Manufacturing

Highlights Advances in tennis, swimming and the high jump came from challenging the ‘best practices’, and finding better ways of doing these things. The pandemic has challenged the best practices on how we should work, do business, and shop, catalysing better ways of doing these things. The productivity boom could be a super-boom because the current disruption is not in just one sector but across the entire economy. A productivity super-boom means that the economy will take longer to reabsorb the unemployed, and that structural inflation will stay depressed. This means that interest rate hikes will be much later and much shallower than the market is pricing. For equity investors, a productivity super-boom plus the market’s overestimation of Fed rate hikes structurally favours growth sectors versus value sectors. Thereby, it also structurally favours the S&P500 versus the Eurostoxx50. Fractal analysis: stocks versus bonds remains fragile, and the rally in tin is very fragile. Feature Chart of the WeekThe Pandemic Has Catalysed A Productivity Boom The Pandemic Has Catalysed A Productivity Boom The Pandemic Has Catalysed A Productivity Boom “I believe that the (Fosbury) flop was a natural style and I was just the first to find it” – Dick Fosbury, on how he revolutionised the high jump Watching the Tokyo Olympics, the flurry of new world records reassures us that human athletic productivity continues to advance. It does so in three ways: better biology, better technology, and better ways of doing the same thing. Better biology comes from advances in nutrition and healthcare – at least, for those that embrace the advances. Better technology means better equipment. For example, more ergonomic bikes, sharkskin-like swimwear that minimises water resistance, and running shoes that re-channel energy back into the legs. Albeit this raises the contentious issue that technological advances are giving some athletes an unfair and unnatural advantage. Case in point, World Athletics (and the Tokyo Olympics) have banned prototype versions of Nike’s Vaporfly running shoe that was used by Eliud Kipchoge to run the first sub-two hour marathon. The banned prototype shoe, containing triple carbon plates inside thick ultra-compressed foam, is claimed to improve running economy by up to four percent. But if technological advances are giving some athletes an advantage, it follows that they must also be giving some firms and economies an advantage. While this is unfair in sporting competition, it is fair in economic competition. An important implication is that firms and economies that embrace disruptive technologies and innovations – such as working from home – are likely to generate superior long-term productivity growth than firms and economies that do not. Productivity Growth Comes From Finding Better Ways Of Doing The Same Thing Yet, looking at the longer-term ‘productivity growth’ in sport, many of the greatest advances have come not from better biology or better technology, but just from finding better ways of doing the same thing. Tennis, swimming, and athletics provide three excellent examples of such innovation. A tennis ball weighs just 50 grams, so anybody can hit a tennis ball hard. The difficult part is hitting the ball hard and landing it within the 78 foot court. In the 1970s, Bjorn Borg revolutionised tennis by hitting with aggressive topspin on both the forehand and backhand as well as the serve. Meaning that rather than having to approach the net as was the ‘best practice’, Borg could win matches from the baseline. All it required was a different way of holding the racket and using his arms (Figure I-1). Figure I-1Challenging The Best Practice In Tennis Boosted Its Productivity What The Olympics Teaches Us About Productivity Growth What The Olympics Teaches Us About Productivity Growth Borg’s revolution has a fascinating backstory. Borg’s father, a table tennis champion, won a tennis racket in a table tennis tournament and gave it to the 9-year old Bjorn. Familiar with table tennis and now armed with a tennis racket, the young Borg’s revolution was to play tennis as if it were table tennis – with its trademark topspin on both wings as well as the serve – albeit on a much bigger ‘table.’ And with a racket that was far too heavy for him that he held with both hands. (He eventually switched to a one-handed forehand but kept his two-handed backhand.) Go back a hundred years, and swimming experienced a similar revolution. Until the 1870s, the best practice for European swimmers was the highly inefficient breaststroke. But in 1873, John Arthur Trudgen emulated the technique used by Native Americans whereby the arms moved in a crawl. Later, the Australian Fred Cavill also emulated the Natives’ flutter kick, and thus made mainstream the front crawl, which has significantly increased swimming speed, or swimming ‘productivity.’ All it required was a different way of moving our arms and legs.     But probably the greatest example of athletic innovation came in the 1968 Mexico Olympics, when Dick Fosbury turned the standard high jumping technique on its head – or, more precisely, on its back – to win the gold medal and smash the world record.   Prior to the 1968 Games, the best practice high jump technique had been the ‘straddle’ which involved jumping forward, twisting the body to navigate the bar, and then landing on your feet. Fosbury changed all that forever. He jumped backwards off the wrong foot, arched his back over the bar, and landed on his back (Figure I-2). Figure I-2Challenging The Best Practice In The High Jump Boosted Its Productivity What The Olympics Teaches Us About Productivity Growth What The Olympics Teaches Us About Productivity Growth Just like the tennis topspin and swimming’s front crawl, high jump’s ‘Fosbury flop’ has become the mainstream technique in the sport, taking performance and ‘productivity’ literally to new highs. And just like the tennis topspin and swimming’s front crawl, all it required was a different way of using our existing resources – in this case, jumping backwards rather than forwards. Yet in the case of the innovative Fosbury flop, something else also played an important role – a new environment. Until the 1960s, high jumpers cleared the bar and landed on sawdust, sand, or thin mats. Hence, any innovation in high jump techniques was constrained by having to land on your feet. This changed when Fosbury’s high school became one of the first to install deep foam matting for high jump landing. The Fosbury flop could not have been innovated before the introduction of deep foam matting, because jumping backwards and landing on your back depended on the existence of a soft foam mat for a safe landing. The crucial lesson is that a new environment gives us a chance to challenge beliefs on ‘how things should be done’, a chance to discover new ways of doing the same thing differently, and better. To challenge beliefs on how things should be done, what bigger change in the environment can there be than a global pandemic? The Pandemic Has Catalysed Better Ways Of Doing The Same Thing Just like athletic productivity growth, economic productivity growth comes from better biology (which improves both our physical and intellectual capacity), better technology, and finding better ways of doing the same thing. Of these three drivers, the first two are continuous processes but the third, finding better ways of doing the same thing, gets a massive boost from disruptive changes in the environment such as recessions (Chart of the Week and Chart I-2).   Chart I-2Productivity Surges After Recessions Productivity Surges After Recessions Productivity Surges After Recessions In this regard, any technology that is required already generally exists, but the recession is the necessary catalyst for its wholesale adoption. For example, the mass manufacturing of autos already existed well before the Great Depression, but the Depression was the catalyst for its wholesale adoption. Likewise, word processors existed well before the dot com bust, but the 2000 recession was what finally killed the office typing pool. In the same way, the technology for online shopping and remote meetings has been around for years, but it is the pandemic that has catalysed its wholesale adoption (Chart I-3). Chart I-3The Pandemic Has Accelerated The Shift To Online What The Olympics Teaches Us About Productivity Growth What The Olympics Teaches Us About Productivity Growth As Fosbury said, he was just the first to find a more natural style of high jumping, yet it required a change of environment to challenge the best practice. Similarly, it has taken a global pandemic for us to challenge the best practice on how we should work, do business, shop, and interact (Chart I-4). Chart I-4The Pandemic Has Accelerated The Shift To Online What The Olympics Teaches Us About Productivity Growth What The Olympics Teaches Us About Productivity Growth It is sub-optimal to work in the office or to shop in-person all the time. It is also sub-optimal to do these things remotely all the time. The optimal way is some hybrid of in-person and remote interactions, which will clearly differ for each person. But the pandemic has given us the opportunity to find this more natural and better way, and thereby to give our productivity a massive boost (Chart I-5). Chart I-5The Pandemic Has Challenged The Best Practice On How To Work What The Olympics Teaches Us About Productivity Growth What The Olympics Teaches Us About Productivity Growth The productivity boom could be a super-boom because the current disruption has forced us all to find better ways of doing things. This differentiates the current episode from previous post-recession periods where transformations were focussed in one sector. For example, the 80s recession reshaped manufacturing, the dot com bust changed the technology sector, and the 2008 recession transformed the financial sector. By comparison, the current transformation is penetrating the entire economy. The Investment Conclusion A productivity super-boom carries two important implications for policymakers. It will take longer for the economy to reabsorb the unemployed, and it will keep structural inflation depressed. This means that interest rate hikes will be much later and much shallower than the market is pricing (Chart I-6 and Chart I-7). Chart I-6Rate Hikes Will Be Later Than The Market Is Pricing Rate Hikes Will Be Later Than The Market Is Pricing Rate Hikes Will Be Later Than The Market Is Pricing Chart I-7Rate Hikes Will Be Shallower Than The Market Is Pricing Rate Hikes Will Be Shallower Than The Market Is Pricing Rate Hikes Will Be Shallower Than The Market Is Pricing The investment conclusion is to buy any of the US interest rate futures that expire from December 2022 out to June 2024. The earlier contracts have the higher probabilities of expiring in profit while the later contracts have the greater potential upside. An alternative expression is to buy the 30-year T-bond, or to go long the 30-year T-bond versus the 30-year German bund. For equity investors, a productivity super-boom plus the market’s overestimation of Fed rate hikes structurally favours growth sectors versus value sectors. Thereby, it also structurally favours the S&P500 versus the Eurostoxx50. Fractal Analysis Update Global stocks versus bonds (MSCI All Country World versus 30-year T-bond) continue to exhibit the fragility on the 260-day fractal structure that started in mid-March. Since then, and consistent with this fragility, global stocks have underperformed bonds by 6 percent (Chart I-8). Chart I-8Stocks Versus Bonds Remains Fractally Fragile Stocks Versus Bonds Remains Fractally Fragile Stocks Versus Bonds Remains Fractally Fragile But fragility on a 260-day fractal structure implies elevated risk of a reversal through at least the following six months. On this basis, our recommendation is to remain, at most, neutral to global stocks versus bonds through the summer. Among recent trades, short corn versus wheat, and short marine transportation versus market achieved their profit targets of 12 percent and 16.5 percent respectively, but short Austria versus Chile, and short lead versus platinum hit their stop-losses of 7 percent and 6.4 percent respectively. The 6-month win ratio stands at a very pleasing 71 percent. This week’s recommended trade is to reinitiate the stopped-out metals pair-trade in a modified expression – short tin versus platinum – given the very fragile 130-day and 260-day fractal structure (Chart I-9). Set the profit target and symmetrical stop-loss at 16.5 percent. Chart I-9Tin Is Fractally Fragile Tin Is Fractally Fragile Tin Is Fractally Fragile   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Globalization is recovering to its pre-pandemic trajectory. But it will fail to live up to potential, as the “hyper-globalization” trends of the 1990s are long gone. China was the biggest winner of hyper-globalization. It now faces unprecedented risks in the context of hypo-globalization. Global investors woke up to China’s domestic political risks this year, which include arbitrary regulatory crackdowns on tech and private business. While Chinese officials will ease policy to soothe markets, the cyclical and structural outlook is still negative for this economy. Growth and stimulus have peaked. Political risk will stay high through the national party congress in fall 2022. US-China relations have not stabilized. India, the clearest EM alternative for global investors, is high-priced relative to China and faces troubles of its own. It is too soon to call a bottom for EM relative to DM. Feature Global investors woke up to China’s domestic political risk over the past week, as Beijing extended its regulatory crackdown to private education companies. Our GeoRisk Indicator shows Chinese political risk reaching late 2017 levels while the broad Chinese stock market continued this year’s slide against emerging market peers (Chart 1). Chart 1China: Domestic Political Risk Takes Investors By Surprise Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) A technical bounce in Chinese tech stocks will very likely occur but we would not recommend playing it. The first of our three key views for 2021 is the confluence of internal and external headwinds for China. True, today’s regulatory blitz will pass over like previous ones and the fast money will snap up Chinese tech firms on the cheap. The Communist Party is making a show of force, not destroying its crown jewels in the tech sector. However, the negative factors weighing on China are both cyclical and structural. Until Chinese President Xi Jinping adjusts his strategy and US-China relations stabilize, investors do not have a solid foundation for putting more capital at risk in China. Globalization is in retreat and this is negative for China, the big winner of the past 40 years. Hypo-Globalization Globalization in the truest sense has expanded over millenia. It will only reverse amid civilizational disasters. But the post-Cold War era of “hyper-globalization” is long gone.1 The 2010s saw the emergence of de-globalization. In the wake of COVID-19, global trade is recovering to its post-2008 trend but it is nowhere near recovering the post-1990 trend (Chart 2). Trade exposure has even fallen within the major free trade blocs, like the EU and USMCA (Chart 3). Chart 2Hypo-Globalization Hypo-Globalization Hypo-Globalization Chart 3Trade Intensity Slows Even Within Trade Blocs Trade Intensity Slows Even Within Trade Blocs Trade Intensity Slows Even Within Trade Blocs Of course, with vaccines and stimulus, global trade will recover in the coming decade. We coined the term “hypo-globalization” to capture this predicament, in which globalization is set to rebound but not to its previous trajectory.2 We now inhabit a world that is under-globalized and under-globalizing, i.e. not as open and free as it could be. A major factor is the US-China economic divorce, which is proceeding apace. China’s latest state actions – in diplomacy, finance, and business – underscore its ongoing disengagement from the US-led global architecture. The US, for its part, is now on its third presidency with protectionist leanings. American and European fiscal stimulus are increasingly protectionist in nature, including rising climate protectionism. Bottom Line: The stimulus-fueled recovery from the global pandemic is not leading to re-globalization so much as hypo-globalization. A cyclical reboot of cross-border trade and investment is occurring but will fall short of global potential due to a darkening geopolitical backdrop. Still No Stabilization In US-China Relations Chart 4Do Nations Prefer Growth? Or Security? Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) A giant window of opportunity is closing for China and Russia – they will look back fondly on the days when the US was bogged down in the Middle East. The US current withdrawal from “forever wars” incentivizes Beijing and Moscow to act aggressively now, whether at home or abroad. Investors tend to overrate the Chinese people’s desire for economic prosperity relative to their fear of insecurity and domination by foreign powers. China today is more desirous of strong national defense than faster economic growth (Chart 4). The rise of Chinese nationalism is pronounced since the Great Recession. President Xi Jinping confirmed this trend in his speech for the Communist Party’s first centenary on July 1, 2021. Xi was notably more concerned with foreign threats than his predecessors in 2001 and 2011 (Chart 5).3 China has arrived as a Great Power on the global stage and will resist being foisted into a subsidiary role by western nations. Chart 5Xi Jinping’s Centenary Speech Signaled Nationalist Turn Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) Meanwhile US-China relations have not stabilized. The latest negotiations did not produce agreed upon terms for managing tensions in the relationship. A bilateral summit between Presidents Biden and Xi Jinping has not been agreed to or scheduled, though it could still come together by the end of October. Foreign Minister Wang Yi produced a set of three major demands: that the US not subvert “socialism with Chinese characteristics,” obstruct China’s development, or infringe on China’s sovereignty and territorial integrity (Table 1). The US’s opposition to China’s state-backed economic model, export controls on advanced technology, and attempts to negotiate a trade deal with the province of Taiwan all violate these demands.4 Table 1China’s Three Demands From The United States (July 2021) Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) The removal of US support for China’s economic, development – recently confirmed by the Biden administration – will take a substantial toll on sentiment within China and among global investors. US President Joe Biden and four executive departments have explicitly warned investors not to invest in Hong Kong or in companies with ties to China’s military-industrial complex and human rights abuses. The US now formally accuses China of genocide in the Xinjiang region.5 Bottom Line: There is no stabilization in US-China relations yet. This will keep the risk premium in Chinese currency and equities elevated. The Sino-American divorce is a major driver of hypo-globalization. China’s Regulatory Crackdown President Xi Jinping’s strategy is consistent. He does not want last year’s stimulus splurge to create destabilizing asset bubbles and he wants to continue converting American antagonism into domestic power consolidation, particularly over the private economy. Now China’s sweeping “anti-trust” regulatory crackdown on tech, education, and other sectors is driving a major rethink among investors, ranging from Ark-founder Cathie Wood to perma-bulls like Stephen Roach. The driver of the latest regulatory crackdown is the administration’s reassertion of central party control. The Chinese economy’s potential growth is slowing, putting pressure on the legitimacy of single-party rule. The Communist Party is responding by trying to improve quality of life while promoting nationalism and “socialism with Chinese characteristics,” i.e. strong central government control and guidance over a market economy. Beijing is also using state power and industrial policy to attempt a great leap forward in science and technology in a bid to secure a place in the sun. Fintech, social media, and other innovative platforms have the potential to create networks of information, wealth, and power beyond the party’s control. Their rise can generate social upheaval at home and increase vulnerability to capital markets abroad. They may even divert resources from core technologies that would do more to increase China’s military-industrial capabilities. Beijing’s goal is to guide economic development, break up the concentration of power outside of the party, prevent systemic risks, and increase popular support in an era of falling income growth. Sociopolitical Risks: Social media has demonstrably exacerbated factionalism and social unrest in the United States, while silencing a sitting president. This extent of corporate power is intolerable for China. Economic And Financial Risks: Innovative fintech companies like Ant Group, via platforms like Alipay, were threatening to disrupt one of the Communist Party’s most important levers of power: the banking and financial system. The People’s Bank of China and other regulators insisted that Ant be treated more like a bank if it were to dabble in lending and wealth management. Hence the PBoC imposed capital adequacy and credit reporting requirements.6 Data Security Risks: Didi Chuxing, the ride-sharing company partly owned by Uber, whose business model it copied and elaborated on, defied authorities by attempting to conduct its initial public offering in the United States in June. The Communist Party cracked down on the company after the IPO to show who was in charge. Even more, Beijing wanted to protect its national data and prevent the US from gaining insights into its future technologies such as electric and autonomous vehicles. Foreign Policy Risks: Beijing is also preempting the American financial authorities, who will likely take action to kick Chinese companies that do not conform to common accounting and transparency standards off US stock exchanges. Better to inflict the first blow (and drive Chinese companies to Hong Kong and Shanghai for IPOs) than to allow free-wheeling capitalism to continue, giving Americans both data and leverage. Thus Beijing is continuing the “self-sufficiency” drive, divorcing itself from the US economy and capital markets, while curbing high-flying tech entrepreneurs and companies. The party’s muscle-flexing will culminate in Xi Jinping’s consolidation of power over the Politburo and Central Committee at the twentieth national party congress in fall 2022, where he is expected to take the title of “Chairman” that only Mao Zedong has held before him. The implication is that the regulatory crackdown can easily last for another six-to-12 more months. True, investors will become desensitized to the tech crackdown. But health care and medical technology are said to be in the Chinese government’s sights. So are various mergers and acquisitions. Both regulatory and political risk premia in different sectors can persist. The current administration has waged several sweeping regulatory campaigns against monopolies, corruption, pollution, overcapacity, leverage, and non-governmental organizations. The time between the initial launch of one of these campaigns and their peak intensity ranges from two to five years (Chart 6). Often, but not always, central policy campaigns have an express, three-year plan associated with them. Chart 6ABeijing Cracked Down On Monopolies, Corruption, Pollution... Beijing Cracked Down On Monopolies, Corruption, Pollution... Beijing Cracked Down On Monopolies, Corruption, Pollution... Chart 6B...NGOs, Overcapacity, And Leverage ...NGOs, Overcapacity, And Leverage ...NGOs, Overcapacity, And Leverage Chart 7China Tech: Buyer Beware China Tech: Buyer Beware China Tech: Buyer Beware The first and second year mark the peak impact. The negative profile of Chinese tech stocks relative to their global peers suggests that the current crackdown is stretched, although there is little sign of bottom formation yet (Chart 7). The crackdown began with Alibaba founder Jack Ma, and Alibaba stocks have yet to arrest their fall either in absolute terms or relative to the Hang Seng tech index. Bottom Line: A technical bounce is highly likely for Chinese stocks, especially tech, but we would not recommend playing it because of the negative structural factors. For instance, we fully expect the US to delist Chinese companies that do not meet accounting standards. The Chinese Government’s Pain Threshold? The government is not all-powerful – it faces financial and economic constraints, even if political checks and balances are missing. Beijing does not have an interest in destroying its most innovative companies and sectors. Its goal is to maintain the regime’s survival and power. China’s crackdown on private companies goes against its strategic interest of promoting innovation and therefore it cannot continue indefinitely. The hurried meeting of the China Securities Regulatory Commission with top bankers on July 28 suggests policymakers are already feeling the heat.7 In the case of Ant Group, the company ultimately paid a roughly $3 billion fine (which is 18% of its annual revenues) and was forced to restructure. Ant learned that if it wants to behave more like a bank athen it will be regulated more like a bank. Yet investors will still have to wrestle with the long-term implications of China’s arbitrary use of state power to crack down on various companies and IPOs. This is negative for entrepreneurship and innovation, regardless of the government’s intentions. Chart 8China's Pain Threshold = Property Sector China's Pain Threshold = Property Sector China's Pain Threshold = Property Sector Ultimately the property sector is the critical bellwether: it is a prime target of the government’s measures against speculative asset bubbles. It is also an area where authorities hope to ease the cost of living for Chinese households, whose birth rates and fertility rates are collapsing. While there is no risk of China’s entire economy crumbling because of a crackdown on ride-hailing apps or tutoring services, there is a risk of the economy crumbling if over-zealous regulators crush animal spirits in the $52 trillion property sector, as estimated by Goldman Sachs in 2019. Property is the primary store of wealth for Chinese households and businesses and falling property prices could well lead to an unsustainable rise in debt burdens, a nationwide debt-deflation spiral, and a Japanese-style liquidity trap. Judging by residential floor space started, China is rapidly approaching its overall economic pain threshold, meaning that property sector restrictions should ease, while monetary and credit policy should get easier as necessary to preserve the economic recovery (Chart 8). The economy should improve just in time for the party congress in late 2022. Bottom Line: China will be forced to maintain relatively easy monetary and fiscal policy and avoid pricking the property bubble, which should lend some support to the global recovery and emerging markets economies over the cyclical (12-month) time frame. China’s Regulation And Demographic Pressures Is the Chinese government not acting in the public interest by tamping down financial excesses, discouraging anti-competitive corporate practices, and combating social ills? Yes, there is truth to this. But arbitrary administrative controls will not increase the birth rate, corporate productivity, or potential GDP growth. First, it is true that Chinese households cite high prices for education, housing, and medicine as reasons not to have children (Chart 9). However, price caps do not attack the root causes of these problems. The lack of financial security and investment options has long fueled high house prices. The rabid desire to get ahead in life and the exam-oriented education system have long fueled high education prices. Monetary and fiscal authorities are forced to maintain an accommodative environment to maintain minimum levels of economic growth amid high indebtedness – and yet easy money policies fuel asset price inflation. In Japan, fertility rates began falling with economic development, the entrance of women in the work force, and the rise of consumer society. The fertility rate kept falling even when the country slipped into deflation. It perked up when prices started rising again! But it relapsed after the Great Recession and Fukushima nuclear crisis (Chart 10, top panel). Chart 9China: Concerns About Having Children Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) China’s fertility rate bottomed in the 1990s and has gradually recovered despite the historic surge in property prices (Chart 10, second panel), though it is still well below the replacement rate needed to reverse China’s demographic decline in the absence of immigration. A lower cost of living and a higher quality of life will be positive for fertility but will require deeper reforms.8 Chart 10Fertility Fell In Japan Despite Falling Prices Fertility Fell In Japan Despite Falling Prices Fertility Fell In Japan Despite Falling Prices At the same time, arbitrary regulatory crackdowns that punish entrepreneurs are not likely to boost productivity. Anti-trust actions could increase competition, which would be positive for productivity, but China’s anti-trust actions are not conducted according to rule of law, or due process, so they increase uncertainty rather than providing a more stable investment environment. China’s tech crackdown is also aimed at limiting vulnerability to foreign (American) authorities. Yet disengagement with the global economy will reduce competition, innovation, and productivity in China. Bottom Line: China’s demographic decline will require larger structural changes. It will not be reversed by an arbitrary game of whack-a-mole against the prices of housing, education, and health. India And South Asia Chart 11China Will Ease Policy... Or India Will Break Out China Will Ease Policy... Or India Will Break Out China Will Ease Policy... Or India Will Break Out Global investors have turned to Indian equities over the course of the year and they are now reaching a major technical top relative to Chinese stocks (Chart 11). Assuming that China pulls back on its policy tightening, this relationship should revert to mean. India faces tactical geopolitical and macroeconomic headwinds that will hit her sails and slow her down. In other words, there is no great option for emerging markets at the moment. Over the long run, India benefits if China falters. Following the peak of the second COVID-19 wave in May 2021, some high frequency indicators have showed an improvement in India’s economy. However, activity levels appear weaker than of other emerging markets (Chart 12). Given the stringency levels of India’s first lockdown last spring, year-on-year growth will look faster than it really is. As the base effect wanes, underlying weak demand will become evident. Moreover India is still vulnerable to COVID-19. Only 25% of the population has received one or more vaccine shots which is lower than the global level of 28%. The result will be a larger than expected budget deficit. India refrained from administering a large dose of government spending in 2020 (Chart 13). With key state elections due from early 2022 onwards, the government could opt for larger stimulus. This could assume the form of excise duty cuts on petroleum products or an increase in revenue expenditure. These kinds of measures will not enhance India’s productivity but will add to its fiscal deficit. Chart 12Weak Post-COVID Rebound In India – And Losing Steam Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) Chart 13India Likely To Expand Fiscal Spending Soon Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) Such an unexpected increase in India’s fiscal deficit could be viewed adversely by markets. India’s fiscal discipline tends to be poorer than that of peers (see Chart 13 above). Meanwhile India’s north views Pakistan unfavorably and key state elections are due in this region. Consequently, Indian policy makers may be forced to adopt a far more aggressive foreign policy response to any terrorist strikes from Pakistan or territorial incursions by China over August 2021. The US withdrawal from Afghanistan poses risks for India as it has revived the Taliban’s influence. India has a long history of being targeted by Afghani terrorist groups. And its diplomatic footprint in Afghanistan has been diminishing. Earlier in July, India decided temporarily to close its consulate in Kandahar and evacuated about 50 diplomats and security personnel. As August marks the last month of formal US presence in Afghanistan, negative surprises emanating from Afghanistan should be expected. Bottom Line: Pare exposure to Indian assets on a tactical basis. Our Emerging Markets Strategy takes a more optimistic view but geopolitical changes could act as a negative catalyst in the short term. We urge clients to stay short Indian banks. Investment Takeaways US stimulus contrasts with China’s turmoil. The US Biden administration and congressional negotiators of both parties have tentatively agreed on a $1 trillion infrastructure deal over eight years. Even if this bipartisan deal falls through, Democrats alone can and will pass another $1.3-$2.5 trillion in net deficit spending by the end of the year. Stay short the renminbi. Prefer a balance of investments in the dollar and the euro, given the cross-currents of global recovery yet mounting risks to the reflation trade. A technical bounce in Chinese stocks and tech stocks is nigh. China’s policymakers are starting to respond to immediate financial pressures. However, growth has peaked and structural factors are still negative. The geopolitical outlook is still gloomy and China’s domestic political clock is a headwind for at least 12 more months. Prefer developed market equities over emerging markets (Chart 14). Emerging markets failed to outperform in the first half of the year, contrary to our expectation that the global reflation trade would lift them. China/EM will benefit when Beijing eases policy and growth rebounds. Chart 14Emerging Markets: Not Out Of The Woods Yet Emerging Markets: Not Out Of The Woods Yet Emerging Markets: Not Out Of The Woods Yet Stay short Indian banks and strongman EM currencies, including the Turkish lira, the Brazilian real, and the Philippine peso. The biggest driver of EM underperformance this year is the divergence between the US and China. But until China’s policy corrects, the rest of EM faces downside risks.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 Dani Rodrik, The Globalization Paradox: Democracy and the Future of the World Economy (New York: Norton, 2011). 2 See my "Nationalism And Globalization After COVID-19," Investments & Wealth Monitor (Jan/Feb 2021), pp13-21, investmentsandwealth.org. 3 Our study of Xi’s speech is not limited to this quantitative, word-count analysis. A fuller comparison of his speech with that of his predecessors on the same occasion reveals that Xi was fundamentally more favorable toward Marx, less favorable toward Deng Xiaoping and the pro-market Third Plenum, utterly silent on notions of political reform or liberal reform, more harsh in his rhetoric toward the outside world, and hawkish about the mission of reunifying with Taiwan. 4 The Chinese side also insisted that the US stop revoking visas, punishing companies and institutes, treating the press as foreign agents, and detaining executives. It warned that cooperation – which the US seeks on the environment, Iran, North Korea, and other areas – cannot be achieved while the US imposes punitive measures. 5 See US Department of State, "Xinjiang Supply Chain Business Advisory," July 13, 2021, and "Risks and Considerations for Businesses Operating in Hong Kong," July 16, 2021, state.gov. 6 Top business executives are also subject to these displays of state power. For example, Alibaba founder Jack Ma caricatured China’s traditional banks as “pawn shops” and criticized regulators for stifling innovation. He is now lying low and has taken to painting! 7 See Emily Tan and Evelyn Cheng, "China will still allow IPOs in the United States, securities regulator tells brokerages," CNBC, July 28, 2021, cnbc.com. Officials are sensitive to the market blowback but the fact remains that IPOs in the US have been discouraged and arbitrary regulatory crackdowns are possible at any time. 8 Increasing social spending also requires local governments to raise more revenue but the central government had been cracking down on the major source of revenues for local government: land sales and local government financing vehicles. With the threat of punishment for local excesses and lack of revenue source, local governments have no choice but to cut social services, pushing affluent residents towards private services, while leaving the less fortunate with fewer services. As with financial regulations, the central government may backpedal from too tough regulation of local governments, but more economic and financial pain will be required to make it happen. The Geopolitics Of The Olympics The 2020 Summer Olympics are currently underway in Tokyo, even though it is 2021. The arenas are mostly empty given the global pandemic and economic slowdown. Every four years the Summer Olympics create a golden opportunity for the host nation to showcase its achievements, infrastructure, culture, and beauty. But the Olympics also have a long history of geopolitical significance: terrorist acts, war protests, social demonstrations, and boycotts. In 1906 an Irish athlete climbed a flag pole to wave the Irish flag in protest of his selection to the British team instead of the Irish one. In 1968 two African American athletes raised their fists as an act of protest against racial discrimination in the US after the assassination of Martin Luther King Jr. In 1972, the Palestinian terrorist group Black September massacred eleven Israeli Olympians in Munich, Germany. In 1980 the US led the western bloc to boycott the Moscow Olympics while the Soviet Union and its allies retaliated by boycotting the 1984 Los Angeles Olympics. In 2008, Russia used the Olympics as a convenient distraction from its invasion of Georgia, a major step in its geopolitical resurgence. So far, thankfully, the Tokyo Olympics have gone without incident. However, looking forward, geopolitics is already looming over the upcoming 2022 Winter Olympics in Beijing. Hypo-Globalization (A GeoRisk Update) Hypo-Globalization (A GeoRisk Update) How the world has changed. The 2008 Summer Olympics marked China’s global coming-of-age celebration. The breathtaking opening ceremony featured 15,000 performers and cost $100 million. The $350 million Bird’s Nest Stadium showcased to the world China’s long history, economic prowess, and various other triumphs. All of this took place while the western democratic capitalist economies grappled with what would become the worst financial and economic crisis since the Great Depression. In 2008, global elites spoke of China as a “responsible stakeholder” that was conducting a “peaceful rise” in international affairs. The world welcomed its roughly $600 billion stimulus. Now elites speak of China as primarily a threat and a competitor, a “revisionist” state challenging the liberal world order. China is blamed for a lack of transparency (if not virological malfeasance) in handling the COVID-19 pandemic. It is blamed for breaking governance promises and violating human rights in Hong Kong, for alleged genocide in Xinjiang, and for a list of other wrongdoings, including tough “Wolf Warrior” diplomacy, cyber-crime and cyber-sabotage, and revanchist maritime-territorial claims. Even aside from these accusations it is clear that China is suffering greater financial volatility as a result of its conflicting economic goals. Talk of a diplomatic or even full boycott of Beijing’s winter games is already brewing. Sponsors are also second-guessing their involvement. More than half of Canadians support boycotting the winter games. Germany is another bellwether to watch. In 2014, Germany’s president (not chancellor) boycotted the Sochi Olympics; in 2021, the EU and China are witnessing a major deterioration of relations. Parliamentarians in the UK, Italy, Sweden, Switzerland, and Norway have asked their governments to outline their official stance on the winter games. In the age of “woke capitalism,” a sponsorship boycott of the games is a possibility. This is especially true given the recent Chinese backlash against European multinational corporations for violating China’s own rules of political correctness. A boycott which includes any members of the US, Norway, Canada, Sweden, Germany, or the Netherlands would be substantial as these are the top performers in the Winter Olympics. Even if there is no boycott, there is bound to be some political protests and social demonstrations, and China will not be able to censor anything said by Western broadcasters televising the events. Athletes usually suffer backlash at home if they make critical statements about their country, but they run very little risk of a backlash for criticizing China. If anything, protests against China’s handling of human rights will be tacitly encouraged. Beijing, for its part, will likely overreact, as these days it not only controls the message at home but also attempts more actively to export censorship. This is precisely what the western governments are now trying to counteract, for their own political purposes. The bottom line is that the 2008 Beijing Olympics reflected China’s strengths in stark contrast with the failures of democratic capitalism, while the 2022 Olympics are likely to highlight the opposite: China’s weaknesses, even as the liberal democracies attempt a revival of their global leadership.   Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Section II: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator United Kingdom UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator Section III: Geopolitical Calendar

Feature June’s economic data and second-quarter GDP indicate that China’s economic recovery may have peaked. Slight improvements in some sectors, including manufacturing investment, exports and consumption, were offset by slowing in China’s old economy, such as infrastructure and real estate. A softening economy will weigh on Chinese corporate profits in 2H21. Inflation in Producer Price Index (PPI) has likely peaked, but it remains far above its historic average. Downstream industries may benefit from low interest rates and slightly less inflationary pressures on input prices, however, their profit growth has rolled over given weakening domestic demand and base effect. Industrial profits will shift downward in 2H21, meanwhile China’s macro policy will probably disappoint investors. Last week’s GDP’s numbers show that small-to-medium enterprises (SMEs) and private-sector businesses bore the brunt of rising global commodity prices and a slow recovery in domestic household consumption and services. The data, coupled with recent policy moves, support our view that China’s leadership is focused on helping vulnerable segments of the economy rather than boosting domestic demand by broadly easing policies (Chart 1). Nonetheless, the authorities may resort to easing policy later in 2021 if export growth weakens significantly in the second half of the year. A series of Reserve Requirement Ratio (RRR) and/or interest rate cuts, increased infrastructure project approvals, and/or looser real estate regulations, will signal that China’s ongoing policy tightening cycle has ended. In recent weeks both Chinese onshore and offshore stocks slipped further in absolute terms and relative to global benchmarks (Chart 2). We continue to recommend that investors remain cautious on Chinese stocks, at least through Q3. Chart 1No Broad Easing Yet No Broad Easing Yet No Broad Easing Yet Chart 2Investors Still Cautious On China's Economy And Policy Investors Still Cautious On China's Economy And Policy Investors Still Cautious On China's Economy And Policy   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Q2 GDP: Recovering At A Slower Pace China’s official GDP growth, on a year-over-year basis, slowed to 7.9% in Q2 from 18.3% in Q1 (Chart 3, top panel). While Q2’s weaker reading reflects the base effect in the data, it was slightly below the market’s expectation of 8.0-8.5%. Moreover, on a sequential basis (quarter-over-quarter), Q2’s seasonally adjusted GDP growth was one of the slowest in the past decade (Chart 3, bottom panel). These figures and the underlying data highlight that China’s economic growth momentum, which historically lags the credit impulse by six to nine months, has peaked (Chart 4). However, in 1H21, China aggregate output still grew by a 5.5% average annual rate during the same period over the past two years, well within Chinese policymakers’ target of above 5% growth needed to maintain a stable economy.  Meanwhile, the bifurcation in China’s economic recovery continues.  While robust external demand for Chinese goods helped to underpin manufacturing output, the sector’s profit growth has lagged upstream industries. Moreover, state-owned enterprises (SOEs) are experiencing soaring profit growth whereas SMEs have struggled with rising global commodity prices and sluggish domestic consumption as discussed below. We expect that the pace in credit growth deceleration will moderate in 2H21 and interest rates will stay at historically low levels. However, the authorities are unlikely to loosen macro policies until more signs of economic weaknesses emerge. Chart 3Q2 GDP: Slowing From An Elevated Level Q2 GDP: Slowing From An Elevated Level Q2 GDP: Slowing From An Elevated Level Chart 4Chinese Economic Growth Should Soften Further In 2H21 Chinese Economic Growth Should Soften Further In 2H21 Chinese Economic Growth Should Soften Further In 2H21   Robust Exports, Sluggish Manufacturing Investment Chart 5Subdued Manufacturing Investment Recovery Despite Robust Exports Subdued Manufacturing Investment Recovery Despite Robust Exports Subdued Manufacturing Investment Recovery Despite Robust Exports China’s export growth in June beat market expectations, despite shipping disruptions at major ports in Guangdong province due to a resurgence in COVID-19 cases. However, the recovery in manufacturing investment was muted through most of 1H21 even though export growth was resilient (Chart 5). There are several reasons for the sluggish recovery: the RMB’s rapid appreciation in the first five months of 2021, rising inflation and the limited pricing power that Chinese exporters gained in the first half of the year likely impeded their profits and curbed their propensity to invest (Chart 6). Total export values in USD significantly outpaced those in RMB terms, suggesting that the profit gains by Chinese exporters were offset by the strengthening local currency (Chart 7). Chart 6Rapid RMB Appreciation Will Weigh On Industrial Profits Rapid RMB Appreciation Will Weigh On Industrial Profits Rapid RMB Appreciation Will Weigh On Industrial Profits Chart 7Divergence Between Exports In USD versus RMB Divergence Between Exports In USD versus RMB Divergence Between Exports In USD versus RMB Furthermore, manufacturers in mid-to-downstream industries have been unable to fully pass on rising input costs to domestic consumers, which is evidenced in the faster growth of manufacturing output volume compared with price increases. It contrasts with the previous inflationary cycles, where surging prices for manufactured goods surpassed output volume (Chart 8A & 8B). Chart 8AChina's Manufacturing Recovery: Stronger Volume Than Prices China's Manufacturing Recovery: Stronger Volume Than Prices China's Manufacturing Recovery: Stronger Volume Than Prices Chart 8BMuted Profit Margin Recovery In Manufacturing Compared With Mining Muted Profit Margin Recovery In Manufacturing Compared With Mining Muted Profit Margin Recovery In Manufacturing Compared With Mining June’s improvement in manufacturing investment may not advance into 2H21 without added policy support. The nearly 2% depreciation in the RMB against the dollar in recent weeks will alleviate some pressure on exporters’ profit margins. However, export prices in USD also started to weaken (Chart 9). In addition, June’s manufacturing PMI and a Chinese business school survey,1 reported a deterioration in business conditions among smaller businesses. The weaker sentiment will depress manufacturing investments since China’s manufacturing sector is dominated by private and smaller businesses (Chart 10). Chart 9Chinese Export Prices In USD Are Rolling Over Chinese Export Prices In USD Are Rolling Over Chinese Export Prices In USD Are Rolling Over Chart 10Deteriorating Business Sentiment Will Depress Manufacturing Investments Deteriorating Business Sentiment Will Depress Manufacturing Investments Deteriorating Business Sentiment Will Depress Manufacturing Investments Recent policy measures to keep a low interest-rate environment will help the export and manufacturing sectors by reducing operating costs. The measures are also in keeping with China’s shift from boosting its service sector to maintaining a steady share of manufacturing output in its domestic economy (Chart 11). Chart 11Maintaining A Steady Share Of Manufacturing Output In China's Economy Maintaining A Steady Share Of Manufacturing Output In China's Economy Maintaining A Steady Share Of Manufacturing Output In China's Economy   Policy Tightening In The Old Economy Continues Chart 12Investments In Real Estate Have Lost Steam Investments In Real Estate Have Lost Steam Investments In Real Estate Have Lost Steam Infrastructure investment growth slowed further in June. Investments in real estate, which drove China’s economic recovery in the second half of 2020, are also losing momentum (Chart 12). The slowdown, engineered by policymakers, will likely endure for the rest of the year. Bank loans to real estate developers tumbled to a cyclical low (Chart 13). In addition, deposit and advance payments, the main source of funds for real estate projects, nose-dived along with home sales (Chart 14).  Chart 13No Signs Of Looser Financing Regulations In Property Sector No Signs Of Looser Financing Regulations In Property Sector No Signs Of Looser Financing Regulations In Property Sector Chart 14Falling Home Sales Will Further Depress Real Estate Investments Falling Home Sales Will Further Depress Real Estate Investments Falling Home Sales Will Further Depress Real Estate Investments Chart 15Sharp Pullback In New Infrastructure Project Approvals This Year Sharp Pullback In New Infrastructure Project Approvals This Year Sharp Pullback In New Infrastructure Project Approvals This Year Infrastructure project approvals by the Ministry of Finance remain on a downward trend (Chart 15). Last week, China’s Banking and Insurance Regulatory Commission (CBIRC) announced a new rule to stop financial institutions from lending to local government financing vehicles (LGFV) that hold off-balance sheet government debt. LGFVs are largely used by provincial governments to borrow from banks to help fund infrastructure projects. Regulations targeting the real estate sector will further dampen real estate investments in the second half of this year. Land purchases and housing starts, both leading indicators for real estate investment, have declined since February. Excavator sales and investment in construction equipment also deteriorated sharply (Chart 16). Given that housing prices remain elevated, we do not expect real estate regulations to shift to an easier tone.  The deceleration in China’s old economy is reflected in imports. While the value of imports remains strong, the volume has slowed, which suggests that the surge was due to soaring commodity prices (Chart 17, top panel). In particular, the growth in China’s imports of copper and steel, on a year-over-year basis and in volume terms, contracted in June (Chart 17, bottom panel). Chart 16Construction Activities Set To Slow Further Construction Activities Set To Slow Further Construction Activities Set To Slow Further Chart 17Falling Import Volume Falling Import Volume Falling Import Volume   The Key To A Consumption Recovery Retail sales picked up slightly in June following two consecutive months of decline.  However, retail sales remain below their pre-pandemic level (Chart 18). Labor market dynamics and household income growth, which stayed sluggish through 1H21, hold the key to the speed and magnitude of a recovery in consumption this year (Chart 19). Chart 18Sluggish Recovery In Household Consumption Sluggish Recovery In Household Consumption Sluggish Recovery In Household Consumption Chart 19A Lackluster Consumption Recovery Due To Slow Recovery in Household Income A Lackluster Consumption Recovery Due To Slow Recovery in Household Income A Lackluster Consumption Recovery Due To Slow Recovery in Household Income Household precautionary savings, which remain elevated compared with their historical norms, have depressed the propensity to spend (Chart 20). While the overall unemployment rate in China’s urban centers has steadily declined this year, the rate of jobless young graduates (ages 16-24) picked up and is nearly three percentage points higher than its historical mean (Chart 21). However, the high unemployment among graduates will not encourage policymakers to stimulate the economy. The number of new graduates in both 2020 and 2021 is larger than the historical average, while the growth in new job creation has nearly recovered to that of the pre-pandemic years (Chart 22). Chart 20Households' Propensity For Precautionary Savings Remains Elevated Households' Propensity For Precautionary Savings Remains Elevated Households' Propensity For Precautionary Savings Remains Elevated Chart 21Rising Unemployment Rate Among Younger Workers Rising Unemployment Rate Among Younger Workers Rising Unemployment Rate Among Younger Workers Moreover, labor market slack among young graduates seems to be concentrated in the services sector, and this sector’s improvement is dependent on China’s domestic pandemic situation and inoculation rates rather than on stimulus (Chart 23). Chart 22Urban Job Creation Growth Still On The Mend Urban Job Creation Growth Still On The Mend Urban Job Creation Growth Still On The Mend Chart 23Interruptions In Service Sector Recovery Due To Lingering COVID Cases Interruptions In Service Sector Recovery Due To Lingering COVID Cases Interruptions In Service Sector Recovery Due To Lingering COVID Cases   Elevated Inflation, Downshifting Industrial Profits Chart 24China's PPI May Have Reached A Cyclical Peak... China's PPI May Have Reached A Cyclical Peak... China's PPI May Have Reached A Cyclical Peak... China’s domestic inflationary pressures eased slightly in June with a small decline in both consumer and producer prices. The input price component of the manufacturing PMI, which normally leads the PPI by about three months, dropped sharply last month, which indicates that the PPI may have reached its cyclical peak (Chart 24). However, producer price inflation will likely remain elevated in the second half of the year. Although global industrial metal prices have rolled over since May, they remain at their highest level since 2011 (Chart 25). A rapid deceleration in Chinese credit growth and weakening demand in 2H21 will remove some pressure in the sizzling hot commodity market, but global supply-side constraints will limit the downside in raw material prices, at least through the next six months. Therefore, diminishing inflationary pressures on the PPI will only slightly reduce input costs for China’s mid-to- downstream manufacturers, which have been unable to pass on rising commodity prices to domestic consumers (Chart 26). As discussed earlier, Chinese export prices in both USD and RMB terms have also rolled over. Chart 25...But Global Commodity Prices Are Still Elevated ...But Global Commodity Prices Are Still Elevated ...But Global Commodity Prices Are Still Elevated Chart 26Absence Of Inflation Pass-Through Absence Of Inflation Pass-Through Absence Of Inflation Pass-Through Given that price changes are more important to corporate profits than volume changes, Chinese mid-to-downstream industries will continue to face downward pressure on their profit margins. Profit growth in mid-to-downstream industries consistently lagged their upstream counterparts in the past 12 months (Chart 27). Moreover, state-holding enterprises, which dominate upstream industries, have seen a 150% jump in profit growth from a year ago, while the rate of profit gains among privately owned industrial companies tumbled this year (Chart 28). Chart 27A Faster Mean Reversal In Profit Growth Among Private Companies Taking The Pulse Of China’s Slowing Economy Taking The Pulse Of China’s Slowing Economy Chart 28A Faster Mean Reversal In Profit Growth Among Private Companies A Faster Mean Reversal In Profit Growth Among Private Companies A Faster Mean Reversal In Profit Growth Among Private Companies Chinese policymakers will probably focus on addressing imbalances in China’s industrial sector and economy by supporting SMEs and the private sector. Meanwhile, industrial profit growth will decline in 2H21 from its V-shaped recovery last year, given weakening domestic demand and the waning base effect. Table 1China Macro Data Summary Taking The Pulse Of China’s Slowing Economy Taking The Pulse Of China’s Slowing Economy Table 2China Financial Market Performance Summary Taking The Pulse Of China’s Slowing Economy Taking The Pulse Of China’s Slowing Economy Footnotes 1The CKGSB (Cheung Kong Graduate School Of Business) Business Conditions Index (BCI) comprises four sub-indices: corporate sales, corporate profits, corporate financing environment and inventory levels. Equity Sector Recommendations Cyclical Investment Stance

Highlights It is too early to conclude that the PBoC’s surprise rate cut last Friday to its reserve requirement ratio (RRR) marks the beginning of another policy easing cycle.  Historically it took more than a single RRR reduction to lower interest rates and to boost credit growth. Overall economic conditions do not yet suggest that Chinese policymakers will initiate a broad-based policy easing to spur demand. The end-of-July Politburo meeting will shed more light on whether there is a decisive turn in China’s overall policy stance. In previous cycles, consecutive RRR cuts led to bond market rallies, but were not good leading indicators for equities, which have been more closely correlated with cyclical swings in credit and business cycle. We recommend patience. Chinese onshore stocks are richly valued and their prices can still correct in Q3 when corporate profits and economic growth slow further. Feature The speed and magnitude of the PBoC’s 50-basis point trim in its RRR rate last week exceeded market expectations. The RRR rate drop, combined with June’s better-than-expected credit data, sparked speculation that China’s macroeconomic policy had shifted to an easier mode. A single RRR cut does not indicate that another policy easing cycle is underway. Rather, the PBoC’s intention is to prevent rising demand for liquidity in 2H21 from significantly pushing up interest rates. In addition, we do not expect that the credit impulse will decisively turn around until later this year. We will remain alert to any signs of additional policy easing, particularly because policymakers will face more pressure to maintain trend growth next year. The July Politburo meeting may provide more information on the direction of Chinese macro policy going forward. Meanwhile, investors should stay the course. In previous cycles there were long lags between the first RRR cut and sustained rallies in China’s onshore stock markets. We will continue to maintain an underweight stance towards Chinese stocks through the next three months, given that economic data and corporate profits will likely weaken further in Q3. Surprise, Surprise! The PBoC lowered the RRR rate only two days after the State Council mentioned the possibility, which exceeded the consensus. Historically, the PBoC has always made more than one RRR reduction during easing cycles, separated by about three months. Are more RRR cuts pending and does the initial decrease mark the beginning of another policy easing cycle? It is too early to conclude that a broad-based easing cycle has started, for the following reasons: First, economic fundamentals do not suggest an urgent need for policy easing. The economy is softening, but it is softening from a very elevated level (Chart 1). Importantly, production is weakening at a faster pace than demand and partially due to COVID-related idiosyncrasies. This supply-side issue cannot be solved by monetary easing.  For example, the production subcomponent of the manufacturing PMI fell in June while new orders increased (Chart 2). Since its trough in April last year, the gap between new orders and production has consistently narrowed for 11 of the past 15 months, highlighting that the demand-side recovery has been outpacing the supply-side. The recent resurgence in COVID-19 cases and local lockdowns in Guangdong province, which is China’s manufacturing and export powerhouse, may have curbed June’s manufacturing production and new export orders. Global supply shortages in raw materials and chips also add to the sluggishness in manufacturing production. Chart 1Chinese Economy Is Slowing, But Not Too Slow Chinese Economy Is Slowing, But Not Too Slow Chinese Economy Is Slowing, But Not Too Slow Chart 2Demand Not As Soft Compared With Production Demand Not As Soft Compared With Production Demand Not As Soft Compared With Production Similarly, China’s service PMI slipped notably in June and has closely tracked the country’s domestic COVID-19 situation. The decline is an issue that policy easing and boosting demand will not solve (Chart 3). Secondly, global supply chains are still impaired and commodity prices remain elevated. Even though China’s PPI on a year-over-year basis rolled over in June, it is at its highest level since 2008 (Chart 4). As such, spurring demand through monetary easing would only exacerbate inflationary pressures among producers. Chart 3Slow Recovery In Services Largely Due To Lingering COVID Effects Slow Recovery In Services Largely Due To Lingering COVID Effects Slow Recovery In Services Largely Due To Lingering COVID Effects Chart 4Producer Prices Remain Elevated Producer Prices Remain Elevated Producer Prices Remain Elevated Apart from COVID-related disruptions, the weakness in China’s economy this year has been driven by slower growth in infrastructure and real estate investment due to tightened regulatory oversights that were put in place late last year (Chart 5). Construction PMI declined sharply from its peak in March and both excavator sales and loader sales have plummeted since Q1 this year (Chart 5, bottom panel). However, regulatory tightening towards the housing market and infrastructure projects remain firmly in place, suggesting that policymakers are not looking to stimulate the old economy sectors to support growth. Lastly, despite weaker home sales, housing prices in tier-one cities continue to escalate (Chart 6). The rising prices will keep authorities vigilant about excessive liquidity in the market.    Chart 5It Has Been Chinese Policymakers' Intention To Slow The 'Old Economy' Sectors It Has Been Chinese Policymakers' Intention To Slow The 'Old Economy' Sectors It Has Been Chinese Policymakers' Intention To Slow The 'Old Economy' Sectors Chart 6Housing Market Mania Remains Authorities' Pressure Point Housing Market Mania Remains Authorities' Pressure Point Housing Market Mania Remains Authorities' Pressure Point Bottom Line: Supply-demand dynamics in the global economy and China’s domestic inflationary pressures suggest that it is premature to assume that the RRR cut marks the beginning of another policy easing cycle.  Why Now? Chart 7More 'Pain' Needed For Broad Easing More 'Pain' Needed For Broad Easing More 'Pain' Needed For Broad Easing The drop in the RRR highlights the PBoC’s determination to maintain a low interest-rate environment without any further easing, and does not indicate that the central bank has shifted its current policy setting framework. The PBoC has been reactive rather than proactive in the past as it typically waits for severe signs of economic weakness before broadly relaxing its policy (Chart 7). The PBoC cited two main reasons for the RRR cut. One is to ease liquidity pressures of small to medium enterprises (SMEs), which have been struggling with rising input prices and subdued output prices (Chart 8). This motive is consistent with the PBoC’s monetary position so far this year –the central bank has kept rates at historical low levels while scaling back credit creation (Chart 9).   Chart 8SMEs Under Elevated Pricing Stress SMEs Under Elevated Pricing Stress SMEs Under Elevated Pricing Stress Chart 9The PBoC Has Kept Rates At Historic Low Levels The PBoC Has Kept Rates At Historic Low Levels The PBoC Has Kept Rates At Historic Low Levels Demand for liquidity will rise meaningfully in the second half of the year due to an acceleration in local government bond issuance and the large number of expiring medium-term lending facility (MLF) loans and bonds. The liquidity gap could significantly push up interbank and market-based interest rates without the central bank’s intervention. The amount of maturing MLF and government bonds could be more than RMB1 trillion in July. Thus, the 50bp RRR cut, which the PBoC indicates will free up about RMB1 trillion of liquidity to the banking system, will ensure that interest rates remain stable. Chart 10Bank Lending Rates Have Not Declined With Policy Rates Bank Lending Rates Have Not Declined With Policy Rates Bank Lending Rates Have Not Declined With Policy Rates The PBoC also stated that it intends to keep down financing costs for both banks and SMEs. The statement is vague, but the PBoC may mean it plans to guide bank lending rates lower for SMEs and, at the same time, provide banks (particularly smaller banks) with enough liquidity to encourage lending to those enterprises. To achieve this goal, a broad-based RRR cut would be more effective than other monetary policy tools, such as open-market operations or MLF injections, which normally benefit large commercial banks more than their smaller counterparts. While interbank rates have been sliding since Q4 last year, the weighted average lending rates moved sideways and even ticked up slightly this year (Chart 10). As of Q1 2021, more than half of bank loans charged higher interest rates than the loan prime rate (LPR), highlighting a distribution matrix unfavorable to SMEs (Chart 11). Loan demand from SMEs, as shown in the PBoC survey, peaked much earlier and tumbled more rapidly than their large peers (Chart 12). Chart 11SMEs Face Rising Input And Funding Costs China’s Monetary Policy: Easy, But Not Easing China’s Monetary Policy: Easy, But Not Easing Chart 12Waning SMEs' Demand For Bank Credit Waning SMEs' Demand For Bank Credit Waning SMEs' Demand For Bank Credit Lowering lending rates for SMEs is usually at the cost of the banks by bearing higher default risks and lower profits. A RRR reduction, coupled with recent changes in banks’ deposit rate pricing mechanisms,1 are measures that can potentially reduce the banks’ liability costs. Bottom Line: The PBoC is using a RRR cut to avoid a sudden jump in interest rates from their low levels in 1H21, and to reduce funding costs for the SMEs and banks. What About Credit Growth? Chart 13Credit Numbers In June Beat Market Expectations Credit Numbers In June Beat Market Expectations Credit Numbers In June Beat Market Expectations Credit numbers beat the market’s expectations in June. Both credit growth and impulse rose slightly after a fast deceleration in much of 1H21 (Chart 13). We continue to expect the credit impulse to hover at a low level throughout Q3. Local government bond issuance will pick up in 2H21, but the acceleration will not necessarily lead to a reversal in credit growth (Chart 14). On a year-over-year basis, high base during Q3 last year will depress credit growth and impulse in the next three months. Moreover, in the past couple years, on average local government bonds account for only about 18% of annual total social financing. As such, the pace of bank loan expansion would need to substantially accelerate to reverse the slowdown in credit growth in the next three months. In previous cycles, on average it took more than one RRR cut and about two quarters for credit growth to turn around (Chart 15). Therefore, even if monetary policy is on an easing path, we expect credit growth to pick up in Q4 at the earliest. Chart 14LG Bonds Only A Small Part Of Total Credit Creation China’s Monetary Policy: Easy, But Not Easing China’s Monetary Policy: Easy, But Not Easing Chart 15Credit Growth Lags RRR Cuts By About Two Quarters Credit Growth Lags RRR Cuts By About Two Quarters Credit Growth Lags RRR Cuts By About Two Quarters Furthermore, policymakers are unlikely to deviate from targeting credit growth in line with nominal GDP this year. Based on our estimate, the target suggests that the overall credit impulse relative to 2020 will be negative this year (Chart 16). Chart 16Negative Credit Impulse In 2021 Relative To 2020 Negative Credit Impulse In 2021 Relative To 2020 Negative Credit Impulse In 2021 Relative To 2020 Chart 17The Credit Structure, Rather Than Volume, Will Improve In 2H21 The Credit Structure, Rather Than Volume, Will Improve In 2H21 The Credit Structure, Rather Than Volume, Will Improve In 2H21   Meanwhile, we think that the PBoC will focus on improving the structure of credit creation by continuing to encourage medium- to long-term lending, while scaling back shadow banking and short-term loans (Chart 17). Corporate bond financing improved slightly in June. However, room for further improvement in corporate bond issuance is small this year, given tightened financing reglations on local government financing vehicles. Downside potential for corporate bond yields is also limited in 2H21, when the economy slows and corporate bond default risks are rising (Chart 18).  Given elevated housing prices and tightened regulations to contain the property sector’s leverage, bank lending to real estate developers and mortgages will continue to trend down in the foreseeable future, regardless the direction of interest rates (Chart 19). Chart 18Limited Upsides For Corporate Bond Issuance In 2H21 Limited Upsides For Corporate Bond Issuance In 2H21 Limited Upsides For Corporate Bond Issuance In 2H21 Chart 19Bank Loans To Property Market Unlikely To Pick Up In 2H21 Bank Loans To Property Market Unlikely To Pick Up In 2H21 Bank Loans To Property Market Unlikely To Pick Up In 2H21 Bottom Line: Regardless changes in monetary policy, credit growth will not decisively bottom until later this year. Investment Implications Chart 20Chinese Stock Prices Failed To Break Out Chinese Stock Prices Failed To Break Out Chinese Stock Prices Failed To Break Out Chinese stocks in both onshore and offshore equity markets failed to reverse their trend of underperformance relative to global stocks (Chart 20). Investors should be patient in upgrading their allocation to Chinese stocks from underweight to overweight, in both absolute terms and within a global equity portfolio.  Historically, there has been a long lag between an initial RRR trim and a trough in Chinese onshore stock prices (Chart 21). Although prices moved up along with RRR cut announcements in the past, the price upticks were short lived. Stock prices in previous cycles troughed when the credit impulse and/or the economy bottomed. Given our view that a single RRR decrease does not indicate a broad-based policy easing and the credit impulse is unlikely to pick up until later this year, investors should wait for more price setbacks in Q3 before favoring Chinese stocks again.  Chart 21Long Lags Between First RRR Cut And Stock Market Troughs Long Lags Between First RRR Cut And Stock Market Troughs Long Lags Between First RRR Cut And Stock Market Troughs We are slightly more optimistic than last month about Chinese bonds because the RRR cut has reduced the possibility for any substantial rise in interest rates in 2H21. However, we maintain a cautious view on Chinese government and corporate bonds in Q3. In previous cycles, onshore bond yields often fluctuated sideways or even climbed a bit following the first RRR reduction. It often took several RRR drops, more policy easing signals and sure signs of economic weakening for the bond market to enter a tradable bull run (Chart 22). Therefore, we recommend investors stay on the sidelines for a better entry price point. Chart 22It Takes More Than One RRR Cut To Start A Bond Market Bull Run It Takes More Than One RRR Cut To Start A Bond Market Bull Run It Takes More Than One RRR Cut To Start A Bond Market Bull Run It is also unrealistic to expect the RRR cut will lead to significant and sustained devaluation in the RMB relative to the US dollar. We expect the dollar index to rebound somewhat in Q3 on the back of positive US employment data surprises which will push US bond yields higher. However, following previous RRR cuts, the RMB had sizeable depreciations only when geopolitical events (the US-China trade war in 2018/19) or drastic central bank intervention (the August 2015 de-pegging from the USD) coincided with the RRR cuts. These scenarios are not likely to play out in the next six months (Chart 23). As such, we maintain our view that the CNY will slightly weaken against the USD in Q3 but will end the year at around 6.4. Chart 23Expect Muted And Short-Lived Movements In The USDCNY From A Single RRR Cut Expect Muted And Short-Lived Movements In The USDCNY From A Single RRR Cut Expect Muted And Short-Lived Movements In The USDCNY From A Single RRR Cut   Jing Sima China Strategist jings@bcaresearch.com Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Footnotes 1The reform changes the way banks calculate and offer deposit rates. The upper limit is set on their deposit interest rates by adding basis points to the central bank’s benchmark deposit rates, rather than multiplying the benchmark rates by a specific number. Exclusive: Banks Prepare to Lower Deposit Rates as Rate Cap Reform Takes Effect (caixinglobal.com) Cyclical Investment Stance Equity Sector Recommendations

Highlights Three distinct forces are likely to make South Asia’s geopolitical risks increasingly relevant to global investors. First, India’s tensions with China stem from China’s growing foreign policy assertiveness and India’s shift away from traditional neutrality toward aligning with the US and its allies. This creates a security dilemma in South Asia, just as in East Asia. Second, India’s economy is sputtering in the wake of the COVID-19 pandemic, adding fuel to nationalism and populism in advance of a series of important elections. India will stimulate the economy but it could also become more reactive on the international scene. Third, the US is withdrawing from Afghanistan and negotiating a deal with Iran in an effort to reduce the US military presence in the Middle East and South Asia. This will create a scramble for influence across both regions and a power vacuum in Afghanistan that is highly likely to yield negative surprises for India and its neighbors. Traditionally geopolitical risks in South Asia have a limited impact on markets. India’s growth slowdown and forthcoming fiscal stimulus are more relevant for investors. However, a sharp rise in geopolitical risk would undermine India’s structural advantages as the West diversifies away from China. Stay short Indian banks. Feature Geopolitical risks in South Asia are slowly but surely rising. India-Pakistan and China-India are well-known “conflict-dyads” or pairings. Historically, these two sets have been fighting each other over their fuzzy Himalayan border with limited global financial market consequences. But now fundamental changes are afoot that are altering the geopolitical setting in the region. Specifically, the coming together of three distinct forces could trigger a significant geopolitical event in South Asia. The three forces are as follow: Force #1: Sino-Indian Tensions Get Real About a year ago, Indian and Chinese troops clashed in Ladakh, a disputed territory in the Kashmir region. Following these clashes China reduced its military presence in the Pangong Tso area but its presence in some neighboring areas remains meaningful. Besides the troop build-up along India’s eastern border, China is building more air combat infrastructure in its India-facing western theatre. China’s major air bases have historically been concentrated in China’s eastern region, away from the Indian border (Map 1). Consequently, India has historically enjoyed an advantage in airpower. But China appears to be working to mitigate this disadvantage. Map 1Most Of China’s Major Aviation Units Are Located Away From India South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown Owing to China’s increased military focus along the Sino-India border, India’s threat perception of China has undergone a fundamental change in recent years. Notably, India has diverted some of its key army units away from its western Indo-Pak border towards its eastern border with China. India could now have nearly 200,000 troops deployed along its border with China, which would mark a 40% increase from last year.1 Turning attention to the Indo-Pak border, India’s problems with Pakistan appear under control for now. This is owing to the ceasefire agreement that was renewed by the two countries in February 2021. However, this peace cannot possibly be expected to last. This is mainly because core problems between the two countries (like Pakistan’s support of militant proxies and India’s control over Kashmir) remain unaddressed. History too suggests that bouts of peace between the two warring neighbors rarely last long. These bouts usually end abruptly when a terrorist attack takes place in India. With both political turbulence and economic distress in Pakistan rising, the fragile ceasefire between India and Pakistan could be upended over the next six months. In fact, two events over the last week point to the fragility of the ceasefire: Two drones carrying explosives entered an Indian air force station located in Jammu and Kashmir (i.e. a northern territory that India recently reorganized, to Pakistan’s chagrin). Even as no casualties were reported, this attack marks a turning point for terrorist activity in India as this was the first-time terrorists used drones to enter an Indian military base. Hours later, another drone attack struck an Indian base at the Ratnuchak-Kaluchak army station, the site of a major terrorist attack in 2002. Chart 1China, Pakistan And India Cumulatively Added 41 Nuclear Warheads Over 2020 South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown Given that the ceasefire was agreed recently, any further increase in terrorist activity in India over the next six months would suggest that a more substantial breakdown in relations is nigh. Distinct from these recent tensions, China’s troop deployment along India’s eastern arm and Pakistan’s presence along India’s western arm creates a strategic “pincer” that increasingly threatens India. India is naturally concerned. China and Pakistan are allies who have been working closely on projects including the strategic China-Pakistan Economic Corridor (CPEC). The CPEC is a collection of infrastructure projects in Pakistan that includes the development of a port in Gwadar where a future presence of the People's Liberation Army Navy (PLAN) is envisaged. Gwadar has the potential of providing China land-based access to the Indian Ocean. Trust in the South Asian region is clearly running low. Distinct from troop build-ups and drone-attacks, China, Pakistan, and India cumulatively added more than 40 nuclear warheads over the last year (Chart 1). China is reputed to be engaged in an even larger increase in its nuclear arsenal than the data show.2 From a structural perspective, too, geopolitical risks in the South Asian peninsula are bound to keep rising. When it comes to the conflicting Indo-Pak dyad, India’s geopolitical power has been rising relative to that of Pakistan in the 2000s. However, the geopolitical muscle of the Sino-Pak alliance is much greater than that of India on a standalone basis (Chart 2). Chart 2India Has Aligned With The QUAD To Counter The Sino-Pak Alliance South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown China’s active involvement in South Asia is responsible for driving India’s increasing desire to abandon its historical foreign policy stance of non-alignment. India’s membership in the Quadrilateral Security Dialogue (also known as the QUAD, whose other members include the US, Japan, and Australia) bears testimony to India’s active effort to develop closer relations with the US and its allies (Chart 2). India’s alignment with the US is deepening China’s and Pakistan’s distrust of India. Conventional and nuclear military deterrence should prevent full-scale war. But the regional balance is increasingly fluid which means geopolitical risks will slowly but surely rise in South Asia over the coming year and years. Force #2: A Growth Slowdown Alongside India’s Loaded Election Calendar The pandemic has hit the economies of South Asia particularly hard. South Asia historically maintained higher real GDP growth rates relative to Emerging Markets (EMs). But in 2021, this region’s growth rate is set to be lower than that of EM peers (Chart 3). History is replete with examples of a rise in economic distress triggering geopolitical events. South Asia is characterized by unusually low per capita incomes (Chart 4) and the latest slowdown could exacerbate the risk of both social unrest and geopolitical incidents materialising. Chart 3South Asian Economies Have Been Hit Hard By The Pandemic South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown Chart 4South Asia Is Characterized By Very Low Per Capita Incomes South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown To complicate matters a busy state elections calendar is coming up in India. Elections will be due in seven Indian states in 2022. These states account for about 25% of India’s population. State elections due in 2022 will amount to a high-stakes political battle. During state elections in 2021, the ruling Bharatiya Janata Party (BJP) was the incumbent in only one of the five states. In 2022, the BJP is the incumbent party in most of the states that are due for elections, which means it has the advantage but also has a lot to lose, especially in a post-pandemic environment. Elections kick off in the crucial state of Uttar Pradesh next February. Last time this state faced elections Prime Minister Narendra Modi was willing to go to great lengths to boost his popularity ahead of time. Specifically, he upset the nation with a large-scale and unprecedented de-monetization program. Given the busy state election calendar in 2022, we expect the BJP-led central government to focus on policy actions that can improve its support among Indian voters. Two policies in particular are likely to come through: Fiscal Stimulus Measures To Provide Economic Relief: India has refrained from administering a large post-pandemic stimulus thus far. As per budget estimates, the Indian central government’s total expenditure in FY22 is set to increase only by 1% on a year-on-year basis. But the expenditure-side restraint shown by India’s central government could change. With elections and a pandemic (which has now claimed over 400,000 lives in India), the central government could consider a meaningful increase in spending closer to February 2022. Map 2Northern India Views Pakistan Even More Unfavorably Than Rest Of India South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown India’s Finance Minister already announced a fiscal stimulus package of $85 billion (amounting to 2.8% of GDP) earlier this week. Whilst this stimulus entails limited fresh spending (amounting to about 0.6% of India’s GDP), we would not be surprised if the government follows it up with more spending closer to February 2022. Assertive Foreign Policy To Ward-Off Unfriendly Neighbors: India’s northern states are known to harbor unfavorable views of Pakistan (Map 2). The roots of this phenomenon can be traced to geography and the bloody civil strife of 1947 that was triggered by the partition of British-ruled India into the two independent dominions of India and Pakistan. Given the north’s unfavorable views of Pakistan and given looming elections, Indian policy makers may be forced to adopt a far more aggressive foreign policy response, to any terrorist strikes from Pakistan or territorial incursions by China. This kind of response was observed most recently ahead of the Indian General Elections in April-May 2019. An Indian military convoy was attacked by a suicide-bomber in early February 2019 and a Pakistan-based terrorist group claimed responsibility. A fortnight later the Indian air force launched unexpected airstrikes across the Line of Control which were then followed by the Pakistan air force conducting air strikes in Jammu and Kashmir. While the next round of Pakistani and Indian general elections is not due until 2023 and 2024, respectively, it is worth noting that of the seven state elections due in India in 2022, four are in the north (Uttar Pradesh, Punjab, Uttarakhand, and Himachal Pradesh). Force #3: Power Vacuum In Afghanistan The final reason to be wary of the South Asian geopolitical dynamic is the change in US policy: both the Iran nuclear deal expected in August and the impending withdrawal from Afghanistan in September. The US public has now elected three presidents on the demand that foreign wars be reduced. In the wake of Trump and populism the political establishment is now responding. Therefore Biden will ultimately implement both the Iran deal and the Afghan withdrawal regardless of delays or hang-ups. But then he will have to do damage control. In the case of Iran, a last-minute flare-up of conflict in the region is likely this summer, as the US, Israel, Saudi Arabia, and Iran underscore their red lines before the US and Iran settle down to a deal. Indeed it is already happening, with recent US attacks against Iran-backed Shia militias in Syria and Iraq. A major incident would push up oil prices, which is negative for India. But the endgame, an Iranian economic opening, is positive for India, since it imports oil and has had close relations with Iran historically. In the case of Afghanistan, the US exit will activate latent terrorist forces. It will also create a scramble for influence over this landlocked country that could lead to negative surprises across the region. The first principle of the peace agreement between the US and Afghanistan states that the latter will make all efforts to ensure that Afghan soil is not used to further terrorist activity. However, the enforceability of such a guarantee is next to impossible. Notably, the US withdrawal from Afghanistan will revive the Taliban’s influence in the region. This poses major risks for India, which has a long history of being targeted by Afghani terrorist groups. The Taliban played a critical role in the release of terrorists into Pakistan following the hijacking of an Indian Airlines flight in 1999. Furthermore, the Haqqani network, which has pledged allegiance to the Taliban, has attacked Indian assets in the past. Any attack on India deriving from the power vacuum in Afghanistan would upset the precarious regional balance. Whilst there are no immediate triggers for Afghani groups to launch a terrorist attack in India, the US withdrawal will trigger a tectonic shift in the region. Negative surprises emanating from Afghanistan should be expected. Investment Conclusions Chart 5Indian Banks Appear To Have Factored In All Positives Indian Banks Appear To Have Factored In All Positives Indian Banks Appear To Have Factored In All Positives We reiterate the need to pare exposure to Indian assets on a tactical basis. India’s growth engine is likely to misfire over the second half of the Indian financial year. Macroeconomic headwinds pose the chief risk for investors, but major geopolitical changes could act as a negative catalyst in the current context. So we urge clients to stay short Indian Banks (Chart 5). Financials account for the lion’s share of India’s benchmark index (26% weight). India could opt for an unexpected expansion in its fiscal deficit soon. Whilst we continue to watch fiscal dynamics closely, we expect the fiscal expansion to materialize closer to February 2022 when India’s most populous state (i.e. Uttar Pradesh) will undergo elections. Over the long run, India’s sense of insecurity will escalate in the context of a more assertive China, stronger Sino-Pakistani ties, and a power vacuum in Afghanistan. For that reason, New Delhi will continue to shed its neutrality and improve relations with the US-led coalition of democratic countries, with an aim to balance China. This process will feed China’s insecurity of being surrounded and contained by a hegemonic American system. This security dilemma is a source of South Asian geopolitical risk that will become more globally relevant over time. China’s conflict with the US and western world should create incentives for India to attract trade and investment. However, its ability to do so will be contingent upon domestic political factors and regional geopolitical factors.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Sudhi Ranjan Sen, ‘India Shifts 50,000 Troops to China Border in Historic Move’, Bloomberg, June 28, 2021, bloomberg.com. 2 Joby Warrick, “China is building more than 100 missile silos in its western desert, analysts say,” Washington Post, June 30, 2021, washingtonpost.com.

Highlights China’s Communist Party has overcome a range of challenges over the past 100 years, performed especially well over the past 42 years, but the macro and geopolitical outlook is darkening. The “East Asian miracle” phase of Chinese growth has ended. Potential GDP growth is slowing and it will be harder for Beijing to maintain financial and sociopolitical stability. The Communist Party has shifted the basis of its legitimacy from rapid growth to quality of life and nationalist foreign policy. The latter, however, will undermine the former by stirring up foreign protectionism. In the near term, global investors should favor developed market equities over China/EM equities. But they should favor China and Hong Kong stocks over Taiwanese stocks given significant geopolitical risk over the Taiwan Strait. Structurally, favor the US dollar and euro over the renminbi. Feature Ten years ago, in the lead up to the Communist Party’s 90th anniversary, I wrote a report called “China and the End of the Deng Dynasty,” referring to Deng Xiaoping, the Chinese Communist Party’s great pro-market reformer.1 The argument rested on three points: the end of the export-manufacturing economic model, an increasingly assertive foreign policy, and the revival of Maoist nationalism. After ten years the report holds up reasonably well but it did not venture to forecast what precisely would come next. In reality it is the rule of the Communist Party, and not the leader of any one man, that fits into China’s history of dynastic cycles. As the party celebrates a hundred years since its founding on July 23, 1921, it is necessary to pause and reflect on what the party has achieved over the past century and what the current Xi Jinping era implies for the country’s next 100 years. Single-Party Rule Can Bring Economic Success. Communism Cannot. Regime type does not preclude wealth. Countries can prosper regardless of whether they are ruled by one person, one party, or many parties. The richest countries in the world grew rich over centuries in which their governments evolved from monarchy to democracy and sometimes back again. Even today several of the world’s wealthy democracies are better described as republics or oligarchies. Chart 1China Outperformed Communism But Not Liberal Democracy China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? The rule of one person, or autocracy, is not necessarily bad for economic growth. For every Kim Il Sung of North Korea there is a Lee Kuan Yew of Singapore. But authority based on a single person often expires with that person and rarely survives his grandchild. In China, Chairman Mao Zedong’s death occasioned a power struggle. Deng Xiaoping’s attempts to step down led to popular unrest that threatened the Communist Party’s rule on two separate occasions in the 1980s. The rule of a single party is thought to be more sustainable. Japan and Singapore are effectively single-party states and the wealthiest countries in Asia. They are democracies with leadership rotation and a popular voice in national affairs. And yet South Korea’s boom times occurred under single-party military rule. The same goes for the renegade province of Taiwan. Only around the time these two reached about $11,000-$14,000 GDP per capita did they evolve into multi-party democracies – though their wealth grew rapidly in the wake of that transition. China and soon Vietnam will test whether non-democratic, single-party rule can persist beyond the middle-income economic status that brought about democratic transition in Taiwan (Chart 1). Vietnam and Taiwan are the closest communist and non-communist governing systems, respectively, to mainland China. Insofar as China and Vietnam succeed at catching up with Taiwan it will be for reasons other than Marxist-Leninist ideology. Most communist systems have failed. At the height of international communism in the twentieth century there were 44 states ruled by communist parties; today there are five. China and Vietnam are the rare examples of communist states that not only survived the Soviet Union’s fall but also unleashed market forces and prospered (Chart 2). North Korea survived in squalor; Cuba’s experience is mixed. States that close off their economies do not have a good record of generating wealth. Closed economies lack competition and investment, struggle with stagflation, and often succumb to corruption and political strife. Openness seems to be a more diagnostic variable than government type or ideology, given the prosperity of democratic Japan and non-democratic China. Has the CPC performed better than other communist regimes? Arguably. It performs better than Vietnam but worse than Cuba on critical measures like infant mortality rates and life expectancy. Has it performed better than comparable non-communist regimes? Not really, though it is fast approaching Taiwan in all of these measures (Chart 3). Chart 2Communist States Get Rich By Compromising Their Communism China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? Chart 3China Catching Up To Cuba On Basic Wellbeing China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? What can be said for certain is that, since China’s 1979 reform and opening up, the CPC has avoided many errors and catastrophes. It survived the 1980s, 1990s, and 2000s without succumbing to international isolation, internal divisions, or economic crisis. It has drastically increased its share of global power (Table 1). Contrast this global ascent with the litany of mistakes and crises in the US since the year 2000. The CPC also managed the past decade relatively well despite the Chinese financial turmoil of 2015-16, the US trade war of 2018-19, and the COVID-19 pandemic. However, these events hint at greater challenges to come. China’s transition to a consumer-oriented economy has hardly begun. The struggle to manage systemic financial risk is intensifying today at risk to growth and stability (Chart 4). The trade war is simmering despite the Phase One trade deal and the change of party in the White House. And it is too soon to draw conclusions about the impact of the global pandemic, though China suppressed the virus more rapidly than other countries and led the world into recovery. Table 1China’s Global Rise After ‘Reform And Opening Up’ China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? Chart 4China To Keep Struggling With Financial Instability China To Keep Struggling With Financial Instability China To Keep Struggling With Financial Instability Judging by the points above, there are two significant risks on the horizon. First, the CPC’s revival of neo-Maoist ideology, particularly the new economic mantra of self-reliance and “dual circulation” (import substitution), poses the risk of closing the economy and undermining productivity.2 Second, China’s sliding back into the rule of a single person – after the “consensus rule” that prevailed after Deng Xiaoping – increases the risk of unpredictable decision-making and a succession crisis whenever General Secretary Xi Jinping steps down. The party’s internal logic holds that China’s economic and geopolitical challenges are so enormous as to require a strongman leader at the helm of a single-party and centralized state. But because of the traditional problems with one-man rule, there is no guarantee that the country will remain as stable as it has been over the past 42 years. Slowing Growth Drives Clash With Foreign Powers Every major East Asian economy has enjoyed a “miracle” phase of growth – and every one of them has seen this phase come to an end. Now it is China’s turn. The country’s potential GDP growth is slowing as the population peaks, the labor force shrinks, wages rise, and companies outsource production to cheaper neighbors (Charts 5A & 5B). The Communist Party is attempting to reverse the collapse in the fertility rate by shifting from its historic “one Child policy,” which sharply reduced births. It shifted to a two-child policy in 2016 and a three-child policy in 2021 but the results have not been encouraging over the past five years. Chart 5AChina’s Demographic Decline Accelerating China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? Chart 5BChina’s Demographic Decline Accelerating China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? In the best case China’s growth will follow the trajectory of Taiwan and South Korea, which implies at most a 6% yearly growth rate over the next decade (Chart 6). This is not too slow but it will induce financial instability as well as hardship for overly indebted households, firms, and local governments. Chart 6China's Growth Rates Will Converge With Taiwan, South Korea China's Growth Rates Will Converge With Taiwan, South Korea China's Growth Rates Will Converge With Taiwan, South Korea The Communist Party’s legitimacy was not originally based on rapid economic growth but it came to be seen that way over the roaring decades of the 1980s through the 2000s. Thus when the Great Recession struck the party had to shift the party’s base of legitimacy. The new focus became quality of life, as marked by the Xi administration’s ongoing initiatives to cut back on corruption, pollution, poverty, credit excesses, and industrial overcapacity while increasing spending on health, education, and society (Chart 7). Chart 7China’s Fiscal Burdens Will Rise On Social Welfare Needs China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? The party’s efforts to improve standards of living and consumer safety also coincided with an increase in propaganda, censorship, and repression to foreclose political dissent. The country falls far short in global governance indicators (Chart 8). Chart 8China Lags In Governance, Rule Of Law China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? A second major new source of party legitimacy is nationalist foreign policy. China adopted a “more assertive” foreign and trade policy in the mid-2000s as its import dependencies ballooned. It helped that the US was distracted with wars of choice and financial crises. After the Great Recession the CPC’s foreign policy nationalism became a tool of generating domestic popular support amid slower economic growth. This was apparent in the clashes with Japan and other countries in the East and South China Seas in the early 2010s, in territorial disputes with India throughout the past decade, in political spats with Norway and most recently Australia, and in military showdowns over the Korean peninsula (2015-16) and today the Taiwan Strait (Chart 9). Chart 9Proxy Wars A Real Risk In China’s Periphery China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? If China were primarily focused on foreign policy and global strategy then it would not provoke multiple neighbors on opposite sides of its territory at the same time. This is a good way to motivate the formation of a global balance-of-power coalition that can constrain China in the coming years. But China’s outward assertiveness is not driven primarily by foreign policy considerations. It is driven by the secular economic slowdown at home and the need to use nationalism to drum up domestic support. This is why China seems indifferent to offending multiple countries at once (like India and Australia) as well as more distant trade partners whom it “should be” courting rather than offending (like Europe). Such assertive foreign policy threatens to undermine quality of life, namely by provoking international protectionism and sanctions on trade and investment. The US is galvanizing a coalition of democracies to put pressure on China over its trade practices and human rights. The Asian allies are mostly in step with the US because they fear China’s growing clout. The European states do not have as much to fear from China’s military but they do fear China’s state-backed industry and technological rise. Europe’s elites also worry about anti-establishment political movements just like American elites and therefore are trying to win back the hearts and minds of the working class through a more proactive use of fiscal and industrial policy. This entails a more assertive trade policy. China has so far not adapted to the potential for a unified front among the democracies, other than through rhetoric. Thus the international horizon is darkening even as China’s growth rates shift downward. China’s Geopolitical Outlook Is Dimming China’s government has overcome a range of challenges and crises. The country takes an ever larger role in global trade despite its falling share of global population because of its productivity and competitiveness. The drop in China’s outward direct investment is tied to the global pandemic and may not mark a top, given that the country will still run substantial current account surpluses for the foreseeable future and will need to recycle these into natural resources and foreign production (Chart 10). However, the limited adoption of the renminbi as a reserve currency in the face of this formidable commercial power reveals the world’s reservations about Beijing’s ability to maintain macroeconomic stability, good governance, and peaceful foreign relations. Chart 10China's Rise Continues China's Rise Continues China's Rise Continues Chart 11China's Policy Uncertainty: A Structural Uptrend China's Policy Uncertainty: A Structural Uptrend China's Policy Uncertainty: A Structural Uptrend China is not in a position to alter the course of national policy dramatically prior to the Communist Party’s twentieth national congress in 2022. The Xi administration is focused on normalizing monetary and fiscal policy and heading off any sociopolitical disturbances prior to that critical event, in which General Secretary Xi Jinping, who was originally slated to step down at this time according to the old rules, may be anointed the overarching “chairman” position that Mao Zedong once held. The seventh generation of Chinese leaders will be promoted at this five-year rotation of the Central Committee and will further consolidate the Xi administration’s grip. It will also cement the party’s rotation back to leaders who have ideological educations, as opposed to the norm in the 1990s and early 2000s of promoting leaders with technocratic skills and scientific educations.3 This does not mean that President Xi will refuse to hold a summit with US President Biden in the coming months nor does it mean that US-China strategic and economic dialogue will remain defunct. But it does mean that Beijing is unlikely to make any major course correction until after the 2022 reshuffle – and even then a course correction is unlikely. China has taken its current path because the Communist Party fears the sociopolitical consequences of relinquishing economic control just as potential growth slows. The new ruling philosophy holds that the Soviet Union fell because of Mikhail Gorbachev’s glasnost and perestroika, not because openness and restructuring came too late. Moreover it is far from clear that the US, Europe, and other democratic allies will apply such significant and sustained pressure as to force China to change its overall strategy. America is still internally divided and its foreign policy incoherent; the EU remains reactive and risk-averse. China has a well-established set of strategic goals for 2035 and 2049, the 100th anniversary of the People’s Republic, and the broad outlines will not be abandoned. The implication is that tensions with the US and China’s Asian neighbors will persist. Rising policy uncertainty is a secular trend that will pick back up sooner rather than later (Chart 11), to the detriment of a stable and predictable investment environment. Chart 12Chinese Government’s Net Worth High But Hidden Liabilities Pose Risks China’s Communist Party Turns 100: So What? China’s Communist Party Turns 100: So What? Monetary and fiscal dovishness and a continued debt buildup are the obvious and necessary solutions to China’s combination of falling growth potential, rising social liabilities, the need to maintain the rapid military buildup in the face of geopolitical challenges. Sovereign countries can amass vast debts if they own their own debt and keep nominal growth above average bond yields. China’s government has a very favorable balance sheet when national assets are taken into consideration as well as liabilities, according to the IMF (Chart 12). On the other hand, China’s government is having to assume a lot of hidden liabilities from inefficient state-owned companies and local governments. In the short run there are major systemic financial risks even though in the long run Beijing will be able to increase its borrowing and bail out failing entities in order to maintain stability, just like Japan, the US, and Europe have had to do. The question for China is whether the social and political system will be able to handle major crises as well as the US and Europe have done, which is not that well. Investment Takeaways The rule of a single party is not a bar to economic success – but the rule of a single person is a liability due to the problem of succession. Marxism-Leninism is terrible for productivity unless it is compromised to allow for markets to operate, as in China and Vietnam. States that close their economies to the outside world usually atrophy. There is no compelling evidence that China’s Communist Party has performed better than a non-communist alternative would have done, given the province of Taiwan’s superior performance on most economic indicators. Since 1979, the Communist Party has avoided catastrophic errors. It has capitalized on domestic economic potential and a favorable international environment. Now, in the 2020s, both of these factors are changing for the worse. China’s “miracle” phase of growth has expired, as it did for other East Asian states before it. The maturation of the economy and slowdown of potential GDP have forced the Communist Party to shift the base of its political legitimacy to something other than rapid income growth: namely, quality of life and nationalist foreign policy. An aggressive foreign policy works against quality of life by provoking protectionism from foreign powers, particularly the United States, which is capable of leading a coalition of states to pressure China. The Communist Party’s policy trajectory is unlikely to change much through the twentieth national party congress in 2022. After that, a major course correction to improve relations with the West is conceivable, though we would not bet on it. Between 2021 and China’s 2035 and 2049 milestones, the Communist Party must navigate between rising socioeconomic pressures at home and rising geopolitical pressures abroad. An economic or political breakdown at home, or a total breakdown in relations with the US, could lead to proxy wars in China’s periphery, including but not limited to the Taiwan Strait. For now, global investors should favor the euro and US dollar over the renminbi (Chart 13). Chart 13Prefer The Dollar And Euro To The Renminbi Prefer The Dollar And Euro To The Renminbi Prefer The Dollar And Euro To The Renminbi Mainland investors should favor government bonds relative to stocks. Chinese stocks hit a major peak earlier this year and the government’s seizure of control over the tech sector is taking a toll. Investors should prefer developed market equities relative to Chinese equities until China’s current phase of policy tightening ends and there is at least a temporary improvement in relations with the United States. But investors should also prefer Chinese and Hong Kong stocks relative to Taiwanese due to the high risk of a diplomatic crisis and the tail risk of a war. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 The report concluded, “the emerging trends suggest a likely break from Deng's position toward heavier state intervention in the economy, more contentious relationships with neighbors, and a Party that rules primarily through ideology and social control.” Co-written with Jennifer Richmond, "China and the End of the Deng Dynasty," Stratfor, April 19, 2011, worldview.stratfor.com. 2 The Xi administration’s new concept of “dual circulation” entails that state policy will encourage the domestic economy whereas the international economy will play a secondary role. This is a reversal of the outward and trade-oriented economic model under Deng Xiaoping. See “Xi: China’s economy has potential to maintain long-term stable development,” November 4, 2020, news.cgtn.com. 3 See Willy Wo-Lap Lam, "China’s Seventh-Generation Leadership Emerges onto the Stage," Jamestown Foundation, China Brief 19:7, April 9, 2019, Jamestown.org.

Dear Client, Next week, in lieu of our regular weekly report, I will be hosting two webcasts where I will discuss the outlook for China’s economy and financial markets, a year into policy normalization. The webcasts will be held on Tuesday, June 22 at 10:00 am EDT (English), and Thursday, June 24 at 9:00 am HKT (Mandarin). We will return to our regular publishing schedule on Wednesday, June 30. Best regards, Jing Sima, China Strategist   Feature China’s onshore stocks rebounded in the past two months on the back of a rapidly appreciating RMB versus the US dollar and accelerating foreign capital inflows (Chart 1). However, in our view, China’s domestic policy backdrop and economic fundamentals do not support a sustained rally in Chinese stocks in the next six months. The RMB’s rise vis-à-vis the US dollar will likely falter in the second half of the year as China’s growth weakens. A narrowing in real yields later this year between China’s government bonds and US Treasuries will also discourage foreign flows into Chinese assets. Performance of Chinese cyclical stocks versus defensives failed to decisively breakout in both the onshore and offshore equity markets. An underperformance in cyclical stocks relative to defensives has historically pointed to waning market sentiment towards the Chinese economy (Chart 2). Chart 1Rapid Appreciation In The RMB Buoyed A Recent Rebound In A-Shares Rapid Appreciation In The RMB Buoyed A Recent Rebound In A-Shares Rapid Appreciation In The RMB Buoyed A Recent Rebound In A-Shares Chart 2Cyclical Stocks Continued To Underperform Defensives Cyclical Stocks Continued To Underperform Defensives Cyclical Stocks Continued To Underperform Defensives The number of onshore stocks with prices rising versus falling remains low, even though there has been a slight improvement this year from Q4 2020. The narrow breath in the equity market implies that recent rebound in A-share stocks has been largely driven by a handful of companies (Chart 3). Such narrow breadth suggests that the rebound in Chinese stock prices will not sustain (Chart 4). Chart 3A Narrow-Based Market Rally in A-Shares A Narrow-Based Market Rally in A-Shares A Narrow-Based Market Rally in A-Shares Chart 4Narrowing Market Breadth Has Historically Led To Price Pullbacks Narrowing Market Breadth Has Historically Led To Price Pullbacks Narrowing Market Breadth Has Historically Led To Price Pullbacks A tightened monetary and credit environment has created obstacles for Chinese equities since early this year. Credit numbers released last week show that credit growth deceleration has gathered speed in May, raising the risk of policy overtightening, i.e. credit growth undershooting the government’s 2021 targets. We could see some moderation in the credit growth deceleration into 2H21. A delay in the rollout of local government (LG) bonds and LG special purpose bonds (SPBs) in the first five months of the year means the pace of LG bond issuance between June and October will escalate, which will help to stabilize credit growth. However, weak corporate bond net financing and contracting shadow banking will cap the upside in credit expansion. Chart 5The Economy Could Surprise The Market To The Downside In Q3 The Economy Could Surprise The Market To The Downside In Q3 The Economy Could Surprise The Market To The Downside In Q3 Additionally, if more LG bonds come onto the market in Q3, then we could see tighter interbank liquidity conditions and higher bond yields. This, in turn, would partially offset the positive effects on the economy and equity market from a slower pace in credit growth deceleration. For the next six months, we continue to hold an underweight position in Chinese onshore and investable stocks, in both absolute terms and within a global equity portfolio. Policy tightening has not reversed course and there is an escalating risk that economic data will surprise the market to the downside in Q3 (Chart 5). Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com     Macro Policy Conditions Are Still Unfavorable For Risk Assets A further deterioration in the credit impulse in May reflects Chinese authorities’ efforts to reduce local government leverage and shadow banking activities. Net corporate bond financing contracted for the first time since early 2018, driven by shrinking local government financing vehicle (LGFV) bonds (Chart 6). Meanwhile, the pace of contraction in shadow-bank loans climbed. At this rate of deceleration, credit growth will undershoot the government’s 2021 target, which is expected to be in line with this year’s nominal GDP growth. The pace in credit expansion on a year-over-year basis has dropped to its previous cycle’s trough (Chart 7). Moreover, the speed of the deceleration in credit growth has outpaced the 2017/18 tightening cycle. It has been seven months since Chinese credit growth peaked (October 2020), which is significantly less than the 13 months it took for credit to decline from top to bottom in 2017/18. Chart 6Contraction In Net Corporate Bond Financing And Shadow Banking Dragged Down Credit Growth In May Contraction In Net Corporate Bond Financing And Shadow Banking Dragged Down Credit Growth In May Contraction In Net Corporate Bond Financing And Shadow Banking Dragged Down Credit Growth In May Chart 7Credit Growth Has Decelerated To Its Trough Reached In 2017/18 Tightening Cycle Credit Growth Has Decelerated To Its Trough Reached In 2017/18 Tightening Cycle Credit Growth Has Decelerated To Its Trough Reached In 2017/18 Tightening Cycle Chart 8Most Of LG Bonds Issued In The First Five Months Are Refinancing Bonds The Stars Are Not Yet Aligned For Chinese Stocks The Stars Are Not Yet Aligned For Chinese Stocks So far this year, LG bond issuance is also behind schedule. About 63% of LG bonds issued in the first five months are refinancing bonds (Chart 8). The new LG bonds and LG SPBs issued to date account for only 21% and 16.5%, respectively, of their 2021 quotas. A delay in LG bond issuance in the first five months means that much more bonds will be on the market between June and October, which may help to stabilize credit growth in Q3. However, weak corporate bond financing and an acceleration in contracting shadow banking activities will cap the upside on broad credit. We do not expect a reversal in policy tightening. Instead, credit growth will likely hover near current levels for the rest of the year. In the past, Chinese policymakers eased when the global manufacturing backdrop faltered. Given that global growth is robust, Chinese policymakers will not feel any urgency to reverse policy setting and will likely use the strong external environment as an opportunity for domestic deleveraging. Chinese Exports Will Face Challenges In The Second Half Of The Year Chart 9A Broad-Based Moderation In China's Exports to DMs A Broad-Based Moderation In China's Exports to DMs A Broad-Based Moderation In China's Exports to DMs Export growth slowed in May with a broad-based moderation in the country’s exports to developed markets (DMs), albeit from a very elevated level (Chart 9). The easing in exports reflects an ongoing demand shift in the DMs away from goods to services as economic activity normalizes (Chart 10). China’s robust exports, which have been driven by strong and partly pandemic-induced global demand for goods, will likely gradually lose strength in the second half of the year. China’s weakening new export orders component in the May manufacturing PMI reflects this trend (Chart 11). Chart 10Global Consumption Recovery In Services Will Likely Outpace Goods Global Consumption Recovery In Services Will Likely Outpace Goods Global Consumption Recovery In Services Will Likely Outpace Goods Chart 11China's Softening New Export Orders Signal Further Export-Sector Weakness China's Softening New Export Orders Signal Further Export-Sector Weakness China's Softening New Export Orders Signal Further Export-Sector Weakness An appreciating RMB versus the US dollar is also a headwind for Chinese exports. The USD/CNY historically has led Chinese new export orders by around six months, with the exception of the pandemic-hit outlier in 2020 (Chart 12).  The recent sharp RMB appreciation is starting to weight on Chinese exports. Moreover, BCA’s Geopolitical strategists do not expect that China will principally benefit from US President Biden’s $2.4 trillion infrastructure and green energy plan . US explicitly aims to diminish China’s role as a supplier of US goods and materials. The widening divergence between US’s trade deficit with China and the rest of world already shows evidence (Chart 13). Chart 12The RMB's Rapid Rise Creates Headwinds For Chinese Exports The RMB's Rapid Rise Creates Headwinds For Chinese Exports The RMB's Rapid Rise Creates Headwinds For Chinese Exports Chart 13China's Exports May Not Benefit From Biden's Infrastructure Plan China's Exports May Not Benefit From Biden's Infrastructure Plan China's Exports May Not Benefit From Biden's Infrastructure Plan Still No Inflation Pass-Through Chart 14Chinese Producers Are Unable To Pass Rising Input Costs On To Consumers Chinese Producers Are Unable To Pass Rising Input Costs On To Consumers Chinese Producers Are Unable To Pass Rising Input Costs On To Consumers Chinese surging producer prices overstate domestic inflationary pressures. Inflation in the Producer Price Index (PPI) surged by 9.0% year-over-year in May, jumping to its highest level since 2009. High PPI inflation reflects rising commodity prices and a low base effect. Meanwhile, inflationary pressures are much more muted for consumer goods and services. The gap between producer and consumer prices widened to the highest level since 1990, highlighting the absence of price inflation pass-through from producers to consumers (Chart 14). We expect soaring PPI inflation to be transitory; it will ease when low-base factors from last year and global supply constraints are removed later this year. CPI inflation will remain tame through the year. As such, Chinese authorities are unlikely to tighten monetary policy in response to high PPI readings. Instead, Beijing will continue to use regulatory measures to curb speculation in the commodity market and window-guide industries to readjust material inventories to help ease the pace of rising commodity prices. Historically, PPI inflation’s impact on consumer prices has been weak when prices on producer goods were pushed up by supply shocks rather than mounting domestic demand. The sharp uptick in the PPI during the 2017/18 cycle was mostly due to China’s supply-side reforms and a rapid consolidation in the upstream industries. Global supply constraints linked to the pandemic have also resulted in a sharp upturn in the Chinese PPI since mid-2020. Moreover, Chart 15 shows that the pass-through from PPI inflation to consumers is closely correlated to household income growth. The pass-through has weakened significantly since 2011 when household income growth subdued along with a declining Chinese working population (Chart 16). Chart 15Subdued Household Income Growth Since 2011 Has Suppressed CPI Inflation Subdued Household Income Growth Since 2011 Has Suppressed CPI Inflation Subdued Household Income Growth Since 2011 Has Suppressed CPI Inflation Chart 16Income Growth Decelerated After China's Working Population Peaked Income Growth Decelerated After China's Working Population Peaked Income Growth Decelerated After China's Working Population Peaked Chart 17Profits Diverged Between Upstream And Mid & Downstream Industries The Stars Are Not Yet Aligned For Chinese Stocks The Stars Are Not Yet Aligned For Chinese Stocks Lacking inflation pass-through from producers to consumers has led to a bifurcated profit recovery between upstream and mid & downstream industries. Since late last year, the share of upstream industries in total profits increased sharply at the expense of mid and downstream businesses (Chart 17). A deterioration in the profits of mid and downstream industries will weigh on the outlook for their capex, which in turn, will reduce the demand for upstream goods.     Domestic Demand Remains China’s Weakest Link Investments and household demand remain the weakest links in China’s economy. Sluggish household consumption reflects a fragile post-pandemic recovery in manufacturing and services employment, and a rising propensity for precautionary savings (Chart 18). A PBoC survey shows that households’ preference for more saving deposits soared in 2020 (Chart 19). Although it has slightly diminished since late 2020, the reading is still much higher than its pre-pandemic level and will likely persist to year-end on the back of a subdued outlook for employment and income. Chart 18Weak Employment In Both Manufacturing And Service Industries Weak Employment In Both Manufacturing And Service Industries Weak Employment In Both Manufacturing And Service Industries Chart 19Propensity For Precautionary Savings Is Still Elevated Propensity For Precautionary Savings Is Still Elevated Propensity For Precautionary Savings Is Still Elevated Manufacturing investment continued its rebound in April, but the growth has not rallied to its pre-pandemic state and the recovery was more than offset by falling old-economy infrastructure and real estate investment growth (Chart 20). Although a pickup in LG SPB issuance in Q3 will provide some support to infrastructure expenditures, the effect on aggregate infrastructure investment probably will be muted. China’s Ministry of Finance has raised the requirements for approvals of new investment projects, which have decreased notably since early this year (Chart 21). Hence, growth in infrastructure investment may not significantly improve in 2H21 without a harmonized policy impetus for more bank loans and loosened regulations on local government spending. Chart 20Recovery In Manufacturing Investment Was More Than Offset By Falling Infrastructure And Real Estate Investment Growth Recovery In Manufacturing Investment Was More Than Offset By Falling Infrastructure And Real Estate Investment Growth Recovery In Manufacturing Investment Was More Than Offset By Falling Infrastructure And Real Estate Investment Growth Chart 21Falling New Projects Approval Falling New Projects Approval Falling New Projects Approval Real Estate Sector: Mounting Deleverage Pressure Property developers face challenges from heightened government scrutiny on bank loans and limits on the sector’s leverage ratio, along with curtailed off-balance sheet funding due to Asset Management Regulation (AMR) . Bank loans to real estate developers and household mortgages have tumbled to historical lows and will likely slow further in the next few months (Chart 22, top panel). The tightened financing policies have started to cool demand in the real estate market (Chart 22, bottom panel). Softer housing demand will start to drag down property developers’ capital spending and real estate construction activities (Chart 23). Chart 22Deteriorating Financing Starting To Cool The Property Market Deteriorating Financing Starting To Cool The Property Market Deteriorating Financing Starting To Cool The Property Market Chart 23Real Estate Investments And Construction Activities May Slow Further Real Estate Investments And Construction Activities May Slow Further Real Estate Investments And Construction Activities May Slow Further   Table 1China Macro Data Summary The Stars Are Not Yet Aligned For Chinese Stocks The Stars Are Not Yet Aligned For Chinese Stocks Table 2China Financial Market Performance Summary The Stars Are Not Yet Aligned For Chinese Stocks The Stars Are Not Yet Aligned For Chinese Stocks   Footnotes Cyclical Investment Stance Equity Sector Recommendations

Highlights Geopolitical risk is trickling back into financial markets. China’s fiscal-and-credit impulse collapsed again. The Global Economic Policy Uncertainty Index is ticking back up after the sharp drop from 2020. All of our proprietary GeoRisk Indicators are elevated or rising. Geopolitical risk often rises during bull markets – the Geopolitical Risk Index can even spike without triggering a bear market or recession. Nevertheless a rise in geopolitical risk is positive for the US dollar, which happens to stand at a critical technical point. The macroeconomic backdrop for the dollar is becoming less bearish given China’s impending slowdown. President Biden’s trip to Europe and summit with Russian President Vladimir Putin will underscore a foreign policy of forming a democratic alliance to confront Russia and China, confirming the secular trend of rising geopolitical risk. Shift to a defensive tactical position. Feature Back in March 2017 we wrote a report, “Donald Trump Is Who We Thought He Was,” in which we reaffirmed our 2016 view that President Trump would succeed in steering the US in the direction of fiscal largesse and trade protectionism. Now it is time for us to do the same with President Biden. Our forecast for Biden rested on the same points: the US would pursue fiscal profligacy and mercantilist trade policy. The recognition of a consistent national policy despite extreme partisan divisions is a testament to the usefulness of macro analysis and the geopolitical method. Trump stole the Democrats’ thunder with his anti-austerity and anti-free trade message. Biden stole it back. It was the median voter in the Rust Belt who was calling the shots all along (after all, Biden would still have won the election without Arizona and Georgia). We did make some qualifications, of course. Biden would maintain a hawkish line on China and Russia but he would reject Trump’s aggressive foreign and trade policy when it came to US allies.1 Biden would restore President Obama’s policy on Iran and immigration but not Russia, where there would be no “diplomatic reset.” And Biden’s fiscal profligacy, unlike Trump’s, would come with tax hikes on corporations and the wealthy … even though they would fall far short of offsetting the new spending. This is what brings us to this week’s report: New developments are confirming this view of the Biden administration. Geopolitical Risk And Bull Markets Chart 1Global Geopolitical Risk And The Dollar Global Geopolitical Risk And The Dollar Global Geopolitical Risk And The Dollar In recent weeks Biden has adopted a hawkish policy on China, lowered tensions with Europe, and sought to restore President Obama’s policy of détente with Iran. The jury is still out on relations with Russia – Biden will meet with Putin on June 16 – but we do not expect a 2009-style “reset” that increases engagement. Still, it is too soon to declare a “Biden doctrine” of foreign policy because Biden has not yet faced a major foreign crisis. A major test is coming soon. Biden’s decision to double down on hawkish policy toward China will bring ramifications. His possible deal with Iran faces a range of enemies, including within Iran. His reduction in tensions with Russia is not settled yet. While the specific source and timing of his first major foreign policy crisis is impossible predict, structural tensions are rebuilding. An aggregate of our 13 market-based GeoRisk indicators suggests that global political risk is skyrocketing once again. A sharp spike in the indicator, which is happening now, usually correlates with a dollar rally (Chart 1). This indicator is mean-reverting since it measures the deviation of emerging market currencies, or developed market equity markets, from underlying macroeconomic fundamentals. The implication is positive for the dollar, although the correlation is not always positive. Looking at both the DXY’s level and its rate of change shows periods when the global risk indicator fell yet the dollar stayed strong – and vice versa. The big increase in the indicator over the past week stems mostly from Germany, South Korea, Brazil, and Australia, though all 13 of the indicators are now either elevated or rising, including the China/Taiwan indicators. Some of the increase is due to base effects. As global exports recover, currencies and equities that we monitor are staying weaker than one would expect. This causes the relevant BCA GeoRisk indicator to rise. Base effects from the weak economy in June 2020 will fall out in coming weeks. But the aggregate shows that all of the indicators are either high or rising and, on a country by country level, they are now in established uptrends even aside from base effects. Chart 2Global Policy Uncertainty Revives Global Policy Uncertainty Revives Global Policy Uncertainty Revives Meanwhile the global Economic Policy Uncertainty Index is recovering across the world after the drop in uncertainty following the COVID-19 crisis (Chart 2). Policy uncertainty is also linked to the dollar and this indicator shows that it is rising on a secular basis. The Geopolitical Risk Index, maintained by Matteo Iacoviello and a group of academics affiliated with the Policy Uncertainty Index, is also in a secular uptrend, although cyclically it has not recovered from the post-COVID drop-off. It is sensitive to traditional, war-linked geopolitical risk as reported in newspapers. By contrast our proprietary indicators are sensitive to market perceptions of any kind of risk, not just political, both domestic and international. A comparison of the Geopolitical Risk Index with the S&P 500 over the past century shows that a geopolitical crisis may occur at the beginning of a business cycle but it may not be linked with a recession or bear market. Risk can rise, even extravagantly, during economic expansions without causing major pullbacks. But a crisis event certainly can trigger a recession or bear market, particularly if it is tied to the global oil supply, as in the early 1970s, 1980s, and 1990s (Chart 3). Chart 3Secular Rise In Geopolitical Risk Soon To Reassert Itself Secular Rise In Geopolitical Risk Soon To Reassert Itself Secular Rise In Geopolitical Risk Soon To Reassert Itself While geopolitical risk is normally positive for the dollar, the macroeconomic backdrop is negative. The dollar’s attempt to recover earlier this year faltered. This underlying cyclical bearish dollar trend is due to global economic recovery – which will continue – and extravagant American monetary expansion and budget deficits. This is why we have preferred gold – it is a hedge against both geopolitical risk and inflation expectations. Tactically this year we have refrained from betting against the dollar except when building up some safe-haven positions like Japanese yen. Over the medium and long term we expect geopolitical risk to put a floor under the greenback. The bottom line is that the US dollar is at a critical technical crossroads where it could break out or break down. Macro factors suggest a breakdown but the recovery of global policy uncertainty and geopolitical risk suggests the opposite. We remain neutral. A final quantitative indicator of the recovery of geopolitical risk is the performance of global aerospace and defense stocks (Chart 4). Defense shares are rising in absolute and relative terms. Chart 4Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Can The WWII Peace Be Prolonged? Qualitative assessments of geopolitical risk are necessary to explain why risk is on a secular upswing – why drops in the quantitative indicators are temporary and the troughs keep getting higher. Great nations are returning to aggressive competition after a period of relative peace and prosperity. Over the past two decades Russia and China took advantage of America’s preoccupations with the Middle East, the financial crisis, and domestic partisanship in order to build up their global influence. The result is a world in which authority is contested. The current crisis is not merely about the end of the post-Cold War international order. It is much scarier than that. It is about the decay of the post-WWII international order and the return of the centuries-long struggle for global supremacy among Great Powers. The US and European political establishments fear the collapse of the WWII settlement in the face of eroding legitimacy at home and rising challenges from abroad. The 1945 peace settlement gave rise to both a Cold War and a diplomatic system, including the United Nations Security Council, for resolving differences among the great powers. It also gave rise to European integration and various institutions of American “liberal hegemony.” It is this system of managing great power struggle, and not the post-Cold War system of American domination, that lies in danger of unraveling. This is evident from the following points: American preeminence only lasted fifteen years, or at best until the 2008 Georgia war and global financial crisis. The US has been an incoherent wild card for at least 13 years now, almost as long as it was said to be the global empire. Russian antagonism with the West never really ended. In retrospect the 1990s were a hiatus rather than a conclusion of this conflict. China’s geopolitical rise has thawed the frozen conflicts in Asia from the 1940s-50s – i.e. the Chinese civil war, the Hong Kong and Taiwan Strait predicaments, the Korean conflict, Japanese pacifism, and regional battles for political influence and territory. Europe’s inward focus and difficulty projecting power have been a constant, as has its tendency to act as a constraint on America. Only now is Europe getting closer to full independence (which helped trigger Brexit). Geopolitical pressures will remain historically elevated for the foreseeable future because the underlying problem is whether great power struggle can be contained and major wars can be prevented. Specifically the question is whether the US can accommodate China’s rise – and whether China can continue to channel its domestic ambitions into productive uses (i.e. not attempts to create a Greater Chinese and then East Asian empire). The Great Recession killed off the “East Asia miracle” phase of China’s growth. Potential GDP is declining, which undermines social stability and threatens the Communist Party’s legitimacy. The renminbi is on a downtrend that began with the Xi Jinping era. The sharp rally during the COVID crisis is over, as both domestic and international pressures are rising again (Chart 5). Chart 5Biden Administration Review Of China Policy: More China Bashing Biden Administration Review Of China Policy: More China Bashing Biden Administration Review Of China Policy: More China Bashing While the data for China’s domestic labor protests is limited in extent, we can use it as a proxy for domestic instability in lieu of official statistics that were tellingly discontinued back in 2005. The slowdown in credit growth and the cyclical sectors of the economy suggest that domestic political risk is underrated in the lead up to the 2022 leadership rotation (Chart 6). Chart 6China's Domestic Political Risk Will Rise China's Domestic Political Risk Will Rise China's Domestic Political Risk Will Rise Chart 7Steer Clear Of Taiwan Strait Steer Clear Of Taiwan Strait Steer Clear Of Taiwan Strait The increasing focus on China’s access to key industrial and technological inputs, the tensions over the Taiwan Strait, and the formation of a Russo-Chinese bloc that is excluded from the West all suggest that the risk to global stability is grave and historic. It is reminiscent of the global power struggles of the seventeenth through early twentieth centuries. The outperformance of Taiwanese equities from 2019-20 reflects strong global demand for advanced semiconductors but the global response to this geopolitical bottleneck is to boost production at home and replace Taiwan. Therefore Taiwan’s comparative advantage will erode even as geopolitical risk rises (Chart 7). The drop in geopolitical tensions during COVID-19 is over, as highlighted above. With the US, EU, and other countries launching probes into whether the virus emerged from a laboratory leak in China – contrary to what their publics were told last year – it is likely that a period of national recriminations has begun. There is a substantial risk of nationalism, xenophobia, and jingoism emerging along with new sources of instability. An Alliance Of Democracies The Biden administration’s attempt to restore liberal hegemony across the world requires a period of alliance refurbishment with the Europeans. That is the purpose of his current trip to the UK, Belgium, and Switzerland. But diplomacy only goes so far. The structural factor that has changed is the willingness of the West to utilize government in the economic sphere, i.e. fiscal proactivity. Infrastructure spending and industrial policy, at the service of national security as well as demand-side stimulus, are the order of the day. This revolution in economic policy – a return to Big Government in the West – poses a threat to the authoritarian powers, which have benefited in recent decades by using central strategic planning to take advantage of the West’s democratic and laissez-faire governance. If the West restores a degree of central government – and central coordination via NATO and other institutions – then Beijing and Moscow will face greater pressure on their economies and fewer strategic options. About 16 American allies fall short of the 2% of GDP target for annual defense spending – ranging from Italy to Canada to Germany to Japan. However, recent trends show that defense spending did indeed increase during the Trump administration (Chart 8). Chart 8NATO Boosts Defense Spending Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was The European Union as a whole has added $50 billion to the annual total over the past five years. A discernible rise in defense spending is taking place even in Germany (Chart 9). The same point could be made for Japan, which is significantly boosting defense spending (as a share of output) after decades of saying it would do so without following through. A major reason for the American political establishment’s rejection of President Trump was the risk he posed to the trans-Atlantic alliance. A decline in NATO and US-EU ties would dramatically undermine European security and ultimately American security. Hence Biden is adopting the Trump administration’s hawkish approach to trade with China but winding down the trade war with Europe (Chart 10). Chart 9Europe Spending More On Guns Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 10US Ends Trade War With Europe? Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was A multilateral deal aimed at setting a floor in global corporate taxes rates is intended to prevent the US and Europe from undercutting each other – and to ensure governments have sufficient funding to maintain social spending and reduce income inequality (Chart 11). Inequality is seen as having vitiated sociopolitical stability and trust in government in the democracies. Chart 11‘Global’ Corporate Tax Deal Shows Return Of Big Government, Attempt To Reduce Inequality In The West Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Risks To Biden’s Diplomacy It is possible that Biden’s attempt to restore US alliances will go nowhere over the course of his four-year term in office. The Europeans may well remain risk averse despite their initial signals of willingness to work with Biden to tackle China’s and Russia’s challenges to the western system. The Germans flatly rejected both Biden and Trump on the Nord Stream II natural gas pipeline linkage with Russia, which is virtually complete and which strengthens the foundation of Russo-German engagement (more on this below). The US’s lack of international reliability – given the potential of another partisan reversal in four years – makes it very hard for countries to make any sacrifices on behalf of US initiatives. The US’s profound domestic divisions have only slightly abated since the crises of 2020 and could easily flare up again. A major outbreak of domestic instability could distract Biden from the foreign policy game.2 However, American incapacity is a risk, not our base case, over the coming years. We expect the US economic stimulus to stabilize the country enough that the internal political crisis will be contained and the US will continue to play a global role. The “Civil War Lite” has mostly concluded, excepting one or two aftershocks, and the US is entering into a “Reconstruction Lite” era. The implication is negative for China and Russia, as they will now have to confront an America that, if not wholly unified, is at least recovering. Congress’s impending passage of the Innovation and Competition Act – notably through regular legislative order and bipartisan compromise – is case in point. The Senate has already passed this approximately $250 billion smorgasbord of industrial policy, supply chain resilience, and alliance refurbishment. It will allot around $50 billion to the domestic semiconductor industry almost immediately as well as $17 billion to DARPA, $81 billion for federal research and development through the National Science Foundation, which includes $29 billion for education in science, technology, engineering, and mathematics, and other initiatives (Table 1). Table 1Peak Polarization: US Congress Passes Bipartisan ‘Innovation And Competition Act’ To Counter China Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was With the combination of foreign competition, the political establishment’s need to distract from domestic divisions, and the benefit of debt monetization courtesy of the Federal Reserve, the US is likely to achieve some notable successes in pushing back against China and Russia. On the diplomatic front, the US will meet with some success because the European and Asian allies do not wish to see the US embrace nationalism and isolationism. They have their own interests in deterring Russia and China. Lack Of Engagement With Russia Russian leadership has dealt with the country’s structural weaknesses by adopting aggressive foreign policy. At some point either the weaknesses or the foreign policy will create a crisis that will undermine the current regime – after all, Russia has greatly lagged the West in economic development and quality of life (Chart 12). But President Putin has been successful at improving the country’s wealth and status from its miserably low base in the 1990s and this has preserved sociopolitical stability so far. Chart 12Russia's Domestic Political Risk Russia's Domestic Political Risk Russia's Domestic Political Risk It is debatable whether US policy toward Russia ever really changed under President Trump, but there has certainly not been a change in strategy from Russia. Thus investors should expect US-Russia antagonism to continue after Biden’s summit with Putin even if there is an ostensible improvement. The fundamental purpose of Putin’s strategy has been to salvage the Russian empire after the Soviet collapse, ensure that all world powers recognize Russia’s veto power over major global policies and initiatives, and establish a strong strategic position for the coming decades as Russia’s demographic decline takes its toll. A key component of the strategy has been to increase economic self-sufficiency and reduce exposure to US sanctions. Since the invasion of Ukraine in 2014, Putin has rapidly increased Russia’s foreign exchange reserves so as to buffer against shocks (Chart 13). Chart 13Russia Fortified Against US Sanctions Russia Fortified Against US Sanctions Russia Fortified Against US Sanctions Putin has also reduced Russia’s reliance on the US dollar to about 22% (Chart 14), primarily by substituting the euro and gold. Russia will not be willing or able to purge US dollars from its system entirely but it has been able to limit America’s ability to hurt Russia by constricting access to dollars and the dollar-based global financial architecture. Russian Finance Minister Anton Siluanov highlighted this process ahead of the Biden-Putin summit by declaring that the National Wealth Fund will divest of its remaining $40 billion of its US dollar holdings. Chart 14Russia Diversifies From USD Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was In general this year, Russia is highlighting its various advantages: its resilience against US sanctions, its ability to re-invade Ukraine, its ability to escalate its military presence in Belarus and the Black Sea, and its ability to conduct or condone cyberattacks on vital American food and fuel supplies (Chart 15). Meanwhile the US is suffering from deep political divisions at home and strategic incoherence abroad and these are only starting to be mended by domestic economic stimulus and alliance refurbishment. Chart 15Cyber Security Stocks Recover Cyber Security Stocks Recover Cyber Security Stocks Recover Europe’s risk-aversion when it comes to strategic confrontation with Russia, and the lack of stability in US-Russia relations, means that investors should not chase Russian currency or financial assets amid the cyclical commodity rally. Investors should also expect risk premiums to remain high in developing European economies relative to their developed counterparts. This is true despite the fact that developed market Europe’s outperformance relative to emerging Europe recently peaked and rolled over. From a technical perspective this outperformance looks to subside but geopolitical tensions can easily escalate in the near term, particularly in advance of the Russian and German elections in September (Chart 16). Chart 16Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Europe trades in line with EUR-RUB and these pair trades all correspond closely to geopolitical tensions with Russia (Chart 17). A notable exception is the UK, whose stock market looks attractive relative to eastern Europe and is much more secure from any geopolitical crisis in this region (Chart 17, bottom panel). The pound is particularly attractive against the Czech koruna, as Russo-Czech tensions have heated up in advance of October’s legislative election there (Chart 18). Chart 17Long UK Versus Eastern Europe Long UK Versus Eastern Europe Long UK Versus Eastern Europe Chart 18Long GBP Versus CZK Long GBP Versus CZK Long GBP Versus CZK Meanwhile Russia and China have grown closer together out of strategic necessity. Germany’s Election And Stance Toward Russia Germany’s position on Russia is now critical. The decision to complete the Nord Stream II pipeline against American wishes either means that the Biden administration can be safely ignored – since it prizes multilateralism and alliances above all things and is therefore toothless when opposed – or it means that German will aim to compensate the Americans in some other area of strategic concern. Washington is clearly attempting to rally the Germans to its side with regard to putting pressure on China over its trade practices and human rights. This could be the avenue for the US and Germany to tighten their bond despite the new milestone in German-Russia relations. The US may call on Germany to stand up for eastern Europe against Russian aggression but on that front Berlin will continue to disappoint. It has no desire to be drawn into a new Cold War given that the last one resulted in the partition of Germany. The implication is negative for China on one hand and eastern Europe on the other. Germany’s federal election on September 26 will be important because it will determine who will succeed Chancellor Angela Merkel, both in Germany and on the European and global stage. The ruling Christian Democratic Union (CDU) is hoping to ride Merkel’s coattails to another term in charge of the government. But they are likely to rule alongside the Greens, who have surged in opinion polls in recent years. The state election in Saxony-Anhalt over the weekend saw the CDU win 37% of the popular vote, better than any recent result, while Germany’s second major party, the Social Democrats, continued their decline (Table 2). The far-right Alternative for Germany won 21% of the vote, a downshift from 2016, while the Greens won 6% of the vote, a slight improvement from 2016. All parties underperformed opinion polling except the CDU (Chart 19). Table 2Saxony-Anhalt Election Results Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 19Germany: Conservatives Outperform In Final State Election Before Federal Vote, But Face Challenges Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 20Germany: Greens Will Outperform in 2021 Vote Germany: Greens Will Outperform in 2021 Vote Germany: Greens Will Outperform in 2021 Vote The implication is still not excellent for the CDU. Saxony-Anhalt is a middling German state, a CDU stronghold, and a state with a popular CDU leader. So it is not representative of the national campaign ahead of September. The latest nationwide opinion polling puts the CDU at around 25% support. They are neck-and-neck with the Greens. The country’s left- and right-leaning ideological blocs are also evenly balanced in opinion polls (Chart 20). A potential concern for the CDU is that the Free Democratic Party is ticking up in national polls, which gives them the potential to steal conservative votes. Betting markets are manifestly underrating the chance that Annalena Baerbock and the Greens take over the chancellorship (Charts 21A and 21B). We still give a subjective 35% chance that the Greens will lead the next German government without the CDU, a 30% that the Greens will lead with the CDU, and a 25% chance that the CDU retains power but forms a coalition with the Greens. A coalition government would moderate the Greens’ ambitious agenda of raising taxes on carbon emissions, wealth, the financial sector, and Big Tech. The CDU has already shifted in a pro-environmental, fiscally proactive direction. Chart 21AGerman Greens Will Recover Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 21BGerman Greens Still Underrated Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was No matter what the German election will support fiscal spending and European solidarity, which is positive for the euro and regional equities over the next 12 to 24 months. However, the Greens would pursue a more confrontational stance toward Russia, a petro-state whose special relations with the German establishment have impeded the transition to carbon neutrality. Latin America’s Troubles A final aspect of Biden’s agenda deserves some attention: immigration and the Mexican border. Obviously this one of the areas where Biden starkly differs from Trump, unlike on Europe and China, as mentioned above. Vice President Kamala Harris recently came back from a trip to Guatemala and Mexico that received negative media attention. Harris has been put in charge of managing the border crisis, the surge in immigrant arrivals over 2020-21, both to give her some foreign policy experience and to manage the public outcry. Despite telling immigrants explicitly “Do not come,” Harris has no power to deter the influx at a time when the US economy is fired up on historic economic stimulus and the Democratic Party has cut back on all manner of border and immigration enforcement. From a macro perspective the real story is the collapse of political and geopolitical risk in Mexico. From 2016-20 Mexico faced a protectionist onslaught from the Trump administration and then a left-wing supermajority in Congress. But these structural risks have dissipated with the USMCA trade deal and the inability of President Andrés Manuel López Obrador to follow through with anti-market reforms, as we highlighted in reports in October and April. The midterm election deprived the ruling MORENA party of its single-party majority in the Chamber of Deputies, the lower house of the legislature (Chart 22). AMLO is now politically constrained – he will not be able to revive state control over the energy and power sectors. Chart 22Mexican Midterm Election Constrained Left-Wing Populism, Political Risk Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Chart 23Buy Mexico (And Canada) On US Stimulus Buy Mexico (And Canada) On US Stimulus Buy Mexico (And Canada) On US Stimulus American monetary and fiscal stimulus, and the supply-chain shift away from China, also provide tailwinds for Mexico. In short, the Mexican election adds the final piece to one of our key themes stemming from the Biden administration, US populism, and US-China tensions: favor Mexico and Canada (Chart 23). A further implication is that Mexico should outperform Brazil in the equity space. Brazil is closely linked to China’s credit cycle and metals prices, which are slated to turn down as a result of Chinese policy tightening. Mexico is linked to the US economy and oil prices (Chart 24). While our trade stopped out at -5% last week we still favor the underlying view. Brazilian political risk and unsustainable debt dynamics will continue to weigh on the currency and equities until political change is cemented in the 2022 election and the new government is then forced by financial market riots into undertaking structural reforms. Chart 24Brazil's Troubles Not Truly Over - Mexico Will Outperform Brazil's Troubles Not Truly Over - Mexico Will Outperform Brazil's Troubles Not Truly Over - Mexico Will Outperform Elsewhere in Latin America, the rise of a militant left-wing populist to the presidency in a contested election in Peru, and the ongoing social unrest in Colombia and Chile, are less significant than the abrupt slowdown in China’s credit growth (Charts 25A and 25B). According to our COVID-19 Social Stability Index, investors should favor Mexico. Turkey, the Philippines, South Africa, Colombia, and Brazil are the most likely to see substantial social instability according to this ranking system (Table 3). Chart 25AMexico To Outperform Latin America Mexico To Outperform Latin America Mexico To Outperform Latin America Chart 25BChina’s Slowdown Will Hit South America China's Slowdown Will Hit South America China's Slowdown Will Hit South America Table 3Post-COVID Emerging Market Social Unrest Only Just Beginning Joe Biden Is Who We Thought He Was Joe Biden Is Who We Thought He Was Investment Takeaways Close long emerging markets relative to developed markets for a loss of 6.8% – this is a strategic trade that we will revisit but it faces challenges in the near term due to China’s slowdown (Chart 26). Go long Mexican equities relative to emerging markets on a strategic time frame. Our long Mexico / short Brazil trade hit the stop loss at 5% but the technical profile and investment thesis are still sound over the short and medium term. Chart 26China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets Chart 27Relative Uncertainty And Safe Havens Relative Uncertainty And Safe Havens Relative Uncertainty And Safe Havens China’s sharp fiscal-and-credit slowdown suggests that investors should reduce risk exposure, take a defensive tactical positioning, and wait for China’s policy tightening to be priced before buying risky assets. Our geopolitical method suggests the dollar will rise, while macro fundamentals are becoming less dollar-bearish due to China. We are neutral for now and will reassess for our third quarter forecast later this month. If US policy uncertainty falls relative to global uncertainty then the EUR-USD will also fall and safe-haven assets like Swiss bonds will gain a bid (Chart 27). Gold is an excellent haven amid medium-term geopolitical and inflation risks but we recommend closing our long silver trade for a gain of 4.5%. Disfavor emerging Europe relative to developed Europe, where heavy discounts can persist due to geopolitical risk premiums. We will reassess after the Russian Duma election in September. Go long GBP-CZK. Close the Euro “laggards” trade. Go long an equal-weighted basket of euros and US dollars relative to the Chinese renminbi. Short the TWD-USD on a strategic basis. Prefer South Korea to Taiwan – while the semiconductor splurge favors Taiwan, investors should diversify away from the island that lies at the epicenter of global geopolitical risk. Close long defense relative to cyber stocks for a gain of 9.8%. This was a geopolitical “back to work” trade but the cyber rebound is now significant enough to warrant closing this trade.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Trump’s policy toward Russia is an excellent example of geopolitical constraints. Despite any personal preferences in favor of closer ties with Russia, Trump and his administration ultimately reaffirmed Article 5 of NATO, authorized the sale of lethal weapons to Ukraine, and deployed US troops to Poland and the Czech Republic. 2 As just one example, given the controversial and contested US election of 2020, it is possible that a major terrorist attack could occur. Neither wing of America’s ideological fringes has a monopoly on fanaticism and violence. Meanwhile foreign powers stand to benefit from US civil strife. A truly disruptive sequence of events in the US in the coming years could lead to greater political instability in the US and a period in which global powers would be able to do what they want without having to deal with Biden’s attempt to regroup with Europe and restore some semblance of a global police force. The US would fall behind in foreign affairs, leaving power vacuums in various regions that would see new sources of political and geopolitical risk crop up. Then the US would struggle to catch up, with another set of destabilizing consequences.

Highlights In the near term, the RMB against the US dollar has ceased to be a one-way bet. Market sentiment will re-focus on economic fundamentals, which are less supportive of further RMB appreciation.  In the longer term, the RMB still has some upside potential, but the pace of its growth should be much slower than in the past 12 months. The sharp rise in the trade-weighted RMB index is starting to threaten China’s export sector and has exacerbated the tightening of domestic monetary conditions. Barring a monetary policy reset by Chinese authorities, even a small increase in the broad-RMB index would heighten the risk of a contraction in corporate profit growth in the coming 12 months. We remain risk adverse to Chinese stocks for the next 6 months. Feature Chart 1The RMB Back On A Fast Ascending Path The RMB Back On A Fast Ascending Path The RMB Back On A Fast Ascending Path After a brief pause in March, China’s currency versus the US dollar extended its steep upward trend began in mid-2020 (Chart 1). Chinese policymakers recently ramped up their strong-worded statements warning against speculating on the RMB. Regulators have also taken steps to stem the rise. Questions we have recently been getting from our clients about the RMB can be summarized as follows: After a 10% appreciation since its trough a year ago, does the RMB have more upside in 2021 and beyond? If the RMB continues to appreciate, what would be the impact on China’s economy and corporate sector? What can the PBoC do to slow the pace of the currency’s appreciation? One could argue that the US dollar will continue to weaken, but we see substantial headwinds to the RMB within the year. A weaker US dollar would support global stock prices outside of the US and foreign inflows have driven the recent rally in China’s onshore stocks. However, we think China’s domestic macro policy and economic conditions pose more downside risks on a cyclical basis. How Far Can The RMB Go? A continued upswing in the CNY relative to the USD can no longer be taken for granted. In the coming months, there is a strengthening case for the RMB to fall against the greenback as factors supporting a strong RMB in the past year start to abate. Economic fundamentals will no longer prop up the RMB’s rise going into 2H21. China’s growth momentum is softening due to significant tightening in the monetary environment in the second half of last year and a rapid deceleration in credit growth this year (Chart 2). Meanwhile, the massive rollouts of COVID-19 vaccines in North America and Europe have successfully reduced new infections and hospitalization rates, allowing these countries to reopen their economies. The economic growth gaps between China and the developed markets (DMs) will narrow more significantly in the coming months (Chart 3). Chart 2Chinese Economic Fundamentals Will Start To Weaken Chinese Economic Fundamentals Will Start To Weaken Chinese Economic Fundamentals Will Start To Weaken Chart 3China's Growth Gap Relative To DMs Will Narrow China's Growth Gap Relative To DMs Will Narrow China's Growth Gap Relative To DMs Will Narrow Chart 4Global Consumption Recovery In Services Will Likely Outpace Goods Global Consumption Recovery In Services Will Likely Outpace Goods Global Consumption Recovery In Services Will Likely Outpace Goods China’s large current account surplus will likely start narrowing. It has been driven by strong global demand for goods, which is unlikely to be sustained as the pent-up demand for services in DMs will outpace the consumption for goods (Chart 4). Emerging countries (EMs), many of which are China’s export competitors, lag far behind DMs and China on inoculation rates and some have resurging COVID cases (Chart 5). However, EMs will likely benefit from meaningful expansions in global vaccine production in the second half of the year.1 A catchup in vaccinations in these countries will reduce China’s export-sector advantage, reversing the RMB’s gains over other Asian currencies in the past month. Chart 5China's Asian Neighbors Have Been Hit By Resurging COVID Cases China's Asian Neighbors Have Been Hit By Resurging COVID Cases China's Asian Neighbors Have Been Hit By Resurging COVID Cases The future trend of the USD also matters to the USD/CNY exchange rate. The recent strength of the CNY vis-à-vis the dollar was the mirror image of USD weakness, which has been due to low real rates in the US and recovering economic momentum outside the US (Chart 6). However, the broad dollar index is sitting at a critical technical level that could either breakout or breakdown (Chart 7). When the Fed announces the slowing of asset purchases, which our BCA US Bond Strategy expects before the end of 2021, it could lead to higher US real yields and reverse the trend of hot money flows into China. Chart 6The Sharp Rise In The RMB In The Past Two Months Has Been Dollar-Driven The Sharp Rise In The RMB In The Past Two Months Has Been Dollar-Driven The Sharp Rise In The RMB In The Past Two Months Has Been Dollar-Driven Chart 7The Dollar Index: Breakout or Breakdown? The Dollar Index: Breakout or Breakdown? The Dollar Index: Breakout or Breakdown? Furthermore, the financial market does not seem to have priced in unstable US-China relations, which could undermine global risk appetite (Chart 8). Recent actions by US President Joe Biden – from expanding the investment ban on 59 blacklisted Chinese tech companies to calling for the US intelligence community to investigate the origins of COVID-19 – point to risks for escalating tensions between the two nations. Longer term, the RMB is at about one standard deviation below its fair value, which suggests that it still has more upside potential (Chart 9). Based on our BCA’s Foreign Exchange Strategist’s real effective exchange rate (REER) model, the RMB’s fair value mostly climbed in the past three decades, driven by higher productivity in China relative to its trading partners. However, part of the RMB’s appreciation since mid-2020 has been a catch up to its pre-trade war value and its valuation gap has rapidly narrowed. From the current valuation levels, the pace of RMB appreciation should be much slower going forward. Chart 8Geopolitical Surprises Could Spook The Market Geopolitical Surprises Could Spook The Market Geopolitical Surprises Could Spook The Market Chart 9Valuation Gap Has Rapidly Narrowed Valuation Gap Has Rapidly Narrowed Valuation Gap Has Rapidly Narrowed We also expect China’s real interest rates relative to the US to dwindle in the next three to five years. Demographic headwinds in China herald lower real rates while the Fed is primed to start rate liftoffs within the next two years. Bottom Line: The RMB still has some upside potential in the long run, but the pace of its appreciation should be much slower than in the past 12 months. In the near term, odds are high that economic fundamentals will not boost the RMB any further.  How Does A Stronger RMB Affect China’s Economy? Historically, a stronger RMB relative to the dollar has not had a significant impact on China’s economy. However, if the CNY appreciates considerably versus the greenback so that it pushes up the trade-weighted RMB index, then China’s corporate profits will be negatively affected (Chart 10). Chart 10Strengthening Broad-RMB Index Has Historically Led To Weaker Corporate Profit Growth... Strengthening Broad-RMB Index Has Historically Led To Weaker Corporate Profit Growth... Strengthening Broad-RMB Index Has Historically Led To Weaker Corporate Profit Growth... Chart 11...And Could Significantly Raise Prob Of A Earnings Contraction In 12 Months ...And Could Significantly Raise Prob Of A Earnings Contraction In 12 Months ...And Could Significantly Raise Prob Of A Earnings Contraction In 12 Months Our earnings growth recession probability model confirms our view. If all else is equal, a 3% rise in the trade-weighted RMB index from its current level would more than double the probability of a contraction in earnings growth in the coming 12 months (Chart 11, Scenario 1). On the other hand, all else will not be equal if the broad RMB index goes up by 3%. A quick increase in the RMB’s value against the currencies of its trading partners will impede China’s export growth and tighten domestic monetary conditions. Chart 12Moving Into Restrictive Territory For Chinese Exports Moving Into Restrictive Territory For Chinese Exports Moving Into Restrictive Territory For Chinese Exports Chart 12 shows the impact on export growth from the speed of the RMB’s appreciation; we calculate the rise in an export-weighted RMB index relative to its highs and lows in the past few years. The metric implies that the acceleration in the RMB’s value has reached levels that should be restrictive for exports. The nominal export-weighted RMB index has been significantly above the median value since 2015 and it is approaching the peak reached in that year. Clearly, the strong RMB is linked to a recent weakness in the PMI surveys on export orders. A 3% increase in the trade-weighted RMB from the current level, coupled with a drop in export growth and further deceleration in credit impulse would prop up the earnings contraction probability to more than 50% (Scenario 2 in Chart 11 above). Bottom Line: Our metrics suggest that the RMB’s recent sharp rise is starting to threaten the export sector. An additional 3% appreciation in the broad RMB index would cause a meaningful increase in the probability of a corporate earnings growth contraction in the coming 12 months. What Can The PBoC Do To Halt The RMB Rally? We break this question into two parts: the willingness and the capability of the PBoC to intervene in the currency market.  On the first aspect, the PBoC in recent years has largely refrained from draconian intervention measures in the currency market. Allowing a more market-based currency exchange rate regime is a crucial part of China’s RMB internationalization process. The PBoC seems to be mostly sticking to this long-term goal. Chart 13New FX Regime Began In 2015 Has Significantly Lowered USD Weight In The Broad-RMB Index... New FX Regime Began In 2015 Has Significantly Lowered USD Weight In The Broad-RMB Index... New FX Regime Began In 2015 Has Significantly Lowered USD Weight In The Broad-RMB Index... Importantly, the new exchange rate regime that the PBoC switched to at end-2015 has greatly weakened the link between the USD and the broad RMB trend (Chart 13). Since then China has continuously cut the weighting of the USD in the CFETS currency index basket, which has reduced the impact of dollar moves on the index. Therefore, the PBoC has mostly ignored short-term volatilities in the CNY/USD exchange rate. The central bank tends to intervene only when swings in the CNY/USD exchange rate are large enough and/or the market forms a unilateral view on the Chinese currency to drive sustained movements in the broader RMB index.  For example, the RMB value rose at a much faster rate against the USD compared with its other trading partners in the second half of 2020. However, this year, the pace of growth in the broad RMB index has caught up with that of the CNY/USD appreciation. Moreover, even when the RMB depreciated against the USD in March, the CFETS index basket kept rising and is now breaching its previous peak in April 2018 (Chart 14). As discussed in the previous section, a sharp jump in the trade-weighted RMB would be more detrimental to China’s corporate profits than an increase in the CNY/USD. Chart 14...But The Massive Appreciation In The CNY/USD Of Late Has Pushed The RMB Index To A Three-Year High ...But The Massive Appreciation In The CNY/USD Of Late Has Pushed The RMB Index To A Three-Year High ...But The Massive Appreciation In The CNY/USD Of Late Has Pushed The RMB Index To A Three-Year High Chart 15The PBoC Has Been Trying To Guide Market Expectations Lower On The RMB The PBoC Has Been Trying To Guide Market Expectations Lower On The RMB The PBoC Has Been Trying To Guide Market Expectations Lower On The RMB On the second aspect, the PBoC is unlikely to alter its monetary policy trajectory to tame the RMB’s appreciation. A looser monetary environment would encourage more asset price bubbles domestically and jeopardize policymakers’ ongoing progress in financial and property-market de-risking. If the CFETS strengthens further, Chinese authorities will probably use tools such as managing market expectations and various capital controls to mop up excess FX liquidity generated from capital inflows. In the near term, the PBoC may set a weaker fixing rate against the dollar to dampen market expectations for more RMB growth (Chart 15). An increase in the FX deposit reserve requirement ratio (RRR) rate, announced by the PBoC last week, is another example of the central bank trying to prevent a one-sided expectation by market participants. However, the previous three FX deposit RRR hikes –all taken place more than a decade ago—did little to alter the path of the CNY exchange rate; the pace of USD/CNY depreciation actually accelerated following the May 2007 RRR hike.  The two-percentage point bump in the FX deposit RRR rate will drain China’s domestic FX liquidity by about US$20 billion. Its effect on domestic FX liquidity and FX loan rates is rather limited – FX inflows to Chinese financial institutions since 2H20 were more than US$20 billion a month –more than offsetting the tightening from a RRR rate hike.  The PBoC can further loosen outward capital controls to release some pressure on the RMB’s increase. In a report from November last year we wrote that Chinese policymakers attempted to slow the pace of appreciation in the RMB through a build-up in strategic FX assets by commercial banks and other financial institutions . Since August last year, China has relaxed outbound investment regulations and increased quotas to help channel domestic money into offshore financial markets. China’s commercial banks significantly ramped up their FX assets last year (Chart 16). In Q1 this year, commercial banks enriched their FX asset holdings by US$518.5 billion, a record high in the past five years.  Bottom Line: The PBoC is willing to allow more volatility in the USD/CNY exchange rate, but a sharp jump in the RMB’s value against a basket of other currencies would warrant further policy actions. Chart 16Chinese Banks Ramped Up FX Asset Holdings Chinese Banks Ramped Up FX Asset Holdings Chinese Banks Ramped Up FX Asset Holdings Chart 17Chinese Onshore Stocks Propped Up By Foreign Investors Chinese Onshore Stocks Propped Up By Foreign Investors Chinese Onshore Stocks Propped Up By Foreign Investors Investment Conclusions A tightened monetary and credit environment has created headwinds for Chinese equities since early this year. However, the domestic market appears to have found support at a key technical level of late (Chart 17). The recent rebound in China’s onshore stocks on the back of a sharp CNY appreciation and accelerated foreign capital inflows, in our view, are unsustainable on a cyclical basis. Despite buoyant global economic growth, investors should consider deteriorating cyclical conditions in China when judging the appropriate allocation for Chinese equities. While policy tightening has brought multiples closer to earth than last year, the upside in Chinese stock prices will be capped by subsiding stimulus and slower profit growth ahead. As such, a decisive breakout to the upside in Chinese stock prices will require major reflationary catalysts, and it is the reason we are still risk adverse on Chinese equities (Chart 18). Meanwhile, we continue to favor onshore consumer discretionary stocks relative to the broad A-share market. A strong RMB can be a booster to domestic discretionary spending. We initiated this trade in May last year and it has largely outperformed China’s onshore broad market (Chart 19). We will close the trade when the CNY loses its strength and Chinese domestic demand starts to falter. Chart 18Cyclical Performance In Chinese Stocks Is Still Driven By Economic Fundamentals Cyclical Performance In Chinese Stocks Is Still Driven By Economic Fundamentals Cyclical Performance In Chinese Stocks Is Still Driven By Economic Fundamentals Chart 19Keep A Long CD Position, But On A Short Leash Keep A Long CD Position, But On A Short Leash Keep A Long CD Position, But On A Short Leash   Jing Sima China Strategist jings@bcaresearch.com Footnotes 1The UN estimates that as many as 15 billion vaccine doses could be produced by the second half of 2021, enough to inoculate most of the world’s population. Cyclical Investment Stance Equity Sector Recommendations