year.   Q: What about medical services? Some have speculated that the shift to telemedicine will require much lower spending down the road. A: It is true that spending on outpatient services in September was $43 billon below pre-pandemic levels. However, over two-fifths of that shortfall was in dental services, which are not amenable to telemedicine. Spending on dental services was down 16% from its January 2020 levels, compared to 6% for physician services. A more plausible theory is that many people are still worried about venturing to the doctor’s or dentist’s office. In addition, a lot of elective procedures were canceled or postponed due to the pandemic. Clearing that backlog will lift medical spending next year. Chart 7The Flow Of Savings Has Fallen Back To Pre-Pandemic Levels But The Stock Of Accumulated Savings Remains High The Flow Of Savings Has Fallen Back To Pre-Pandemic Levels But The Stock Of Accumulated Savings Remains High The Flow Of Savings Has Fallen Back To Pre-Pandemic Levels But The Stock Of Accumulated Savings Remains High In any case, the cost of a telemedicine appointment is typically no different from an in-person one. And, to the extent that telemedicine does become more widespread, this could encourage more people to seek medical assistance. Lastly, even if spending on certain services does not fully recover after the pandemic, this will probably simply result in a permanent increase in spending on goods. The only way that overall consumer spending will falter is if the savings rate rises, which seems unlikely to us. Q: Why do you say that? The savings rate has been very high throughout the pandemic. A: The savings rate did spike during the pandemic, but that was mainly because fewer services were available, and because households were getting transfer payments from the government. Now that these payments have ended, the savings rate has dropped to 7.5%, roughly where it was prior to the pandemic. There is good reason to think the savings rate will keep falling next year. Households are sitting on $2.3 trillion in excess savings, most of which reside in bank deposits (Chart 7). As they run down those savings, consumption will rise in relation to income. The household deleveraging cycle is over. After initially plunging during the pandemic, credit card balances are rising (Chart 8). Banks are eager to make consumer loans (Chart 9). Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 10). As we discussed three weeks ago, the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Chart 8APost-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Post-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Post-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Chart 8BPost-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Post-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Post-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare   Chart 9Banks Are Easing Credit Standards For Consumer Loans Banks Are Easing Credit Standards For Consumer Loans Banks Are Easing Credit Standards For Consumer Loans Chart 10A Record Rise In Household Net Worth A Record Rise In Household Net Worth A Record Rise In Household Net Worth   Q: Household wealth could fall as the Fed starts tapering and eventually raising rates. Wouldn’t that cool the economy? A: The taper is a fait accompli, and markets are already pricing in rate hikes starting in the second half of next year. If the Fed were to signal its intention to raise rates more quickly than what has been priced in, then home prices and stocks could certainly weaken. We do not think the Fed will pivot in a more hawkish direction before the end of next year, however. The Fed’s estimate of the neutral rate is only 2.5%, a big step down from its estimate of 4.25% in 2012. The market’s view is broadly in line with the Fed’s (Chart 11).  Despite the upward move in realized inflation, long-term inflation expectations remain in check – expected inflation 5-to-10 years out in the University of Michigan survey has increased from 2.3% in late 2019 to 2.9%, bringing it back to where it was between 2010 and 2015. The 5-year/ 5-year forward TIPS breakeven inflation rate is near the bottom end of the Fed’s comfort zone (Chart 12). Chart 11The Fed And Investors Still Believe In Secular Stagnation The Fed And Investors Still Believe In Secular Stagnation The Fed And Investors Still Believe In Secular Stagnation Chart 12Long-Term Inflation Expectations Are Not Yet A Concern For The Fed Long-Term Inflation Expectations Are Not Yet A Concern For The Fed Long-Term Inflation Expectations Are Not Yet A Concern For The Fed   Q: What about fiscal policy? Isn’t it set to tighten sharply next year? A: The US budget deficit will decline next year. However, this will happen against the backdrop of strong private demand growth. Moreover, budget deficits are likely to remain elevated in the post-pandemic period. This week, President Biden signed a $1.2 trillion infrastructure bill into law, containing $550 billion in new spending. BCA’s geopolitical strategists expect Congress to pass a $1.5-to-$2 trillion social spending bill using the reconciliation process. All in all, the IMF foresees the US cyclically-adjusted primary budget deficit averaging 4.9% of GDP between 2022 and 2026, compared to 2.0% of GDP between 2014 and 2019 (Chart 13). Chart 13 Chart 14While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend   It should also be noted that government spending on goods and services has been quite weak over the past two years (Chart 14). The budget deficit surged because transfer payments exploded. Unlike direct government spending, which is set to accelerate over the next few years, households saved a large share of transfer payments. Thus, the fiscal multiplier will increase next year, even as the budget deficit shrinks.   Q: We have focused a lot on demand, but what about supply? There are over 4 million fewer Americans employed today than before the pandemic and yet the job openings rate is near a record high. Chart 15Despite A Notable Decline, There Are Still A Lot Of People Avoiding Work Because Of Worries About Contracting Or Transmitting Covid Despite A Notable Decline, There Are Still A Lot Of People Avoiding Work Because Of Worries About Contracting Or Transmitting Covid Despite A Notable Decline, There Are Still A Lot Of People Avoiding Work Because Of Worries About Contracting Or Transmitting Covid A: Some people who left the workforce will regain employment. According to the Census Bureau’s Household Pulse Survey, there are still 2.5 million people not working because they are afraid of catching or transmitting the virus (Chart 15). That said, some workers may remain sidelined for a while longer. The very same survey also revealed that about 8 million of the 100 million workers currently subject to vaccine mandates say that “they will definitely not get the vaccine.” In addition, about 3.6 million workers have retired since the start of the pandemic, about 1.2 million more than one would have expected based on pre-existing demographic trends. Most of these retirees will not work again. Lifestyle choices may keep others from seeking employment. Female labor participation has declined much more during the pandemic and than it did during the Great Recession (Chart 16). While many mothers will re-enter the labor force now that schools have reopened, some may simply choose to stay at home. Chart 16 The bottom line is that the pandemic has reduced labor supply at a time when labor demand remains very strong. This is likely to exacerbate the labor shortage.   Q: Any chance that higher productivity will offset some of the damage to the supply side of the economy from decreased labor participation? A: US labor productivity did increase sharply during the initial stages of the pandemic. However, that appears to have been largely driven by composition effects in which low-skilled, poorly-paid service workers lost their jobs. As these low-skilled workers have returned to the labor force, productivity growth has dropped. The absolute level of productivity declined by 5.0% at an annualized rate in the third quarter, leading to an 8.3% increase in labor costs. It is telling that productivity growth has been extremely weak outside the US (Chart 17). This gives weight to the view that the pandemic-induced changes in business practices have not contributed to higher productivity, at least so far. It is also noteworthy that a recent study of 10,000 skilled professionals at a major IT company revealed that work-from-home policies decreased productivity by 8%-to-19%, mainly because people ended up working longer. Increased investment spending should eventually boost productivity. Core capital goods orders, which lead corporate capex, are up 18% since the start of the pandemic (Chart 18). However, the near-term impact of increased investment spending will be to boost aggregate demand, stoking inflation in the process. Chart 17 Chart 18US Capex Should Pick Up US Capex Should Pick Up US Capex Should Pick Up   Q: We have spoken a lot about the US, but the world’s second biggest economy, China, is facing a massive deflationary shock from the implosion of its real estate market. Could that deflationary impulse potentially cancel out the inflationary impulse from an overheated US economy? A: You are quite correct that inflation has risen the most in the US. While inflation has picked up in Europe, this mainly reflects base effects (Chart 19). Inflation in China has fallen since the start of the pandemic despite booming exports. There are striking demographic parallels between China today and Japan in the early 1990s. The bursting of Japan’s property bubble corresponded with a peak in the country’s working-age population (Chart 20). China’s working-age population has also peaked and is set to decline by more than 40% over the remainder of the century. Chart 19The US Stands Out As The Inflation Leader The US Stands Out As The Inflation Leader The US Stands Out As The Inflation Leader Chart 20Demographic Parallels Between China And Japan Demographic Parallels Between China And Japan Demographic Parallels Between China And Japan That said, there are important differences between the two nations. In 1990, Japan was a rich economy; output-per-hour was nearly 70% of US levels. China is still a middle-income economy; output-per-hour is only 20% of US levels (Chart 21). China has the ability to outgrow some of its problems in a way that Japan did not. In addition, Chinese policymakers have learned from some of Japan’s mistakes. They have been trying to curb the economy’s dependence on property development; real estate development investment has fallen from 12% of GDP in 2014 to less than 10% of GDP (Chart 22). China is still building too many new homes, but unlike Japan in the 1990s, the government is likely to pursue stimulus measures to compensate for a shrinking property sector. This should keep the economy from entering a deflationary slump. Chart 21 Chart 22Real Estate Investment Has Peaked In China Real Estate Investment Has Peaked In China Real Estate Investment Has Peaked In China   Q: Let’s bring this back to markets. What is the main investment takeaway from your view? A: The main takeaway is that investors should remain bullish on stocks and other risk assets for the next 12 months but be prepared to turn more cautious in 2023. The neutral rate of interest in the US is higher than generally assumed. This means that monetary policy is currently more accommodative than widely believed, which is good for stocks. Unfortunately, it also means that a policy error is likely: The Fed will keep rates too low for too long, causing the economy to overheat. Chart 23Bank Stocks Tend To Outperform When Yields Rise Bank Stocks Tend To Outperform When Yields Rise Bank Stocks Tend To Outperform When Yields Rise This overheating will not be evident over the next six months. As we noted at the outset of this report, the US economy is currently at the top of the proverbial two steps in our projected “two steps up, one step down” trajectory for inflation. The cresting in durable goods inflation will provide a temporary respite from inflationary worries, even as the underlying long-term driver of higher inflation – an increasingly tight labor market – gains traction. Strong consumer demand and persistent labor shortages will incentivize companies to invest in new capacity and automate production. This will benefit industrial stocks and select tech names. Rising bond yields will also boost bank shares (Chart 23). A country’s current account balance is simply the difference between what it saves and what it invests. With savings on the downswing and investment on the upswing, the US will find it increasingly difficult to finance its burgeoning trade deficit. The US dollar is a high momentum currency, so we wouldn’t necessarily bet against the greenback in the near term (Chart 24). Nevertheless, with “long dollar” now a consensus trade, we would position for a weaker dollar over a 12-month horizon (Chart 25). Chart 24 Chart 25Long Dollar Is A Crowded Trade Long Dollar Is A Crowded Trade Long Dollar Is A Crowded Trade   Chart 26A Depreciating Dollar Next Year Should Help Non-US Equities A Depreciating Dollar Next Year Should Help Non-US Equities A Depreciating Dollar Next Year Should Help Non-US Equities A depreciating dollar next year should help non-US equities, especially beleaguered emerging markets (Chart 26). The dollar will strengthen anew in 2023, as the Fed is forced to turn more hawkish, and global equities begin to buckle.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image