Mega Themes

Highlights The report from last week’s National People’s Congress (NPC) indicates a gradual pullback in policy support this year. Fiscal thrust will be neutral in 2021, whereas the rate of credit expansion will be slightly lower compared with last year. China’s economy should run on its own momentum in the first half, before slowing to a benign and managed rate. Nonetheless, the risk of policy overtightening is nontrivial and could threaten the cyclical outlook on China’s economy and corporate profits. The recent price correction in Chinese stocks has not yet run its course. Moreover, equity prices in both onshore and offshore markets are breaching their technical resistance. We are downgrading our tactical (0 to 3 months) and cyclical (6 to 12 months) positions on Chinese stocks to underweight relative to global benchmarks. Feature China’s budget and key economic initiatives unveiled at last week’s NPC indicate that policy tightening will be gradual this year. Overall, maintaining stability, both socially and economically, remains the focal point of Premier Li Keqiang’s work plan presented at the NPC’s annual plenary session in Beijing. However, investors have centered on the government’s plan to have a smaller policy push on growth in its budget compared with last year, fearing that economic and corporate profit rebound will disappoint. The Shanghai Composite Index dropped by 6% during the week when the NPC took place. In our view, the risks of a policy over-tightening in the next six months are high. As such, with this report we are downgrading our cyclical call on Chinese stocks to underweight within a global equity portfolio.      Reading Policy Tea Leaves China's growth trajectory since the middle of 2020 has given the government comfort in staying the course on policy normalization. The question is how much Chinese policymakers are willing to pull back support for the economy this year. Overall, the central government plans a smaller policy push in this year's budget and intends to let the economy run on its own steam. Further policy reflation is not in the cards unless a relapse in the economy threatens job creation. The NPC outlined a growth target “above 6%” for 2021 and did not set a numerical goal for the 14th Five-Year Plan from 2021 to 2025. However, de-emphasizing growth does not mean China has abandoned its GDP targets (Table 1). Indeed, in most years in the past two decades, China’s expansion in GDP has overshot objectives set at the NPC (Chart 1). Our baseline estimate is that real GDP will increase by 8% in 2021. Table 12021 Economic And Policy Targets National People’s Congress Sets Tone For 2021 Growth National People’s Congress Sets Tone For 2021 Growth Chart 1Actual Econ Growth Rates Have Overshot Targets In Most Years Actual Econ Growth Rates Have Overshot Targets In Most Years Actual Econ Growth Rates Have Overshot Targets In Most Years   We also maintain our view that the rate of credit expansion will be reduced by 2 to 3 percentage points this year to about 11% annually, which is in line with nominal GDP growth (Chart 2). On the fiscal front, the target for a budget deficit was cut by less than half percentage point compared with last year. When taking into account both the government’s budgetary and fund expenditures, the broad-measure fiscal deficit will probably be around 8% of GDP (about the same as last year), which implies there will not be any fresh fiscal thrust in 2021 (Chart 3) Chart 2Credit Growth Will Decelerate From Last Year Credit Growth Will Decelerate From Last Year Credit Growth Will Decelerate From Last Year Chart 3Neutral Fiscal Thrust Neutral Fiscal Thrust Neutral Fiscal Thrust The pullback in fiscal impulse is larger than in 2010, 2014, and 2017, following the previous three fiscal expansionary cycles. However, the government's eased budget deficit target this year does not mean government expenditure growth will slow. Government revenues climbed sharply by the end of 2020 and will continue to improve this year (Chart 4). Higher revenues will allow more government spending while keeping the fiscal deficit within its objectives. Chart 4Gov Revenue Is On The mend But Spending Has Yet To Pick Up Gov Revenue Is On The mend But Spending Has Yet To Pick Up Gov Revenue Is On The mend But Spending Has Yet To Pick Up Chart 5A Small Reduction In ##br##LG Bond Quota National People’s Congress Sets Tone For 2021 Growth National People’s Congress Sets Tone For 2021 Growth Furthermore, the quota for local government special purpose bonds was reduced by only 2% from last year.  It should help to support a steady growth in China’s infrastructure investment (Chart 5). The data from January and February total social financing shows a noticeable improvement in corporate demand for bank loans, as well as the composition of bank loans. Corporate demand for medium- and long-term loans remains on a strong uptrend, which reflects an ongoing recovery in corporate profits and supports an optimistic view on capital investment in the months ahead (Chart 6). Chart 6More Demand For Longer-Term Loans Reflects Better Investment Propensity More Demand For Longer-Term Loans Reflects Better Investment Propensity More Demand For Longer-Term Loans Reflects Better Investment Propensity Bottom Line: The growth and budget targets set at this year’s NPC suggest only a modest pullback in policy support. Downside Risks To The Economy Chart 7Econ Growth Usually Peaks Six To Nine Months After Credit Expansion Rate Slows Econ Growth Usually Peaks Six To Nine Months After Credit Expansion Rate Slows Econ Growth Usually Peaks Six To Nine Months After Credit Expansion Rate Slows Despite a relatively dovish tone from the NPC, investors should not be complacent about the risk of a policy-tightening overshoot, which could lead to disappointing economic and profit growth this year.  In most of the previous policy tightening cycles, China’s economic activities remained resilient in the first 6 to 9 months (Chart 7). One exception was 2014, when nominal GDP growth dropped sharply as soon as credit growth slowed. The reason is that Chinese authorities kept a very disciplined fiscal stance and aggressively tightened monetary policy, while allowing the RMB to soft peg to a rising USD. In other words, macroeconomic policies were too restrictive during the 2013/14 cycle. Although messages from the NPC do not suggest that Chinese authorities are on such an aggressive tightening path this year, investors should watch the following signs that could threaten China's cyclical economic health: Policymakers may keep monetary conditions too tight, by allowing the RMB to rise too fast while lifting bank lending and policy rates. Currently rates are maintained at historically low levels, much lower than in previous policy tightening cycles (Chart 8). However, the trade-weighted RMB has appreciated by 6% since its trough in July last year and has returned to its pre US-China trade war level (Chart 9).  The Chairman of China’s Banking and Insurance Regulatory Commission recently signaled that bank lending rates would climb. Although we do not expect the rate to return to its 2014 or 2017 level, China is much more indebted than in previous cycles. Even a small bump in interest rates will place a burden on corporates and local governments’ debt servicing cost, dampening their propensity to invest (Chart 10).  Chart 8Aggressive Rate Hikes Are ##br##Unlikely This Year Aggressive Rate Hikes Are Unlikely This Year Aggressive Rate Hikes Are Unlikely This Year Chart 9Rising RMB Should Refrain Chinese Policymakers From Further Tightening Monetary Stance Rising RMB Should Refrain Chinese Policymakers From Further Tightening Monetary Stance Rising RMB Should Refrain Chinese Policymakers From Further Tightening Monetary Stance Chart 10Chinese Private Sector Has Become Much More Sensitive To Rising Interest Rates Chinese Private Sector Has Become Much More Sensitive To Rising Interest Rates Chinese Private Sector Has Become Much More Sensitive To Rising Interest Rates Chart 11Bank Lending To Property Sector Has Become Increasingly Restrictive Bank Lending To Property Sector Has Become Increasingly Restrictive Bank Lending To Property Sector Has Become Increasingly Restrictive   Policies could become too restrictive in key old-economy industries. Chinese authorities have reiterated their determination to contain price bubbles in the property sector. For the first time since 2017, bank lending to real estate developers grew at a pace far below overall bank loans and continued to trend downward in February this year (Chart 11). Moreover, household mortgage loans have reached their slowest expansion rate since 2013.  At 22% of China’s total bank lending, a sharp setback in the property sector’s loan growth will be a significant drag on total credit and the economy.   A worsened imbalance in supply and demand could lead to too much buildup in industrial inventory. Manufacturing inventories recovered sharply following last year’s massive stimulus and many sectors have surpassed their pre-pandemic levels (Chart 12). Strong external demand helped to boost China’s production and propensity to restock on raw materials. However, both China’s core CPI and producer prices for consumer goods remain in the doldrums, which indicates that domestic final demand has yet to fully recover (Chart 13).  As discussed in last week’s report, reopening the world economy in 2H21 should benefit the service sector more than tradeable goods. China’s inventory buildup, particularly in the upstream industries, could turn excessive when export growth slows and domestic demand fails to pick up the slack. Chart 12How Far Can Chinas Inventory Restocking Cycle Go? How Far Can Chinas Inventory Restocking Cycle Go? How Far Can Chinas Inventory Restocking Cycle Go? Chart 13Final Demand Remains ##br##Weak Final Demand Remains Weak Final Demand Remains Weak The service sector could take longer than expected to recuperate, even though China’s domestic COVID-19 situation is under control. China’s services sector has flourished in recent years and accounted for 54% of the nation’s pre-pandemic economic output. However, about half of the service sector output is tied to real estate and financial services. Increasing pressures from tighter policy regulations targeting both the property and online financial service sectors could dampen their support to the economy more than policymakers anticipated. At the same time, wage and household income growth could remain tame by China’s standards (Chart 14).   The NPC’s targeted 7% annual increase in spending for national research and development – far below the 12% annual average reached during the past five years – will not be enough to offset the slowdowns in real estate and financial services (Chart 15). Chart 14Household Income Growth Has Yet To Recover Household Income Growth Has Yet To Recover Household Income Growth Has Yet To Recover Chart 15Chinas Pace Of R&D Investment Has Slowed Along With Econ Growth Chinas Pace Of R&D Investment Has Slowed Along With Econ Growth Chinas Pace Of R&D Investment Has Slowed Along With Econ Growth Bottom Line: The downside risks to China’s cyclical growth trajectory are nontrivial. A tug-of-war between policy tightening and growth support will likely persist throughout this year. Investment Implications We recommend investors to underweight Chinese stocks within a global equity portfolio, in the next 0 to 9 months (Chart 16A and 16B). Chart 16AChinese Stocks Are At Their Technical Resistance Chinese Stocks Are At Their Technical Resistance Chinese Stocks Are At Their Technical Resistance Chart 16BChinese Stocks Are At Their Technical Resistance Chinese Stocks Are At Their Technical Resistance Chinese Stocks Are At Their Technical Resistance On January 13, we tactically downgraded Chinese stocks from overweight to neutral, anticipating that China’s equity markets are sensitive to rising expectations of policy tightening, due to higher corporate debt-servicing costs and lofty valuations.  Chinese stock prices peaked in mid-February, but in our view the correction has not yet run its course. In terms of the economy, we maintain our baseline view that China's overall policy environment this year will be more accommodative than in 2017/18. The growth momentum carried over from last year's stimulus should prevent China's economy and corporate profits from slumping by too much this year. However, as policy supports are scaled back, investors will increasingly focus on the intensity of China’s domestic policy tightening and the uncertainties surrounding it. Downside risks are nontrivial and will continue to weigh on investors' sentiment. For investors that are mainly exposed to the Chinese domestic equity market, the near-term setbacks in the A-share market are taking some air out of Chinese equities' frothy valuations, and may pave the way for a more optimistic cyclical outlook beyond the next 9 to 12 months. We recommend domestic investors to stay on the sidelines for now, but will start recommending sector rotations in the next few months when opportunities arise. Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights The Biden administration’s early actions suggest it will be hawkish on China as expected – and the giant Microsoft hack merely confirms the difficulty of reducing strategic tensions. US-China talks are set to resume and piecemeal engagement is possible. However, most of the areas of engagement touted in the media are overrated. Competition will prevail over cooperation. Cybersecurity stocks have corrected, creating an entry point for investors seeking exposure to a secular theme of Great Power conflict in the cyber realm and beyond. Global defense stocks are even more attractive than cyberstocks as a “back to work” trade in the geopolitical context. Continue to build up safe-haven hedges as geopolitical risk remains structurally elevated and underrated by financial markets. Feature The Biden administration passed its first major law, the $1.9 trillion American Rescue Plan, on March 10. This gargantuan infusion of fiscal stimulus accounts for about 2% of global GDP and 9% of US GDP, a tailwind for risky assets when taken with a receding pandemic and normalizing global economy. The US dollar has perked up so far this year on the back of this extraordinary pump-priming and the rapid rollout of COVID-19 vaccines, which have lifted relative growth expectations with the rest of the world. Hence the dollar is rising for fundamentally positive reasons that will benefit global growth rather than choke it off. Our Foreign Exchange Strategist Chester Ntonifor argues that the dollar has 2-3% of additional upside before relapsing under the weight of rising global growth, inflation expectations, commodity prices, and relative equity flows into international markets. We agree with the dollar bear market thesis. But there are two geopolitical risks that investors must monitor: Cyclically, China’s combined monetary and fiscal stimulus is peaking, growth will decelerate, and the central government runs a non-negligible risk of overtightening policy. However, China’s National People’s Congress so far confirms our view that Beijing will not overtighten. Structurally, the US-China cold war is continuing apace under President Biden, as expected. The two sides are engaging in normal diplomacy as appropriate to a new US administration but the Microsoft Exchange hack (see below) underscores the trend of confrontation over cooperation. Chart 1Long JPY / Short KRW As Geopolitical Risk Is Underrated Long JPY / Short KRW As Geopolitical Risk Is Underrated Long JPY / Short KRW As Geopolitical Risk Is Underrated The second point reinforces the first since persistent US pressure on China will discourage it from excessive deleveraging at home. In a world where China is struggling to cap excessive leverage, the US is pursuing “extreme competition” with China (Biden’s words), and yet the US rule of law is intact, global investors will not abandon the US dollar in a general panic and loss of confidence. They will, however, continue to diversify away from the dollar on a cyclical basis given that global growth will accelerate while US policy will remain extremely accommodative. Reinforcing the point, geopolitical frictions are rising even outside the US-China conflict. A temporary drop in risk occurred in the New Year as a result of the rollout of vaccines, the defeat of President Trump, and the resolution of Brexit. But going forward, geopolitical risk will reaccelerate, with various implications that we highlight in this report. While we would not call an early end to the dollar bounce, we will keep in place our tactical long JPY-USD and long CHF-USD hedges. These currencies offer a good hedge in the context of a dollar bear market and structurally high geopolitical risk. If the dollar weakens anew on good news for global growth then the yen and franc will benefit on a relative basis as they are cheap, whereas if geopolitical risk explodes they will benefit as safe havens. We also recommend going long the Japanese yen relative to the South Korean won given the disparity in valuations highlighted by our Emerging Markets team, and the fact that geopolitical tensions center on the US and China (Chart 1). “Our Most Serious Competitor, China” Why are we so sure that geopolitical risk will remain structurally elevated and deliver negative surprises to ebullient equity markets? Our Geopolitical Power Index shows that China’s rise and Russia’s resurgence are disruptive to the US-led global order (Chart 2). If anything this process has accelerated over the COVID-19 crisis. China and Russia have authoritarian control over their societies and are implementing mercantilist and autarkic economic policies. They are carving out spheres of influence in their regions and using asymmetric warfare against the US and its allies. They have also created a de facto alliance in their shared interest in undermining the unity of the West. The US is meanwhile attempting to build an alliance of democracies against them, heightening their insecurities about America’s power and unpredictability (Chart 3). Chart 2Great Power Struggle Continues Great Power Struggle Continues Great Power Struggle Continues Massive fiscal and monetary stimulus is positive for economic growth and corporate earnings but it reduces the barriers to geopolitical conflict. Nations can pursue foreign and trade policies in their self-interest with less concern about the blowback from rivals if they are fueled up with artificially stimulated domestic demand. Chart 3Biden: ‘Our Most Serious Competitor, China’ More Reasons To Buy Cybersecurity And Defense Stocks More Reasons To Buy Cybersecurity And Defense Stocks Total trade between the US and China, at 3.2% and 4.7% of GDP respectively in 2018, was not enough to prevent trade war from erupting. Today the cost of trade frictions is even lower. The US has passed 25.4% of GDP in fiscal stimulus so far since January 1, 2020. China’s total fiscal-and-credit impulse has risen by 8.4% of GDP over the same time period. The Biden administration is co-opting Trump’s hawkish foreign and trade policy toward China, judging by its initial statements and actions (Appendix Table 1). Specifically, Biden has issued an executive order on securing domestic supply chains that demonstrates his commitment to the Trumpian goal of diversifying away from China and on-shoring production, or at least offshoring to allied nations. The Democratic Party is also unveiling bipartisan legislation in Congress that attempts to reduce reliance on China.1 These executive decrees are partly spurred on by the global shortage of semiconductors. China, the US, and the US’s allies are all attempting to build alternative semiconductor supply chains that bypass Taiwan, a critical bottleneck in the production of the most advanced computer chips. The Taiwanese say they will coordinate with “like-minded economies” to alleviate shortages, by which they mean fellow democracies. But this exposes Taiwan to greater geopolitical risk insofar as it excludes mainland China from supplies, either due to rationing or American export controls. The surge in semiconductor sales and share prices of semi companies (especially materials and equipment makers) will continue as countries will need a constant supply of ever more advanced chips to feed into the new innovation and technology race, the renewable energy race, and the buildout of 5G networks and beyond (Chart 4). It takes huge investments of time and capital to build alternative fabrication plants and supply lines yet governments are only beginning to put their muscle into it via stimulus packages and industrial policy. Chart 4Semiconductor Supply Shortage Semiconductor Supply Shortage Semiconductor Supply Shortage Supply shocks have geopolitical consequences. The oil shocks of the 1970s and early 1990s motivated the US to escalate its interventions and involvement in the Middle East. They also motivated the US to invest in stockpiles of critical goods and alternative sources of production so as to reduce dependency (Chart 5). Although semiconductors are not fungible like commodities, and the US has tremendous advantages in semiconductor design and production, nevertheless the bottleneck in Taiwan will take years to alleviate. Hence the US will become more active in supply security at home and more active in alliance-building in Asia Pacific to deter China from taking Taiwan by force or denying regional access to the US and its allies. China faces the same bottleneck, which threatens its technological advance, economic productivity, and ultimately its political stability and international defense. Chart 5ASupply Shortages Motivate Strategic Investments Supply Shortages Motivate Strategic Investments Supply Shortages Motivate Strategic Investments Chart 5BSupply Shortages Motivate Strategic Investments Supply Shortages Motivate Strategic Investments Supply Shortages Motivate Strategic Investments Semiconductor and semi equipment stock prices have gone vertical as highlighted above but one way to envision the surge in global growth and capex for chip makers is to compare these stocks relative to the shares of Big Tech companies in the communication service sector, i.e. those involved in social networking and entertainment, such as Twitter, Facebook, and Netflix. On a relative basis the semi stocks can outperform these interactive media firms which face a combination of negative shocks from rising interest rates, regulation, economic normalization, and ideologically fueled competition (Chart 6). Chart 6Long Chips Versus Big Tech Long Chips Versus Big Tech Long Chips Versus Big Tech What about the potential for the US and China to enhance cooperation in areas of shared interest? Generally the opportunity for re-engagement is overrated. The Biden administration says there will be engagement where possible. The first high-level talks will occur in Alaska on March 18-19 between Secretary of State Antony Blinken, National Security Adviser Jake Sullivan, Central Foreign Affairs Commissioner Yang Jiechi, and Foreign Minister Wang Yi. Presidents Biden and Xi Jinping may hold a bilateral summit sometime soon and the old strategic and economic dialogue may resume, enabling cabinet-level officials to explore a range of areas for cooperation independently of high-stakes strategic negotiations. However, a close look at the policy areas targeted for engagement reveals important limitations: Health: There is little room for concrete cooperation on the COVID-19 pandemic given that the pandemic is already receding, the Chinese have not satisfied American demands for data transparency, Chinese officials have fanned theories that the virus originated in the US, and the US is taking measures to move pharmaceutical and health equipment supply chains out of China. Trade: Trade is an area of potential cooperation given that the two countries will continue trading while their economies rebound. The Phase One trade deal remains in place. However, China only made structural concessions on agriculture in this deal so any additional structural changes will have to be the subject of extensive negotiations. Secretary of Treasury Janet Yellen says the US will use the “full array of tools” to ensure compliance and will punish China for abuses of the global trade system. Cybersecurity: On cybersecurity, China greeted the Biden administration by hacking the Microsoft Exchange email system, an even larger event than Russia’s SolarWinds hack last year. Both hacks highlight how cyberspace is a major arena of modern Great Power struggle, making it unlikely that there will be effective cooperation. The hack suggests Beijing remains more concerned about accessing technology while it can than reducing tensions. The Americans will make demands of China at the Alaska meetings. Environment: As for the environment, the US is a net oil exporter while China imports 73% of its oil, 42% of its natural gas and 7.8% of its coal consumption, with 40% and 10% of its oil and gas coming from the Middle East. The US wants to be at the cutting edge of renewable energy technology but it has nowhere near the impetus of China (or Europe), which are diversifying away from fossil fuels for the sake of national security. Moreover China will want its own companies, not American, to meet its renewable needs. This is true even if there is success in reducing barriers for green trade, since the whole point of diversifying from Middle Eastern oil supplies is strategic self-sufficiency. The Americans would have to accept less energy self-sufficiency and greater renewable dependence on China. Nuclear Proliferation: Cooperation can occur here as the Biden administration will seek to return to a deal with the Iranians restraining their nuclear ambitions while maintaining a diplomatic limiting North Korea’s nuclear weapons stockpile and ballistic missile development. China and Russia will accept the US rejoining the 2015 Iranian nuclear deal but they will require significant concessions if they are to join the US in forcing anything more substantial on the Iranians. China may enforce sanctions on North Korea but then it will expect concessions on trade and technology that the Biden administration will not want to give merely for the sake of North Korea. Bottom Line: The Biden administration’s China strategy is taking shape and it is hawkish as expected. It is not ultra-hawkish, however, as the key characteristic is that it is a defensive posture in the wake of the perceived failures of Trump’s strategy of “attack, attack, attack.” This means largely maintaining the leverage that Trump built for the US while shifting the focus to actions that the US can take to improve its domestic production, supply chain resilience, and coordination with allied producers. Punitive measures are an option, however, and if relations deteriorate over time, as expected, they will be increasingly relied on. Buy The Dip In Cybersecurity Stocks A linchpin of the above analysis is the Microsoft Exchange hack, which some have called the largest hack in US history, since it confirms the view that the Biden administration will not be able to de-escalate strategic tensions with China much. China has been particularly frantic to acquire technology through hacking and cyber-espionage over the past decade as it attempts to achieve a Great Leap Forward in productivity in light of slowing potential growth that threatens single-party rule over the long run. The breakdown in ties between Presidents Barack Obama and Xi Jinping occurred not only because of Xi’s perceived violation of a personal pledge not to militarize the South China Sea but also because of the failure of a cybersecurity cooperation deal between the two. When the Trump administration arrived on the scene it sought to increase pressure on China and cybersecurity was immediately identified as an area where pushback was long overdue. Cyber conflict is highly likely to persist, not only with Russia but also with China. Cyber operations are a way for states to engage in Great Power struggle while still managing the level of tensions and avoiding a military conflict in the real world. The cyber realm is a realm of anarchy in which states are insecure about their capabilities and are constantly testing opponents’ defenses and their own offensive capabilities. They can also act to undermine each other with plausible deniability in the cyber realm, since multiple state and quasi-state actors and a vast criminal underworld make it difficult to identify culprits with confidence. Revisionist states like China, North Korea, Russia, and Iran have an advantage in asymmetric warfare, including cyber, since it enables them to undermine the US and West without putting their weaker conventional forces in jeopardy. Cybersecurity stocks have corrected but the general up-trend is well established and fully justified (Chart 7). It is not clear, however, that investors should favor cybersecurity stocks over the general NASDAQ index (Chart 8). The trend has been sideways in recent years and is trying to form a bottom. Cybersecurity stocks are volatile, as can be seen compared to tech stocks as a whole, and in both cases the general trend is for rising volatility as the macro backdrop shifts in favor of higher interest rates and inflation expectations (Chart 9). Chart 7Cyber Security Stocks Corrected Cyber Security Stocks Corrected Cyber Security Stocks Corrected Chart 8Major Hacks Failed To Boost Cyber Vs NASDAQ Major Hacks Failed To Boost Cyber Vs NASDAQ Major Hacks Failed To Boost Cyber Vs NASDAQ Chart 9Volatility Of Cyber & Tech Stocks Rising Volatility Of Cyber & Tech Stocks Rising Volatility Of Cyber & Tech Stocks Rising Great Power struggle will not remain limited to the cyber realm. There is a fundamental problem of military insecurity plaguing the world’s major powers. Furthermore the global economic upturn and new energy and industrial innovation race will drive up commodity prices, which will in turn reactivate territorial and maritime disputes. Turf battles will re-escalate in the South and East China Seas, the Persian Gulf and Indian Ocean basin, the Mediterranean, and even the Baltic Sea and Arctic. One way to play this shift is as a geopolitical “back to work” trade – long defense stocks relative to cybersecurity stocks (Chart 10). The global defense sector saw a run-up in demand, capital expenditures, and profits late in the last business cycle. That all came crashing down with the pandemic, which supercharged cybersecurity as a necessary corollary to the swarm of online activity as households hunkered down to avoid the virus and obey government social restrictions. Cybersecurity stocks have higher EV/EBITDA ratios and lower profit margins and return on equity compared to defense stocks or the broad market. Chart 10Long Defense / Short Cyber Security: 'Back To Work' For Geopolitics Long Defense / Short Cyber Security: 'Back To Work' For Geopolitics Long Defense / Short Cyber Security: 'Back To Work' For Geopolitics The trade does not mean cybersecurity stocks will fall in absolute terms – we maintain our bullish case for cybersecurity stocks – but merely that defense stocks will make relative gains as economic normalization continues in the context of Great Power struggle. Bottom Line: Structurally elevated geopolitical risks will continue to drive demand for cybersecurity in absolute terms. However, we would favor global defense stocks on a relative basis. The US Is Not As War-Weary As People Think America is consumed with domestic divisions and distractions. Since 2008 Washington has repeatedly demonstrated an unwillingness to confront foreign rivals over small territorial conquests. This risk aversion has created power vacuums, inviting ambitious regional powers like China, Russia, Iran, and Turkey to act assertively in their immediate neighborhoods. However, the US is not embracing isolationism. Public opinion polling shows Americans are still committed to an active role in global affairs (Chart 11). The 2020 election confirms that verdict. Nor are Americans demanding big cuts in defense spending. Only 31% of Americans think defense spending is “too much” and only 12% think the national defense is stronger than it needs to be (Chart 12). Chart 11No Isolationism Here No Isolationism Here No Isolationism Here True, the Democratic Party is much more inclined to cut defense spending than the Republicans. About 43% of Democrats demand cuts, while 32% are complacent about the current level of spending (compared to 8% and 44% for Republicans). But it is primarily the progressive wing of the party that seeks outright cuts and the progressives are not the ones who took power. Chart 12Americans Against ‘Forever Wars’ But Not Truly Dovish More Reasons To Buy Cybersecurity And Defense Stocks More Reasons To Buy Cybersecurity And Defense Stocks Biden and his cabinet represent the Washington establishment, including the military-industrial complex. Even if Vice President Kamala Harris should become president she would, if anything, need to prove her hawkish credentials. Defense spending cuts might be projected nominally in Biden’s presidential budgets but they will not muster majorities in the two narrowly divided chambers of Congress. Biden has co-opted Trump’s (and Obama’s) message of strategic withdrawal and military drawdown. He is targeting a date of withdrawal from Afghanistan on May 1, notwithstanding the leverage that a military presence there could yield in its priority negotiations with Iran. Yet he is not jeopardizing the American troop presence in Germany and South Korea, much more geopolitically consequential spheres of action in a long competition with Russia and China. While it is true (and widely known) that Americans have turned against “forever wars,” this really means Middle Eastern quagmires like Iraq and Afghanistan and does not mean that the American public or political establishment have truly become anti-war “doves.” The US public recognizes the need to counter China and Russia and Congress will continue appropriating funds for defense as well as for industrial policy. The Biden administration will increase awareness about the risks of a lack of deterrence and alliance-building. This is especially apparent given the military buildup in China. The annual legislative session has revealed an important increase in military focus in Beijing in the context of the US rivalry. Previously, in the thirteenth five-year plan and the nineteenth National Party Congress, the People’s Liberation Army aimed to achieve “informatization and mechanization” reforms by 2020 and total modernization by 2035. However, at the fifth plenum of the central committee in October, the central government introduced a new military goal for the PLA’s 100th anniversary in 2027 – a “military centennial goal” to match with the 2021 centennial of the Communist Party and the 2049 centennial goal of the founding of the People’s Republic. While details about this new military centenary are lacking, the obvious implication is that the Communist Party and PLA are continuing to shift the focus to “fighting and winning wars,” particularly in the context of the need to deter the United States. The official defense budget is supposed to grow 6.8% in 2021, only slightly higher than the 6.6% goal in 2020, but observers have long known that China’s military budget could be as much as twice as high as official statistics indicate. The point is that defense spending is going up, as one would expect, in the context of persistent US-China tensions. Bottom Line: Just as US-China cooperation will be hindered by mutual efforts to reduce supply chain dependency and support domestic demand, so too it will be hindered by mutual efforts to increase defense readiness and capability in the event of military conflict. The beneficiary of continued high levels of US defense spending and Chinese spending increases – in the context of a more general global arms buildup – will be global arms makers. Investment Takeaways Geopolitical risk remains structurally elevated despite the temporary drop in tensions in late 2020 and early 2021. The China-backed Microsoft Exchange hack reinforces the Biden administration’s initial foreign policy comments and actions suggesting that US policy will remain hawkish on China. While Biden will adopt a more defensive rather than offensive strategy relative to Trump, there is no chance that he will return to the status quo ante. The Obama administration itself grew more hawkish on China in 2015-16 in the face of cyber threats and strategic tensions in the South China Sea. Cybersecurity stocks will continue to benefit from secular demand in an era of Great Power competition where nations use cyberattacks as a form of asymmetric warfare and a means of minimizing the risks of conflict. The recent correction in cybersecurity stocks creates a good entry point. We closed our earlier trade in January for a gain of 31% but have remained thematically bullish and recommend going long in absolute terms. We would favor defense over cybersecurity stocks as a geopolitical version of the “back to work” trade in which conventional economic activity revives, including geopolitical competition for territory, resources, and strategic security. Defense stocks are undervalued and relative share prices are unlikely to fall to 2010-era lows given the structural increase in geopolitical risk (Chart 13). Chart 13Global Defense Stocks Oversold Global Defense Stocks Oversold Global Defense Stocks Oversold Chart 14Global Defense Stocks Profitable, Less Indebted Global Defense Stocks Profitable, Less Indebted Global Defense Stocks Profitable, Less Indebted Defense stocks have seen profit margins hold up and are not too heavily burdened by debt relative to the broad market (Chart 14). Defense stocks have a higher return on equity than the average for non-financial corporations and cash flow will improve as a new capex cycle begins in which nations seek to improve their security and gain access to territory and resources (Chart 15). Chart 15Defense Stocks: High RoE, Capex Will Revive Defense Stocks: High RoE, Capex Will Revive Defense Stocks: High RoE, Capex Will Revive Chart 16Discount On Global Defense Stocks Discount On Global Defense Stocks Discount On Global Defense Stocks Valuation metrics show that global defense stocks are trading at a discount (Chart 16).     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table 1 Appendix Table 1Biden Administration's First 100 Days: Key Statements And Actions On China More Reasons To Buy Cybersecurity And Defense Stocks More Reasons To Buy Cybersecurity And Defense Stocks Footnotes 1 See Federal Register, "America’s Supply Chains", Mar. 1, 2021, federalregister.gov and Richard Cowan and Alexandra Alper, "Top U.S. Senate Democrat directs lawmakers to craft bill to counter China", Feb. 23, 2021, reuters.com.

Highlights UK Interest Rates: A series of rolling shocks dating back to the 2008 financial crisis has prevented the Bank of England (BoE) from normalizing crisis-era levels of interest rates, even during years when inflation was overshooting the BoE 2% target. Brexit and COVID-19 were the last of those two shocks, but the growth- and inflation-dampening effects of both are fading fast. Implications for Gilts & GBP: The BoE’s dovish rhetoric, including hints that negative policy rates are still a viable option, looks increasingly inappropriate. The surge in real UK bond yields seen over the past month is just the beginning of a medium-term process of interest rate normalization. Maintain below-benchmark duration on Gilts, while downgrading UK allocations within dedicated global fixed income portfolios to neutral. The pound has upside in this environment, especially if depressed UK productivity starts to recover. Feature Chart 1UK Real Yields: Deeply Negative Why Are UK Interest Rates Still So Low? Why Are UK Interest Rates Still So Low? The UK has become one of the more peculiar corners of the global fixed income universe. The outright level of longer-term Gilt yields is in the middle of the pack among the major advanced economies. The story is much different, however, when breaking those nominal UK yields into the real and inflation expectations components. The deeply negative real yields on UK inflation-linked Gilts are the lowest among the majors, even in a world where sub-0% real yields are prevalent in most countries (Chart 1). The flipside of that deeply negative real yield is a high level of inflation expectations. The breakeven inflation rate derived from the difference between the nominal and real 10-year Gilt yields is 3.3%, the highest in the developed “linkers” universe. Inflation expectations in UK consumer surveys are at similar levels, well above the 2% inflation target of the Bank of England (BoE), suggesting little confidence in the central bank’s ability or willingness to hit its own inflation goals. In this Special Report, jointly published by BCA Research Global Fixed Income Strategy and Foreign Exchange Strategy, we investigate why UK real interest rates have remained so persistently negative and assess the possibility of a shift in the low interest rate regime in a post-Brexit, post-pandemic UK – a move that could be quite bearish for UK fixed income markets and bullish for the British pound. Can The BoE Ignore Cyclical Upward Pressure On UK Bond Yields? The UK has suffered from a series of shocks, starting with the 2008 crisis, that have limited the ability of the BoE to attempt to tighten monetary policy. The 2011/12 European debt crisis hurt the UK’s most important trading partners, while the 2016 Brexit vote began a multi-year process of uncertainty over the future of those trading relationships. The COVID-19 pandemic is the latest shock, triggering a recession of historic proportions. The UK economy contracted by -10% in 2020, the largest decline since “The Great Frost” downturn of 1709. UK bond yields collapsed in response as the BoE cut rates to near-0% and reinforced that easy stance with aggressive quantitative easing and promises to keep rates unchanged over at the next few years. Today, UK financial markets are waking up to a world beyond the current COVID-19 lockdowns. The UK is running one of the world’s most successful vaccination rollouts, with 23 million jabs, or 35 per 100 people, already having been administered. UK Prime Minister Boris Johnson recently unveiled a bold plan to fully reopen the UK economy from the current severe lockdowns by mid-year. The UK government’s latest budget called for additional spending measures over the next year, including maintaining the work furlough scheme that has supported household incomes during the pandemic. As a result, UK growth expectations have exploded higher. According to the Bloomberg consensus economics survey, UK nominal GDP growth is expected to surge to 8.4% over calendar year 2021, an annual pace not seen since 1990 (Chart 2). Nominal Gilt yields have begun to reprice higher to reflect those surging growth expectations, with the 5-year/5-year forward Gilt yield climbing 67bps so far in 2021. Real Gilt yields are also moving higher with the 10-year inflation-linked Gilt climbing 38bps year to date, providing additional interest rate support that has fueled a surge in the pound versus the dollar (bottom panel). Our own BoE Monitor - containing growth, inflation and financial variables that typically lead to pressure on the central bank to adjust monetary policy – is signaling a reduced need for additional policy easing (Chart 3). The momentum of changes in longer-maturity UK Gilts and the trade-weighted UK currency index are usually correlated to the ebbs and flows of the BoE Monitor. The latest surge higher in yields and the currency suggests that the markets are anticipating the type of recovery that will put pressure on the BoE to tighten. Chart 2A Growth-Driven Repricing Of Gilts & GBP A Growth-Driven Repricing Of Gilts & GBP A Growth-Driven Repricing Of Gilts & GBP Chart 3Gilts & GBP Sniffing Out A Less Dovish BoE? Gilts & GBP Sniffing Out A Less Dovish BoE? Gilts & GBP Sniffing Out A Less Dovish BoE? It may take a while to see the BoE turn more hawkish, however. The BoE has become one of least active central banks in the world over the past decade. After the BoE cut its official policy interest rate, the Bank Rate, by 500bps during the 2008 financial crisis and 2009 recession, rates were kept in a range between 0.25% and 0.75% for ten consecutive years. The BoE cut rates aggressively in response to the COVID-19 pandemic, lowering the Bank Rate in March 2020 from 0.75% to 0.1%, where it still stands. The BoE has used quantitative easing (QE) and forward guidance to try and limit movements in bond yields whenever cyclical surges in inflation could have justified tighter monetary policy. That has led to an extended period of a negative BoE Bank Rate, something not seen since the inflationary 1970s (Chart 4). Back then, the BoE was lagging the surge in UK inflation, but still hiking nominal interest rates. Today, the central bank is keeping nominal rates near 0% with much lower levels of inflation. Chart 4Over A Decade Of Negative Real UK Interest Rates Over A Decade Of Negative Real UK Interest Rates Over A Decade Of Negative Real UK Interest Rates Short-term interest rate markets are still pricing in a very slow response from the BoE to the current growth optimism. Only 36bps of rate hikes over the next two years are discounted in the UK overnight index swap (OIS) curve. This go-slow response is in line with the BoE’s guidance on future rate hikes which, similar to the language used by other central banks like the Fed, calls for no pre-emptive rate hikes before inflation has sustainably returned to the BoE target. That combination would be consistent with current forward market pricing on both short-term interest rates and inflation. Chart 5BoE Keeping Real Rates Well Below R* BoE Keeping Real Rates Well Below R* BoE Keeping Real Rates Well Below R* In Chart 5, we show the real BoE Bank Rate, constructed by subtracting UK core CPI inflation from the Bank Rate. We also show a forward real rate calculated using the forward UK OIS and CPI swap curves. The market-implied path of the real Bank Rate shows very little change over the next decade, with the real Bank Rate expected to average around -2.5%. This is far below the estimates of a neutral UK real rate (or “r-star”) of just under 2%, as calculated by the New York Fed or recent academic studies. The neutral UK real rate has likely dipped because of the pandemic. The UK Office For Budget Responsibility (OBR) estimates that there has been a long-term “scarring” of the UK economy from COVID-19 through supply-side factors like weaker investment spending, lower productivity growth and diminished labor force participation – equal to three percentage points of the level of potential GDP.1 The BoE estimates a smaller “scarring” of 1.75 percentage points of potential output, but coming with a 6.5% reduction in the size of the UK capital stock. While these are significant reductions in the supply-side of the UK economy, they are not enough to account for the 4.5 percentage point difference between pre-pandemic estimates of the UK r-star and the market-implied path of the real BoE Bank Rate over the next decade. The implication is that the markets are not expecting the BoE to deviate from its strategy of doing very little with interest rates, even as growth recovers from the pandemic shock. That can be seen in the recent upturn in UK inflation expectations that is evident in both market-implied and survey-based measures. Chart 6UK Inflation Expectations Reflect BoE Policy, Not Actual Inflation UK Inflation Expectations Reflect BoE Policy, Not Actual Inflation UK Inflation Expectations Reflect BoE Policy, Not Actual Inflation The 5-year/5-year forward UK CPI swap rate now sits at 3.6%, not far off the 3.3% level of 5-10 year consumer inflation expectations from the latest YouGov/Citigroup survey (Chart 6). The fact that inflation expectations can remain so elevated at a time when headline CPI inflation is struggling to avoid deflation is striking. This indicates a belief that the BoE will do very little in the future to stop a booming UK economy that is expected to put sustained downward pressure on the UK unemployment rate over the next few years (bottom panel). This is from a relatively low starting point of the unemployment rate given the massive government support programs that have limited the amount of pandemic-related layoffs over the past year. The BoE should have reasons to be more concerned about a resurgence of UK inflation. In its latest Monetary Policy Report, the BoE published estimates showing that the entire collapse in UK inflation in 2020 was attributable to weaker demand for goods and services – especially the latter (Chart 7). This suggests that UK inflation could rebound by a similar amount as the UK economy reopens from pandemic lockdowns. According to the UK OBR, 21% of UK household spending is on items described as “social consumption”, like restaurants and hotels (Chart 8). This is a much larger proportion than seen in other major developed economies (excluding Spain) and explains why consumer spending plunged so much more dramatically in the UK during 2020 than in other countries. Chart 7Only A Temporary Drag On UK Inflation From COVID-19 Why Are UK Interest Rates Still So Low? Why Are UK Interest Rates Still So Low? Chart 8UK Households More Focused On “Social Consumption” Why Are UK Interest Rates Still So Low? Why Are UK Interest Rates Still So Low? If the UK pandemic-related restrictions are eased as planned over the next few months, the potential for a sharp snapback in UK consumer spending is significant. The BoE estimates that UK households now have £125bn of “excess” savings thanks to government income support and reduced spending on discretionary items like dining out and vacations. This is the fuel to support a rapid recovery in consumption over the next 6-12 months, especially as personal income growth will get a boost as furloughed workers begin returning to work (Chart 9). Chart 9UK Economy On The Mend UK Economy On The Mend UK Economy On The Mend Chart 10Big Boost To UK Growth From Housing & Government Spending Big Boost To UK Growth From Housing & Government Spending Big Boost To UK Growth From Housing & Government Spending A similar argument can be made for investment spending – the BoE estimates that UK businesses have amassed £100bn pounds of excess cash, and the latest reading on the BoE’s Agents' Survey of UK firms shows a slight increase after months of decline (bottom panel). With a Brexit deal with the EU finally reached at the start of 2021, UK businesses can also look to increase investment spending that had been delayed because of the years of Brexit uncertainty. The UK economy is already getting a boost from a recovery in the housing market fueled by low interest rates, high household savings and improving consumer confidence. Mortgage approvals have soared to the highest level since 2007, while house prices are now expanding at a 6.4% annual rate (Chart 10). Add it all up, and the economic momentum in the UK is positive and likely to accelerate further in the coming months as a greater share of the population becomes vaccinated. The BoE’s dovish policy stance is likely to appear increasingly inappropriate relative to accelerating UK growth and inflation trends over the next several months. Thus, on a cyclical basis, UK bond yields, both nominal and real, have more upside potential even after the recent increase. Bottom Line: A series of rolling shocks dating back to the 2008 financial crisis has prevented the Bank of England (BoE) from normalizing crisis-era levels of interest rates, even during years when inflation was overshooting the BoE 2% target. Brexit and COVID-19 were the last of those two shocks, but the growth- and inflation-dampening effects of both are fading fast. Structural Forces Keeping UK Interest Rates Low Are Fading Looking beyond the cyclical drivers, the structural factors that have held down UK interest rates in recent years are also starting to fade. The supply side of the UK economy has suffered because of Brexit uncertainty. The OECD’s estimate of potential UK GDP growth fell from 1.75% in 2015 to 1.0% in 2020 (Chart 11). This was mostly due to declining productivity growth – a consequence of years of very weak business investment. The 5-year annualized growth rate of real UK investment spending fell to -3% in 2020, a contraction only matched during the past 30 years after the 1992 ERM crisis and 2008 financial crisis. That plunge in investment coincided with almost no growth in UK labor productivity over that same 5-year window. Chart 11The Road To Faster Potential UK Growth Starts With Investment The Road To Faster Potential UK Growth Starts With Investment The Road To Faster Potential UK Growth Starts With Investment Slowing population growth also weighed on UK potential growth, slowing to the lowest level in 15 years in 2019 as immigration from EU countries to the UK fell sharply. COVID-19 also hurt immigration flows into the UK last year. The UK Office for National Statistics estimated that the non-UK born population in the UK fell by 2.7% between June 2019 and June 2020. Diminished potential GDP growth is a factor that would structurally reduce the equilibrium real UK interest rate. We are likely past the worst for that downward pressure on potential growth and real rates. Population growth should also stabilize as the UK borders open up again and pandemic travel restrictions are loosened. Measured productivity is already starting to see a cyclical recovery, while investment spending is likely to improve as cash-rich UK companies began to ramp up capital spending plans deferred by Brexit and COVID-19. While the process leading from faster investment spending into speedier productivity growth is typically slow, the key point is that the worst of downtrend is likely over. This is an important development that has implications for UK fixed income markets. When looking at an international comparison of real central bank policy rates within the developed economies, the UK has fallen into the grouping of countries with persistently negative policy rates, namely Japan, the euro area, Switzerland, Sweden and Norway (Chart 12). We have dubbed that group the “Secular Stagnation 5”, after the term made famous by former US Treasury Secretary Lawrence Summers describing a state where the “natural” real rate of interest (r-star) that equates savings with investment is structurally negative. Chart 12Does The UK Belong In The 'Secular Stagnation 5'? Does The UK Belong In The 'Secular Stagnation 5'? Does The UK Belong In The 'Secular Stagnation 5'? Does the UK belong in the “Secular Stagnation 5”? As a way to assess this, we made some comparisons of selected UK data with the same data for those five countries. When looking at potential GDP growth and population growth, the UK sits right in the middle of the range of those growth rates for the five countries (Chart 13). UK productivity growth has underperformed the others recently but, prior to the 2016 Brexit shock, UK productivity was also in the middle of the Secular Stagnation 5 range. Chart 13Brexit Became A Major Hit To UK Potential Growth Brexit Became A Major Hit To UK Potential Growth Brexit Became A Major Hit To UK Potential Growth Chart 14UK Economy Less Focused On Investment & Exports UK Economy Less Focused On Investment & Exports UK Economy Less Focused On Investment & Exports On other measures, the UK is nothing like those other countries. The UK’s economy is far less geared towards exports and investment (Chart 14) and is more tilted towards consumer spending. That can be seen most clearly when looking at the data on savings/investment balances. The UK continuously runs a current account deficit, as opposed to the persistent surpluses seen in the Secular Stagnation 5 (Chart 15). Put another way, the UK is not a “surplus” country that saves more than it invests on a structural basis, a condition that typically depresses real interest rates. Chart 15The UK Is Not A Surplus Country The UK Is Not A Surplus Country The UK Is Not A Surplus Country Chart 16Gilts Will Not Become A Low-Beta Market Gilts Will Not Become A Low-Beta Market Gilts Will Not Become A Low-Beta Market Based on these cross-country comparisons, it is unusual for the UK to have such persistently low real interest rates. This has implications for UK bond yields. Over the past few years, Gilts have been transitioning from a status as a “high yield beta” market – whose yield movements are more correlated to swings in the overall level of global bond yields. The lower beta markets are in countries like Germany, France and Japan – all members of the Secular Stagnation club (Chart 16). The UK does not appear to warrant a permanent membership in that low-yielding group, based on structural factors. That is evident when looking at how Gilt yields are rising even with the BoE absorbing an increasing share of the stock of outstanding Gilts (bottom panel). We conclude that the transition of the UK to a low-beta market is related to the Brexit uncertainty post 2016 and the pandemic shock that has hit the consumer-focused UK economy exceptionally hard – both factors that are set to fade over the next year. Bottom Line: The BoE’s dovish rhetoric, including hints that negative policy rates are still a viable option, looks increasingly inappropriate. The surge in real UK bond yields seen over the past month is just the beginning of a medium-term process of interest rate normalization. Investment Conclusions Chart 17Downgrade Gilts To Underweight Downgrade Gilts To Underweight Downgrade Gilts To Underweight Our assessment of the cyclical and structural drivers of UK interest rates leads us to the following conclusions on UK fixed income and currency strategy: Duration: Maintain a below-benchmark exposure to UK interest rate movements. Gilt yields will rise by more than is discounted in the forwards over the next 6-12 months (Chart 17), coming more through rising real yields as the UK economy continues its post-Brexit, post-pandemic recovery. Country Allocation: Downgrade strategic allocations to UK Gilts to neutral from overweight in dedicated fixed income portfolios. Our long-standing view that Brexit uncertainty would lead to the outperformance of Gilts versus other developed bond markets is no longer valid. It is still too soon to move to a full underweight stance on Gilts – a better opportunity will develop by mid-year once it is more evident that the current success on UK vaccinations leads to a faster reopening of the UK economy. Yield Curve: Maintain positioning for a bearish steepening of the UK Gilt yield curve. While there is limited scope for more steepening through an even larger increase in inflation breakevens from current elevated levels, the long end of the Gilt curve can move higher by more than the front end as the market re-rates Gilts to a higher-beta status with a higher future trajectory for UK interest rates. Corporate Credit: Downgrade UK investment grade corporate bond exposure to neutral from overweight in dedicated fixed income portfolios. UK corporate spreads have returned to the 2017 lows and, while an improving growth dynamic is not overly bearish for credit, there is no longer a compelling valuation-based case for staying overweight UK investment grade corporates. This move brings our recommended UK allocation in line with our neutral stance on US and euro area investment grade corporates. Chart 18GBP/USD Appears Cheap On A PPP Basis GBP/USD Appears Cheap On A PPP Basis GBP/USD Appears Cheap On A PPP Basis Chart 19Low Productivity Is Weighing On The Pound Low Productivity Is Weighing On The Pound Low Productivity Is Weighing On The Pound Currency: A growth-driven path towards interest rate normalization should be positive for the British pound, which remains undervalued versus the US dollar on a purchasing power parity basis (Chart 18).2 A move to 1.45 on GBP/USD is possible within the next six months. A broader move towards pound strength will require an improvement in business investment, as the trade-weighted pound looks fairly valued on our productivity-based model (Chart 19). We do maintain our view that EUR/GBP can approach 0.80 by year-end based on a relatively stronger cyclical improvement in UK growth versus the euro area.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 For further details on the OBR estimates of UK growth, inflation and fiscal policy, please see the March 2021 OBR Economic & Financial Outlook, which can be found here: https://obr.uk/ 2 Please see BCA Research Foreign Exchange Strategy Report, "Thoughts On The British Pound", dated December 18, 2020, available at fes.bcaresearch.com.

Highlights China’s economic recovery is in a later stage than the US. A rebound in US Treasury yields is unlikely to trigger upward pressure on government bond yields in China. Imported inflation through mounting commodity and oil prices should be transitory and does not pose enough risk for Chinese authorities to further tighten policies. Historically, Chinese stocks have little correlation with changes in US Treasury yields; Chinese equity prices are primarily driven by the country’s domestic credit growth and economic conditions. We maintain our tactical (0 to 3 months) neutral position on Chinese stocks, in both absolute and relative terms. However, the near-term pullbacks are taking some air out of Chinese equities' frothy valuations,  providing room for a cyclical upswing. Chinese offshore stocks, which are highly concentrated in the tech sector, are facing multiple challenges. We are closing our long investable consumer discretionary/short investable consumer staples trade and we recommend long A-shares/short MSCI China Index. Feature Chinese stocks extended their February losses into the first week of March. Market participants fear that escalating real government bond yields in the US and elsewhere will have a sustained negative impact on Chinese risk assets, reinforced by ongoing policy normalization in China. Global equity prices have been buffeted by crosscurrents. An acceleration in the deployment of vaccines and increased economic reopenings provide a positive backdrop to the recovery of corporate profits. At the same time, optimism about global growth and broadening fiscal stimulus in the US has prompted investors to expect higher policy rates sooner. The US 10-year Treasury yield is up by 68bps so far this year, depressing US equity valuations and sending ripple effects across global bourses. In this report, we examine how rising US and global bond yields would affect China’s domestic monetary policy and risk-asset prices.  Will Climbing US Treasury Yields Push Up Chinese Rates? Chart 1Chinese Gov Bond Yields Have Led The US Counterpart Since 2015 Chinese Gov Bond Yields Have Led The US Counterpart Since 2015 Chinese Gov Bond Yields Have Led The US Counterpart Since 2015 Increasing bond yields in the US will not necessarily lead to higher bond yields in China. Chart 1 shows that the direction of China’s 10-year government bond yield has a tight correlation with its US counterpart. It is not surprising because business cycles in these giant economies have become more synchronized. Interestingly, China’s 10-year Treasury bond yield has led the US one since 2015. This may be due to China’s growing importance in the world economy. China’s credit and domestic demand growth leads the prices of many industrial metals and in turn, business cycles in many economies. China’s rising long-duration government bond yields reflect expectations of an improving domestic economy, and these expectations often spill over to the rest of the world, including the US. Although the recent sharp rebound in the US Treasury yield is mainly driven by domestic factors, the rebound is unlikely to spill over to their Chinese peers, because the countries are in different stages of their business and policy cycles. America is still at its early stage of economic recovery and fresh stimulus measures are still being rolled out, whereas China has already normalized its policy rates back to pre-pandemic levels and its credit growth peaked in Q4 last year. Chinese fixed-income markets will soon start pricing in moderating growth momentum in the second half of this year, suppressing the long-end of China’s Treasury yield curve (Chart 2). Importantly, none of the optimism that has lifted US Treasury yields - a vaccine-led global growth recovery and a massive US fiscal stimulus – would warrant a better outlook for China. Reopening worldwide economies will likely unleash pent-up demand for services, such as travel and catering, rather than merchandise trade. Chart 3 shows that since the pandemic US spending on goods, which benefited Chinese exports, has soared relative to spending on services. The trend will probably reverse when the US and world economy fully opens, limiting the upside for China’s exports and its contribution to growth this year. Chart 2China And The US Are In Different Stages Of Their Economic Recoveries China And The US Are In Different Stages Of Their Economic Recoveries China And The US Are In Different Stages Of Their Economic Recoveries Chart 3US Consumers Have Been Spending Much More On Goods Than Services During The Pandemic US Consumers Have Been Spending Much More On Goods Than Services During The Pandemic US Consumers Have Been Spending Much More On Goods Than Services During The Pandemic Bottom Line: China’s waning growth momentum will insulate Chinese bond yields from higher US Treasury yields.   Do Rising Inflation Expectations In The US Pose Risks Of Policy Tightening In China? Chart 4Imported Inflation Shouldnt Constrain The PBoC Imported Inflation Shouldnt Constrain The PBoC Imported Inflation Shouldnt Constrain The PBoC While China’s monetary policymaking is not entirely insulated from exogenous shocks, it is primarily driven by domestic economic conditions and inflation dynamics. We are not complacent about the risk of a meaningful uptick in global inflation, but we do not consider imported inflation a major policy constraint for the PBoC this year (Chart 4). Furthermore, at last week’s National People’s Congress (NPC), China set the inflation target in 2021 at 3%, which is a high bar to breach. Mounting commodity prices, particularly crude oil prices, may put upward pressures on China’s producer prices, but their impact on China’s overall inflation will be limited for the following reasons: China accounts for a large portion of the world’s commodity demand. Given that the country’s credit impulse has already peaked, domestic demand in capital-intensive sectors (such as construction and infrastructure spending) will slow this year. Reinforced policy restrictions on the property sector will also restrain the upside price potential in industrial raw materials such as steel and cement (Chart 5). For producers, the main and sustained risk for imported inflation will be concentrated in crude oil. The PPI may spike in Q2 and Q3 this year due to advancing oil prices and the extremely low base factor from the same period last year. The PBoC will likely view a spike in the PPI as transitory. Moreover, the recent improvement in producer pricing power appears to be narrow. The output price for consumer goods, which accounts for 25% of the PPI price basket, remains subdued (Chart 6). Chart 5Chinas Demand For Raw Materials Will Slow Chinas Demand For Raw Materials Will Slow Chinas Demand For Raw Materials Will Slow Chart 6Output Price For Consumer Goods Remains In Contraction Output Price For Consumer Goods Remains In Contraction Output Price For Consumer Goods Remains In Contraction Importantly, when oil prices plummeted in the first half of 2020, China’s crude oil inventories showed the fastest upturn on record (Chart 7). It suggests that China’s inventory restocking from last year may help to partially offset the impact from elevated oil prices this year. For consumers, oil prices account for a much smaller percentage of China’s CPI basket than in the US (Chart 8). Food prices, particularly pork, drive China’s headline CPI and can be idiosyncratic. We expect food price increases to be well contained this year due to improved supplies and the high base effect from last year.  Chart 7Massive Buildup in Chinas Crude Oil Inventory In 2020 Massive Buildup in Chinas Crude Oil Inventory In 2020 Massive Buildup in Chinas Crude Oil Inventory In 2020 Chart 8Oil Prices Account For A Small Portion In China's Consumer Spending Oil Prices Account For A Small Portion In Chinas Consumer Spending Oil Prices Account For A Small Portion In Chinas Consumer Spending Importantly, China’s inflation expectations have not recovered to their pre-pandemic levels and consumer confidence on future income growth also remains below its end-2019 figure (Chart 9). If this trend holds, then it will be difficult for producers to pass through escalating input costs to end users. Although China’s economy has strengthened, it is far from overheating (Chart 10). Without a sustained above-trend growth rebound, it is difficult to expect genuine inflationary pressures. The pandemic has distorted the balance of global supply and demand, propping up demand and price tags attached to it. In China’s case, however, production capacity and capital expenditures rebounded faster than demand and consumer spending, constraining the upsides in inflation (Chart 11).   Chart 9Consumer Inflation Expectations Have Not Fully Recovered Consumer Inflation Expectations Have Not Fully Recovered Consumer Inflation Expectations Have Not Fully Recovered Chart 10Chinese Economy Is Not Yet Overheating Chinese Economy Is Not Yet Overheating Chinese Economy Is Not Yet Overheating China’s CPI is at its lowest point since 2009, making China’s real yields much greater than in the US. Rising real US government bond yields could be mildly positive for China because they help to narrow the Sino-US interest rate differential and temper the pace of the RMB’s appreciation (Chart 12). A breather in the RMB’s gains would be a welcome reflationary force for Chinese exporters and we doubt that Chinese policymakers will spoil it with a rush to hike domestic rates. Chart 11And Production Has Recovered Faster Than Demand And Production Has Recovered Faster Than Demand And Production Has Recovered Faster Than Demand Chart 12Narrowing Real Rate Differentials Helps To Tamper The RMB Appreciation Narrowing Real Rate Differentials Helps To Tamper The RMB Appreciation Narrowing Real Rate Differentials Helps To Tamper The RMB Appreciation Bottom Line: It is premature to worry about an inflation overshoot in China. The current environment is characterized as easing deflation rather than rising inflation. Our base case remains that inflationary pressures will stay at bay this year. Are Higher US Treasury Yields Headwinds For Chinese Stocks? Historically, Chinese stocks have exhibited a loose cyclical correlation with US government bond yields, particularly in the onshore market (Chart 13). Equity prices in China are more closely correlated with domestic long-duration government bond yields, but the relationship is inconsistent (Chart 14). Chart 13Chinese Stocks Have Little Correlation With US Treasury Yields Chinese Stocks Have Little Correlation With US Treasury Yields Chinese Stocks Have Little Correlation With US Treasury Yields Chart 14Correlations Between Chinese Stocks And Domestic Gov Bond Yields Are Inconsistent Correlations Between Chinese Stocks And Domestic Gov Bond Yields Are Inconsistent Correlations Between Chinese Stocks And Domestic Gov Bond Yields Are Inconsistent Chinese stocks are much more sensitive to changes in the quantity of domestic money supply than the price of money. A sharp rebound in China’s 10-year government bond yield in the second half of last year did not stop Chinese stocks from rallying. The insensitivity of Chinese stocks to changes in the price of money is particularly prevalent during the early stage of an economic recovery. As we pointed out in a previous report, since 2015 the PBoC has shifted its policy to target interest rates instead of the quantity of money supply. Thus, credit growth, which propels China’s business cycle and corporate profits, can still trend higher even as bond yields pick up. This explains why domestic credit growth, rather than China’s real government bond yields, has been the primary driver of the forward P/E of Chinese stocks (Chart 15A and 15B). This contrasts with the S&P, in which the forward P/E ratio moves in lockstep with the inverted real yield in US Treasuries (Chart 16). Chart 15ACredit Growth Has Been Driving Up Chinese Stock Valuations Credit Growth Has Been Driving Up Chinese Stock Valuations Credit Growth Has Been Driving Up Chinese Stock Valuations Chart 15BCredit Growth Has Been Driving Up Chinese Stock Valuations Credit Growth Has Been Driving Up Chinese Stock Valuations Credit Growth Has Been Driving Up Chinese Stock Valuations Credit growth in China peaked in Q4 last year and the intensity of the economic recovery has started to moderate. Hence, regardless of the changes in bond yields, Chinese stocks will need to rely on profit growth in order to sustain an upward trend (Chart 17). Chart 16Falling Real Rates Were Propping Up US Equity Valuations Falling Real Rates Were Propping Up US Equity Valuations Falling Real Rates Were Propping Up US Equity Valuations Chart 17Earnings Growth Needs To Accelerate To Support Chinese Stock Performance Earnings Growth Needs To Accelerate To Support Chinese Stock Performance Earnings Growth Needs To Accelerate To Support Chinese Stock Performance The good news is that recent gyrations in the US equity market, coupled with concerns about further tightening in China’s domestic economic policy have triggered shakeouts in China’s equity markets. The pullback in stock prices has helped to shed some excesses in frothy Chinese valuations and has opened a door for more upsides in Chinese stock on a cyclical basis. Bottom Line: Rising Treasury yields in the US or China will not have a direct negative impact on Chinese equities. Last year’s massive credit expansion has lifted both earnings and multiples in Chinese stocks and an acceleration in earnings growth is now needed to support stock performance. Investment Implications The key message from last week’s NPC meetings suggests that policy tightening will be gradual this year. While the 6% growth target was lower than expected, it represents a floor rather than a suggested range and it will likely be exceeded. Bond yields and policy rates are already at their pre-pandemic levels, indicating that there is not much room for further monetary policy tightening this year. The announced objectives for the fiscal deficit and local government bond quotas are only modestly smaller than last year. The economic and policy-support targets support our view that policymakers will be cautious and not overdo tightening. We will elaborate on our takeaways from this year’s NPC in next week’s report. Chart 18Chinese Cyclicals Can Still Benefit From An Improving Global Economic Backdrop Chinese Cyclicals Can Still Benefit From An Improving Global Economic Backdrop Chinese Cyclicals Can Still Benefit From An Improving Global Economic Backdrop Meanwhile, there is still some room for Chinese cyclical stocks to run higher relative to defensives, given the current Goldilocks backdrop of global economic recovery and accommodative monetary policy (Chart 18). We maintain a tactical (0 to 3 months) neutral position on Chinese stocks, in both absolute and relative terms. The market correction has not fully run its course. However, the near-term pullbacks are taking some air out of Chinese equities' frothy valuations, providing room for a cyclical upswing. We are closing our long investable consumer discretionary/short investable consumer staples trade. Instead, we recommend the following trade: long A-share stocks/short MSCI China Index. Investable consumer discretionary sector stocks, which are concentrated in China’s technology giants, face a confluence of challenges ranging from the ripple effects of falling stock prices in the US tech sector and tightened antitrust regulations in China (Chart 19). In contrast, the A-share index is heavily weighted in value stocks while the MSCI China investable index has a large proportion of expensive new economy stocks (Chart 20). The trade is in line with our view that the investment backdrop has shifted in favor of global value versus growth stocks due to a strong US expansion, rising US bond yields and a weaker US dollar. Chart 19Chinese Investable Tech Sector Is Facing Strong Headwinds Chinese Investable Tech Sector Is Facing Strong Headwinds Chinese Investable Tech Sector Is Facing Strong Headwinds Chart 20Overweight A Shares Versus Chinese Investable Stocks Overweight A Shares Versus Chinese Investable Stocks Overweight A Shares Versus Chinese Investable Stocks   Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights China’s primary vulnerabilities over the past decade have been, and remain, credit/money excesses and a misallocation of capital. China’s advantage has not been its banking system or monetary policy’s "magic touch," but its ability to continuously raise productivity at a solid rate. Inflation has remained subdued due to robust productivity gains. Without the latter, policymakers would have little room to navigate and secure economic and financial stability. As long as solid productivity gains persist, the economy will absorb excesses over time and remain structurally sound. Feature China’s credit and fiscal stimulus has peaked and will roll over significantly in 2021. Hence, the question now is: what will be the extent of the economic slowdown? The magnitude of the growth slowdown depends not only on the pace and extent of credit and fiscal tightening but also on the structural health of the economy. In a structurally sound economy, the end of a credit and fiscal stimulus does not produce a sharp and extended slowdown. Conversely, in an economy saddled with structural malaises, modest policy tightening could produce a dramatic or prolonged business cycle downtrend. Two examples from China’s not-so-distant past are the credit tightening in 2004 and policy tightening in 2013-14. After the acute credit tightening in 2004 and the ensuing loan slowdown, China’s growth moderated briefly but remained robust and, in fact, reaccelerated in 2005 (Chart 1, top panel). However, following the 2013-14 policy tightening episode, China’s industrial sector experienced an extended downtrend (Chart 2, top panel). Chart 1China In Mid-2000s: Market Performance Amid Credit Tightening China In Mid-2000s: Market Performance Amid Credit Tightening China In Mid-2000s: Market Performance Amid Credit Tightening Chart 2China In Mid-2010s: Market Performance Amid Policy Tightening China In Mid-2010s: Market Performance Amid Policy Tightening China In Mid-2010s: Market Performance Amid Policy Tightening   Consistently, China-related plays in financial markets experienced only a brief and short-lived shakeout in 2004 and resumed their bull market within a short time span (Chart 1, bottom panel). But in 2013-15, China-plays experienced a deep and extended bear market (Chart 2, bottom panel). In this report, we assess the structural health of the mainland economy. “Soft-Budget” Constraints And Capital Misallocation China’s primary vulnerabilities over the past decade have been, and remain, credit excesses and a misallocation of capital. Loose credit and fiscal policies – “soft-budget” constraints – starting in 2009 fueled money creation on a grand scale, causing corporate and household debt to mushroom. This has massively inflated property prices and led to capital misallocation. Many of these excesses have by and large lingered. In particular: Broad money supply in China has surged 4.7-fold since January 2009 (Chart 3, top panel). This is significantly above the 2.3-fold increase in the US, and the 1.6-fold rise in the euro area and in Japan. Chart 3Broad Money Excesses: China Has Been An Outlier Broad Money Excesses: China Has Been An Outlier Broad Money Excesses: China Has Been An Outlier Not only has broad money supply skyrocketed in China by much more than in other economies, but it has also risen by much more relative to its own nominal GDP (Chart 3, middle panel). Since January 2009, as unorthodox monetary policies gained traction around the world, the broad money-to-GDP ratio has risen by 80 percentage points in China, 35-percentage points in the US, 25-percentage points in the euro area and 70-percentage points in Japan.     Chart 4China: No Deleveraging So Far China: No Deleveraging So Far China: No Deleveraging So Far Notably, China’s broad money-to-GDP ratio is the highest in the world, as illustrated in the middle panel of Chart 3. Finally, the absolute amount of broad money – all types of local currency deposits and cash in circulation converted into dollars to make numbers comparable – now stands at $40 trillion in China, $18 trillion in the US and the euro area each and $11 trillion in Japan (Chart 3, bottom panel). In brief, China’s money (RMB) supply is greater than the sum of money supply in the US and euro area. China’s domestic credit growth has been outpacing nominal GDP growth since 2008 (Chart 4, top panel). Consequently, its domestic credit-to-GDP ratio is making new highs (Chart 4, bottom panel). A continuously rising domestic debt-to-GDP ratio indicates that the nation has not really deleveraged in the past ten years. Concerning debt structure, local and central government debt stands at 61% of GDP, enterprise (including SOE) debt represents 162% of GDP and household debt is 61% of GDP. Notably, enterprise debt is the highest in the world, as illustrated in Chart 5.  This chart shows a decline in China’s corporate credit-to-GDP ratio from 2016 to 2018. The drop, however, is due to the Local Government Financing Vehicles (LGFV) debt swap. Authorities simply moved debt from LGFV balance sheets to local governments, which represents an accounting reshuffle and not genuine deleveraging. Meanwhile, households in China are as leveraged as those in the US (Chart 6) when debt-to-disposable income ratios are compared. The latter is how consumer debt is measured in all countries around the world. Chart 5Chinas Corporate Debt Is The Highest In the World Chinas Corporate Debt Is The Highest In the World Chinas Corporate Debt Is The Highest In the World Chart 6Chinese Households Are As Leveraged As US Ones Chinese Households Are As Leveraged As US Ones Chinese Households Are As Leveraged As US Ones Chart 7Debt Servicing Costs In China Are High Debt Servicing Costs In China Are High Debt Servicing Costs In China Are High Finally, the true indicator of debt stress is the debt-service ratio. The Bank for International Settlements (BIS) estimates that the debt-service ratio for Chinese enterprises and households is above 20% of income. The same ratio for the US rolled over at 18% in 2007 during the credit crisis (Chart 7). There are several symptoms consistent with pervasive capital misallocation. First, return on assets (RoA) for non-financial onshore listed companies has dropped to an 20-year low (Chart 8, top panel). Companies have raised substantial capital to invest but the return on investment has been disappointing, resulting in a falling RoA. Second, a falling output-to-capital ratio – an inverse analog of a rising incremental capital-to-output ratio (ICOR) – also indicates capital misallocation and falling efficiency (Chart 9). Chart 8Falling Return On Assets And Slowing Productivity Growth Falling Return On Assets And Slowing Productivity Growth Falling Return On Assets And Slowing Productivity Growth Chart 9Output Per Unit Of Capex Is Falling Output Per Unit Of Capex Is Falling Output Per Unit Of Capex Is Falling   Falling return on capital is the natural outcome of too much investment. It is simply impossible to invest more than 40% of GDP every year over a 20-year period without capital misallocation. It has become difficult to find profitable projects, especially as China’s economy is no longer as underinvested as it was 20 years ago. Falling efficiency ultimately entails lower productivity and, eventually, declining potential real GDP growth. Has China Deleveraged? Following such an epic credit boom, one would typically expect creditors in general and banks in particular to undertake profound cleansing of their balance sheets, and for the amounts involved to be colossal. However, Chinese banks have not yet done this on a meaningful scale. We estimate that banks have disposed – written-off and sold - RMB 9.4 trillion in loans since 2012, which is equivalent to 6.6% of all loans originated since January 2009 (when the credit boom commenced). In addition, banks’ NPL provisions remain very low at 3.4% of their loan book. In a nutshell, banks have not yet sufficiently cleansed their balance sheets. Not surprisingly, their share prices have been among the worst performers in the Chinese equity universe and in the EM space more generally. Overall, the Chinese economy was very healthy and was on an extremely solid foundation until the credit boom (“soft-budget” constraints) began in 2009. Since then, the economic model has bred inefficiencies which could weigh on growth going forward. One widely circulated counterargument against the thesis of excessive credit/money growth in China has been that Chinese households save a lot. As the argument goes, this is what has prompted banks to lend out those deposits. This analysis is incorrect, and we have written extensively about this topic in a series of reports that are available upon request. The interaction between money creation, credit and savings is outside the scope of this report. We therefore limit the discussion to the key inferences from the series of reports we published: National savings, including household savings, do not create money supply or deposits. Also, banks do not lend out deposits. Money/deposits are created by commercial banks when they make loans to, or buy assets from, non-banks. This is true for any economy in the world. Chart 10Gradual Deleveraging But No Crisis In Japan In 1990s Gradual Deleveraging But No Crisis In Japan In 1990s Gradual Deleveraging But No Crisis In Japan In 1990s We agree that Chinese households do have a high savings rate. However, their savings do not impact whether banks originate loans and create deposits, i.e., expand money supply. To expand their balance sheets, banks require liquidity/excess reserves, not deposits. In short, the enormous money supply in China has been an outcome of reckless behavior on the part of banks and borrowers rather than originating out of household or national savings. As such, at the current levels, Chinese money and credit represent major excesses and, thereby, pose risks to financial stability and long-term development. A pertinent question is as follows: Is there an economy that did not experience a credit crisis following a credit bubble? Japan is one example. Yet, Japan suffered from deleveraging. The top panel of Chart 10 demonstrates that bank loan growth peaked at 12% in 1990 and gradually slowed thereafter, ultimately contracting. The bottom panel of Chart 10 shows that Japan’s companies and households underwent gradual deleveraging beginning in the mid-1990s. Such a long lasting but gradual adjustment contrasts with the acute and sharp crisis that occurred in the US in 2007-08. To sum up, credit excesses do not need to culminate in a credit crisis; Japan being the primary example. However, it is unusual for the non-public debt-to-GDP ratio to continuously rise from already elevated levels. In brief, China has seen its money and credit excesses rise continually and the problem has yet to be addressed. Other Structural Headwinds Chart 11China Is Much More Industrialized Than Commonly Believed China Is Much More Industrialized Than Commonly Believed China Is Much More Industrialized Than Commonly Believed The Chinese economy is facing other structural headwinds: First, the oft-quoted 60% urbanization rate understates the extent of China’s industrialization. China is much more industrialized than generally perceived: the country’s industrialization rate is currently 85% – i.e., 85% of jobs in China are already in non-agricultural sectors (Chart 11). This entails a slower rate of industrialization and urbanization going forward. Second, the labor force is shrinking. This is a major drag on the nation’s potential real GDP growth rate – which is equal to the sum of productivity growth and labor force growth. In turn, productivity growth is estimated to have slowed down to about 6% with total factor productivity growth slipping to 2% (Chart 8, bottom panel, above). Chart 12Re-Balancing Is About Slowing Capex Not Accelerating Consumer Spending Re-Balancing Is About Slowing Capex Not Accelerating Consumer Spending Re-Balancing Is About Slowing Capex Not Accelerating Consumer Spending As we discussed in our recent Special Report A Primer On Productivity, productivity is the most important variable for any country’s long-term development and 6% is still a very high number. The challenge for China in the coming years is to prevent its productivity growth rate from dropping below 4.5-5%. Third, there is a misconception about what rebalancing really means for this economy. Consumer spending in China has in fact been booming over the past 20 years – it has been growing at a compounded annual growth rate (CAGR) of 10.3% in real terms from 1998 until 2020 (pandemic) (Chart 12, top panel). Hence, the imbalance in China has not been sluggish consumer spending, which has actually been booming for the past 20 years. Rather, capital expenditure has been too strong for too long (Chart 12, bottom panel). Healthy rebalancing entails a slowdown in investment spending – not an acceleration in household demand. Hence, the market relevant question is: can the growth rate of household expenditure accelerate above 10% CAGR in real terms as capital spending decelerates? Our hunch is that this is unlikely. The basis is that investment outlays account for more than 40% of GDP and create many jobs and income, which in turn feeds into consumer spending. A meaningful downshift in capital expenditures will produce lower household income growth, resulting in a moderation in consumer spending growth. Bottom Line: Maturing industrialization, a shrinking labor force and an imperative to slow capital spending all constitute formidable headwinds to China’s secular growth outlook. China’s Advantage: What Makes It Distinct  Chart 13China Does Not Have An Inflation Problem China Does Not Have An Inflation Problem China Does Not Have An Inflation Problem Although all of the above structural drawbacks have persisted for the past ten years, the Chinese economy (1) has not experienced a credit crisis; and (2) has not seen an inflation outbreak despite burgeoning money supply. The question is: why? Concerning the credit excesses and the property bubble, China has avoided a credit crisis because its banking system has shown extreme forbearance towards debtors, i.e., banks have not forced corporate restructuring when companies were unable to service their debt. Besides, authorities – being fully aware of the risk of financial instability – have been lenient towards banks and debtors, tolerating continued credit overflow and rising credit excesses. The domestic credit growth rate has never dropped below nominal GDP growth (Chart 4 above). Rather, it has remained above 10% – despite several episodes of policy tightening and deleveraging campaigns. Authorities in any country with effective control over banks could do this. However, many economies with such a rampant money/credit boom would exhibit very high inflation. Yet, inflation in China has been absent (Chart 13). Critically, China’s advantage over other nations has not been its banking system or its monetary policy’s "magic touch" but its ability to continuously grow productivity at a solid rate. Inflation has remained subdued due to robust productivity gains. Without the latter, policymakers would have little room to navigate and secure economic and financial stability. The lack of inflation in China amid the credit and money boom is critical to understanding the unique structure and character of its economy. We have the following considerations: First, rampant money growth is typically associated with higher inflation because of the presumption that new money creation stimulates the demand for, but not the supply of goods and services. This is presently the case in the US where monetarization of public debt and fiscal transfers to households are boosting demand but not the potential productive capacity. However, in China’s case, credit flow to enterprises has always dwarfed credit to consumers. This means that the lion’s share of credit origination/money creation has been going directly into capital spending. Investment expenditures have led to rapid expansion of production capacity in the majority of industries. As a result, output has exceeded demand, resulting in an oversupply of goods and services and ultimately, in falling prices. Chart 14A and 14B illustrate that production capacity in many sectors in China has exploded over the past 20 years. In many industries, production capacity and output have expanded more than 10-fold since 2000. The outcome has been chronic deflation in many goods (Chart 15). Chart 14AProduction Capacity Has Been Surging In Many Industries Production Capacity Has Been Surging In Many Industries Production Capacity Has Been Surging In Many Industries Chart 14BProduction Capacity Has Been Surging In Many Industries Production Capacity Has Been Surging In Many Industries Production Capacity Has Been Surging In Many Industries   In short, too much credit/money channeled into expanding production capacity could lead to deflation. Second, when banks make new loans/create new money, inflation occurs in goods/commodities that money is used to purchase. Those goods/commodities experienced periods of high price inflation during money/credit growth acceleration. For example, China’s credit/money growth impulse explains swings in commodities prices (Chart 16). Hence, the link between credit/money and certain goods/commodities prices has held up. Chart 15Goods Deflation Is Pervasive In China Goods Deflation Is Pervasive In China Goods Deflation Is Pervasive In China Chart 16Money Impulse Is Sending A Warning For Industrial Metals Money Impulse Is Sending A Warning For Industrial Metals Money Impulse Is Sending A Warning For Industrial Metals   Finally, the application of digital technologies in service sectors has kept a lid on service price inflation. Hence, China has benefited from productivity-enabled disinflation despite the ongoing money/credit boom. That said, there are also areas where there has been rampant inflation. These include land, housing and high-end services. On the whole, deflation in goods prices due to oversupply has overwhelmed the pockets of high inflation in services. Crucially, unit labor costs in both the industrial economy (secondary industry) and service sectors have been contained as strong wage growth has been offset by robust productivity gains (Chart 17). The following factors have enabled high productivity growth in China: Chinese people are genuinely entrepreneurial, hardworking and disciplined. Educational attainment has been rising and innovation has proliferated. China has closed the gap in all patents with the US (Chart 18, top panel). It has actually surpassed the US in the number of semiconductor patents (Chart 18, bottom panel). Chart 17Rising Wages But Stable Unit Labor Costs Rising Wages But Stable Unit Labor Costs Rising Wages But Stable Unit Labor Costs Chart 18China Has Become A Global Innovation Hub China Has Become A Global Innovation Hub China Has Become A Global Innovation Hub Chart 19China Is Pursuing Automation On A Large Scale China Is Pursuing Automation On A Large Scale China Is Pursuing Automation On A Large Scale Our report from June 24, 2020 has elucidated the nation’s innovation drive. Rising spending on research and development will ensure China’s continued ascent as a major global innovation hub. Consistent with rising productivity, China’s share in global trade continues to rise. China is aggressively implementing automation in many of its industries, replacing labor with robotics. Specifically, the number employees in the industrial sector has been falling while production of industrial robots - and presumably, demand for them - has surged (Chart 19). The outcome will be continued rapid productivity gains which will allow companies to keep a lid on costs and secure reasonable profit margins without resorting to price hikes. What could cause productivity growth to slow? The main risk is complacency associated with easy credit and recurring fiscal stimulus, i.e., “soft-budget constraints”. If zombie companies continue to enjoy easy access to financing and are not forced to restructure and become more efficient, the pace of productivity gains will decelerate with negative consequences for potential GDP growth and inflation. In such a case, the credit system’s forbearance towards enterprises that misallocate capital will continue channeling money to projects with low efficiency. The latter will increase the supply of goods and services that are not demanded. This will produce pockets of short-term deflation but will lay the foundation for higher inflation down the road.1  Bottom Line: China’s unique advantage has been its ability to avoid inflation despite the money/credit boom. Using a large share of credit to expand production capacity – rather than consumption – has been the key to maintaining low inflation. The latter has allowed policymakers to avoid material tightening policy and has kept the currency competitive.  In brief, the nation has been able to maintain reasonably high productivity gains, albeit slower relative to pre-2010. As long as productivity grows at a solid rate, the economy will over time absorb excesses with moderate pain/setbacks and will do well structurally. Investment Considerations Appreciating the long-term negative ramifications of “soft-budget” constraints, Chinese policymakers have embarked on another tightening campaign since last summer. This policy stance will continue, and the economy is now facing triple tightening: Monetary and fiscal tightening: The total social financing and our broad money (M3) impulses have already rolled over (Chart 16 above). Fiscal policy will also tighten relative to the unprecedented stimulus of last year. Regulatory tightening on banks and non-bank financial institutions: Authorities are planning to reinforce asset management regulation by the end of this year. This will limit how much these financial institutions can expand their balance sheets reinforcing a credit slowdown. Property market tightening: Restrictions on both property purchases and property developers’ leverage will lead to a notable slump in real estate construction. Chart 20Overweight A Shares Versus Chinese Investable Stocks Overweight A Shares Versus Chinese Investable Stocks Overweight A Shares Versus Chinese Investable Stocks As China’s credit-sensitive sectors – construction and infrastructure spending – slow down this year, the risk-reward for industrial commodities and other China-plays worldwide is poor. Regarding Chinese stocks, Chinese A-shares will begin outperforming Chinese Investable stocks (Chart 20). We recommend the following strategy: long A shares / short China investable stocks. The primary reason is that the A-share index is heavy in value stocks while the MSCI China investable index has a large weight in expensive new economy stocks. The global investment backdrop has shifted in favor of global value versus global growth stocks due to strong US growth and rising US bond yields. Also, there has been more rampant speculation in global stocks that affect Chinese investable stocks more than onshore equities. Notably, the Composite A-share large and A-share small cap indexes have not performed well since July while investable stocks had been surging until recently. As to the exchange rate, the RMB is overbought and will likely experience a setback as the US dollar rebounds. However, the yuan’s long-term outlook versus the US dollar depends on the relative productivity growth. As long as the productivity growth differential between China and the US does not narrow, the RMB will appreciate versus the dollar on a structural basis. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 Deflation can turn into inflation when the economy produces goods/services that are not demanded (type A goods) and not producing the ones that are in demand (type B goods). As a result, prices of type A goods will deflate often overwhelming inflation type B goods keeping overall inflation very low. Consequently, production of type-A goods will halt because plunging prices will discourage output. As a result, deflation will abate in the economy. If the economy still cannot produce type-B goods – the ones in demand, inflation will become prevalent.

Dear Client From March 18 I will be writing under a new product title, the BCA Research Counterpoint. The aim of the Counterpoint is to generate a high volume of investment opportunities that are unconnected to the business cycle and run counter to the conventional wisdom. For those of you that have followed the European Investment Strategy through the past ten years, Counterpoint will seamlessly continue the same intellectual framework of investment ‘mega-themes’, fundamental analysis, fractal analysis, and sector primacy. The difference is that the investment opportunities will encompass all geographies. To whet your appetite, early Counterpoint reports will introduce new investment mega-themes including: the compelling structural case for cryptocurrencies; why shocks such as the pandemic are inherently predictable; and the structural transformation coming to the global labour market. There will also be an upgrade of the proprietary Fractal Trading System to generate more ideas per week and to boost the win ratio towards 70 percent. As for the European Investment Strategy, it will continue in the very capable hands of my colleague and friend, Mathieu Savary. Mathieu has previously written the Foreign Exchange Service, the flagship Bank Credit Analyst, and most recently the Daily Insights. Moreover, Mathieu is French. So if anyone knows how Europe works (and doesn’t work), it is Mathieu! I do hope you read both products. Best regards Dhaval Highlights If bond yields continue their march higher, the most dangerous earthquake will happen in the global real estate market. If higher bond yields caused even a 10 percent decline in the $300 trillion global real estate market it would unleash a deflationary impulse equal to one third of world GDP This would make any preceding inflationary impulse feel like a waltz in the park. For long-term investors who can ride out near term pain, there are three important conclusions: The ultimate low in bond yields is still ahead of us. The structural bull market in stocks will continue until bond yields reach their ultimate low. Equity investors should structurally tilt towards ‘growth’ sectors that will benefit from the ultimate low in bond yields. Feature Chart of the WeekThe Real Estate Market Dwarfs The Stock Market And The Global Economy The Real Estate Market Dwarfs The Stock Market And The Global Economy The Real Estate Market Dwarfs The Stock Market And The Global Economy In the last couple of weeks, higher bond yields have caused tremors in the stock market. But if bond yields continue their march higher and stay there, the most dangerous earthquake will not happen in the stock market, it will happen in the real estate market. The $90 trillion worth of the global stock market is large, but it is chicken feed compared with the $300 trillion worth of global real estate (Chart of the Week). The big worry is that the valuation of global real estate is critically dependent on bond yields staying low. If higher bond yields caused even a 10 percent decline in global real estate values, it would amount to a $30 trillion plunge in global wealth. Such a deflationary impulse, equal to one third of world GDP, would make any preceding inflationary impulse feel like a waltz in the park. Hence, to anybody worried that we are on the road to inflation, we pose a simple question. How would the world economy cope with the massive deflationary impact on $300 trillion of global real estate?1   The Real Risk Is Real Estate Over the past decade, global real estate rents have broadly tracked nominal GDP, as they should. But real estate prices have massively outperformed rents (Chart I-2). The reason is that the valuation paid for those rents has surged by 35 percent. This ‘multiple expansion’ of real estate which has added $80 trillion to global wealth – broadly equivalent to global GDP – is entirely due to lower bond yields. Chart I-2Real Estate Prices Have Massively Outperformed Rents And GDP Real Estate Prices Have Massively Outperformed Rents And GDP Real Estate Prices Have Massively Outperformed Rents And GDP Within the global real estate market, the residential segment constitutes 80 percent by value. Commercial real estate accounts for a little over 10 percent, and agricultural and forestry real estate makes up the remainder. It follows that the most important component of the real estate boom has been a housing boom. Given that most homes are owner-occupied, the boom in house prices has boosted the wealth of the ordinary global citizen by much more than the boom in stock prices. Moreover, the 2010s housing boom was unprecedented in its penetration and regional breadth, simultaneously encompassing cities, suburbs, and rural areas across North America, Europe, Asia and Australasia. Even Germany and Japan joined in, making it the most widely participated-in housing boom in economic history. What was behind this synchronised and broad-based housing boom? The answer is the universal decline in bond yields. As the global real estate firm Savills puts it: “Real estate has increased significantly in value, spurred on by the intervention of central banks and their suppression of bond yields” In fact, as the US and China now dominate the global real estate market, the downtrend in the global rental yield has closely tracked the downtrend in the US and China long bond yields. The big danger would be if this downtrend turned into an uptrend, undermining the valuation of $300 trillion of global real estate. To repeat, even a 10 percent synchronised decline in global real estate prices would wipe out $30 trillion of global wealth equal to one third of annual GDP, and it would impact almost everybody. The ‘multiple expansion’ of real estate has added $80 trillion to global wealth, broadly equivalent to global GDP. But where is the pain point? Our answer is that if inflation fears lifted the average US and China 30-year bond yield to 3.75 percent (from 3 percent now), it would constitute the change in trend that would unleash a massive countervailing deflationary impulse from falling house prices (Chart I-3). Chart I-3Higher Bond Yields Would Unleash A Massive Deflationary Impulse From Falling House Prices Higher Bond Yields Would Unleash A Massive Deflationary Impulse From Falling House Prices Higher Bond Yields Would Unleash A Massive Deflationary Impulse From Falling House Prices Waiting For Rationality To Return To Stocks In the stock market, the August to mid-February period was a brief aberration in which stocks rallied in tandem with rising bond yields. But looking at the bigger picture, the bull market in stocks, just as for real estate, is due to lower bond yields (Chart I-4). Chart I-4The August To Mid-February Rally In Stocks Was An Aberration The August To Mid-February Rally In Stocks Was An Aberration The August To Mid-February Rally In Stocks Was An Aberration Since 2008, global stock market profits have gone nowhere. Therefore, the only reason that the stock market surged is that the valuation paid for those unchanged profits surged. Just as for real estate, the stock market’s valuation surged because bond yields collapsed (Chart I-5). Chart I-5The Bull Market In Stocks Is Entirely Due To Higher Valuations The Bull Market In Stocks Is Entirely Due To Higher Valuations The Bull Market In Stocks Is Entirely Due To Higher Valuations Taking account of this downtrend in bond yields, the post-2008 boom in valuations is rational. However, as we warned two weeks ago, the continued expansion of valuations while bond yields are backing up means that The Rational Bubble Is Turning Irrational. The point of vulnerability is in high-flying tech stocks. Since 2009, the technology sector earnings yield has always maintained a minimum 2.5 percent premium over the 10-year T-bond yield, defining the envelope of the rational bubble. But in recent weeks, this envelope has been breached, indicating that valuation is entering a new and irrational phase (Chart I-6). Chart I-6The Rational Bubble Is Turning Irrational The Rational Bubble Is Turning Irrational The Rational Bubble Is Turning Irrational For long-term investors the pressing questions are: how much higher can bond yields go, and for how long? Our answers are, much less than 1 percent, and not for long – because the deflationary impact on $300 trillion of real estate would eventually force bond yields into a very sharp reversal. The Road To Inflation Ends At Deflation Many people believe that ‘real’ assets such as real estate and stocks perform well in an inflationary scare. But this is a misunderstanding. Granted, the income generated by real assets should keep pace with nominal GDP. But the valuation paid for that income collapses, taking the price of the asset down with it. From the state of price stability, in which most developed economies now find themselves, the creation of inflation is a non-linear phenomenon. Non-linear means that policymakers’ efforts result in either nothing (witness Japan or Switzerland), or in uncontrolled inflation (witness the US in the late 1960s). In fact, can you name any economy that has shifted from price stability to a controlled inflation? If you can, please tell me in an email! When an economy phase shifts from price stability to price instability, the valuations of real assets collapse. This is because the starting valuation needed to generate a given real return during uncontrolled inflation is much lower than during price stability. When an economy phase shifts from price stability to price instability, the valuations of real assets collapse. Chart I-7 should make this crystal clear. During the low-inflation 1990s and 2000s, a starting price to earnings multiple of 15 consistently generated a prospective 10-year real return of 10 percent. But during the uncontrolled inflation of the 1970s, the same starting multiple of 15 generated a real return of zero. To generate a real return of 10 percent, the starting multiple had to sink to 7. This explains why the prices of stocks and real estate collapsed in the 1970s and why they would collapse again in a new inflationary scare. Chart I-7In An Inflation Scare, Valuations Have To Collapse To Generate An Adequate Real Return In An Inflation Scare, Valuations Have To Collapse To Generate An Adequate Real Return In An Inflation Scare, Valuations Have To Collapse To Generate An Adequate Real Return As an aside, this also explains why so-called ‘financial repression’ – whereby the central bank holds down bond yields while the government generates inflation – will not work. While it is conceivable that a government could corner its government bond market and thereby repress it, it would be near-impossible to repress the much larger asset-classes of stocks and real estate. Once these large and privately priced markets sniffed out the government’s nefarious plan, the valuation of such assets would collapse to generate the previously required real return – the result being an almighty crash in stock and real estate prices. Given that the combined value of such markets dwarfs the $90 trillion global economy, the road to inflation would end at deflation. For long-term investors who can ride out near term pain, all of this leads to three important conclusions: The ultimate low in bond yields is still ahead of us. The structural bull market in stocks will continue until bond yields reach their ultimate low. Equity investors should structurally tilt towards ‘growth’ sectors that will benefit from the ultimate low in bond yields. Fractal Trading System* In a very successful week, short MSCI Korea versus MSCI AC World achieved its 10.6 percent profit target and short tin versus lead quickly achieved its 13 percent profit target. This takes the rolling 12-month win ratio to 60 percent. Given the transition to the new product title, there are no new trades this week. We look forward to introducing the upgraded Fractal Trading System and some new trades in the BCA Counterpoint on March 18. Chart I-8MSCI Korea Vs. MSCI All-Country World MSCI Korea Vs. MSCI All-Country World MSCI Korea Vs. MSCI All-Country World * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Source: Savills Prime Index: World Cities, August 2020; and Savills: 8 things to know about global real estate value, July 2018. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Interest Rate 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 The price of Bitcoin has surged this year as the digital currency has gained increasing acceptance. Just as was the case with gold, a global financial system built around Bitcoin would be precariously unstable. Bitcoin transactions are expensive to make and slow to execute, making the currency unsuitable as a medium of exchange. Bitcoin miners consume more energy than many countries. ESG funds are likely to shun companies that associate themselves with the currency. Governments, which stand to lose billions of dollars in seigniorage revenue, will put up more obstacles to Bitcoin. As a result, Bitcoin will lose most of its value over time. Bitcoin And Bullion: Back To The Future? Modern banks grew out of the activity of goldsmith guilds during the Middle Ages. Not only did goldsmiths craft beautiful items from precious metals, but because they had to maintain adequate security, they also tended to offer safekeeping services. Chart 1An Inelastic Money Supply Historically Led To More Banking Crises Bitcoin: A Solution In Search Of A Problem Bitcoin: A Solution In Search Of A Problem A wealthy merchant who deposited some gold coins with a goldsmith would receive a receipt validating his claim on the coins. Rather than rushing back to the goldsmith to withdraw some coins in order to make a purchase, it became common practice to offer the receipt instead. To facilitate commerce, goldsmiths began to offer receipts for specific values, marking the creation of the first proto-banknotes. On a typical day, only a small fraction of the gold held on deposit would be withdrawn. As long as goldsmiths always had enough gold on hand to meet demand, they could issue notes in excess of the amount of gold that they held in their vaults. Sometimes the goldsmiths would use those additional notes to purchase goods for themselves. Other times, they would lend out the notes, with interest charged to the borrower. The fractional reserve banking system was born. As the fledgling banking system evolved, it became more sophisticated. Nevertheless, it continued to suffer from a fundamental flaw: It was highly vulnerable to self-fulfilling crises. If people began to fear that a bank would run out of gold reserves, they would rush to the bank to be the first to withdraw their funds. Chart 1 shows that bank runs were very common during the 19th century. What Is Bitcoin Good For? Not Much When Bitcoin enthusiasts talk about a world in which global finance is centred on cryptocurrencies, they see the future. Personally, I see the past. John Maynard Keynes famously called the gold standard a barbarous relic. He had a point. A world based on the “Bitcoin standard” would be just as chaotic as the one that was built on the gold standard. Bitcoin’s defenders would argue that the digital currency has advantages that gold, and more importantly, fiat money do not have. But what exactly are those advantages? It certainly is not ease of use. Whereas the Visa network processes nearly 25,000 transactions per second, the Bitcoin mempool, the pool of unconfirmed transactions, has trouble handling five (Chart 2). Bitcoin transactions take 10 minutes to an hour to complete compared to just a few seconds for most debit or credit cards. The average fee for a Bitcoin transaction is around $30 – a number that has been rising over the past year (Chart 3). Chart 2Bitcoin: The Speed Of Transactions, Or Lack Of It Bitcoin: The Speed Of Transactions, Or Lack Of It Bitcoin: The Speed Of Transactions, Or Lack Of It Chart 3Bitcoin: The Cost Per Transaction Is Rising Bitcoin: The Cost Per Transaction Is Rising Bitcoin: The Cost Per Transaction Is Rising Crypto-optimists insist that these impediments will recede over time. However, this is far from certain. Efforts to expedite Bitcoin transactions have run into “fundamental issues.” Markus Brunnermeier and Joseph Abadi have argued that no cryptocurrency can fully satisfy the three desirable properties of decentralization, correctness, and cost-efficiency. Unlike centralized institutions such as banks, blockchain technology works by generating a sort-of consensus among its participants about what constitutes a legitimate transaction. By its nature, the process tends to be very resource-intensive. Bitcoin’s Big Environmental Footprint Chart 4Bitcoin Is Not Your Eco-Currency (I) Bitcoin: A Solution In Search Of A Problem Bitcoin: A Solution In Search Of A Problem This raises another problem with Bitcoin: Its environmental impact. A single Bitcoin transaction consumes more than four times as much energy as 100,000 Visa transactions (Chart 4). Bitcoin’s annual electricity consumption now exceeds that of Pakistan and its 217 million inhabitants (Chart 5). The Bitcoin algorithm requires that “miners” solve computationally intensive problems to earn new coins. It should be stressed that the solutions to these problems have no social value. Miners are not solving protein-folding algorithms that are useful for the discovery of new drugs. They are basically wasting CPU cycles by competing with one another to guess extremely large numbers in the hopes of acquiring a shrinking volume of new coins (the total number of Bitcoins that can ever be produced is limited to 21 million). Chart 5Bitcoin Is Not Your Eco-Currency (II) Bitcoin: A Solution In Search Of A Problem Bitcoin: A Solution In Search Of A Problem To make matters worse, more than two-thirds of Bitcoin mining takes place in China, where electricity is primarily generated using coal. Companies that claim to be environmentally conscious have no business trafficking in Bitcoin. What Explains The Bitcoin Bubble? Given the seemingly intractable existential problems that Bitcoin faces, why has its price gone through the roof? To some extent, the euphoria over Bitcoin is part of a broader speculative mania that has swept over everything from shares of electric vehicle companies to dubious SPACs and highly shorted “meme stocks.” No commentary about Bitcoin on the internet is complete with an obligatory prediction that it is “going to da moon.” Chart 6Lower Spending And Higher Income Led To Mounting Excess Savings Lower Spending And Higher Income Led To Mounting Excess Savings Lower Spending And Higher Income Led To Mounting Excess Savings Occasionally funny late-night talk show host John Oliver has joked that Bitcoin is “everything you don’t understand about money combined with everything you don’t understand about computers.” When people don’t have a good basis for determining what something is worth, they can let their imaginations run wild, causing prices to become unhinged from reality. Bitcoin and other cryptocurrencies are especially susceptible to feedback loops because they rely on network effects: The more people that use Bitcoin, the more appealing it is for others to use it. PayPal’s decision to let its customers trade Bitcoin on its platform, as well as Tesla’s announcement that it will accept it as payment, have stoked hopes that the digital currency is about to go mainstream. A surfeit of savings has also helped propel Bitcoin. US households accumulated $1.5 trillion in excess savings in 2020, two-thirds of which came from spending less than they normally would (Chart 6). The counterpart to the savings glut is a dearth of high-yielding assets. Bitcoin does not generate any cash flow, but with real rates still in negative territory, the prospect of capital appreciation has been more than enough to compensate investors for that deficiency. Bitcoin: Risks Tilted To The Downside Of course, if the price of Bitcoin were to start trending lower, speculators could flee the currency en masse. And therein lies the problem: If people decide that Bitcoin is not worth much, then it will not be worth much. Chart 7The Uses Of Gold: A Breakdown Bitcoin: A Solution In Search Of A Problem Bitcoin: A Solution In Search Of A Problem One could argue that the same risk plagues gold. There is some truth to this argument, but it should be noted that gold does have alternative uses, most notably jewelry. According to the World Gold Council, jewelry comprised 46% of the above-ground stock of gold at the end of 2020. Private investors held 22% of the gold stock, while central banks held 17% (Chart 7). Bitcoin has absolutely no alternative use to fall back on. Whereas central banks have been willing to hold gold as part of their external reserves, the same courtesy is unlikely to be extended to Bitcoin. The existence of fiat currencies gives central banks the power to set interest rates and provide liquidity backstops to the financial sector. Bitcoin would deprive them of that power. Governments derive significant benefits from the ability of their central banks to create money out of thin air and use it to purchase goods and services. In the US, this “seigniorage revenue” amounts to over $100 billion per year. Bitcoin threatens this stream of revenue. Speaking to The New York Times DealBook conference on Monday, Treasury Secretary Janet Yellen panned Bitcoin: “To the extent it is used I fear it’s often for illicit finance” she said, adding “It’s an extremely inefficient way of conducting transactions, and the amount of energy that’s consumed in processing those transactions is staggering.” Many companies have cozied up to Bitcoin in order to associate themselves with the digital currency’s technological mystique. As ESG funds start to flee Bitcoin, its price will begin a downward spiral. Stay away.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com    

Highlights Higher yields in China should continue to encourage inflows into the RMB. However, the gap between Chinese and US/global interest rates will narrow. This will temper the pace of RMB appreciation. The RMB remains modestly undervalued. Higher productivity gains in China will raise the fair value of the currency. The US dollar could have entered a structural bear market. This will also buffet the CNY-USD exchange rate. A big driver for the RMB in the coming years will also be widespread diversification away from USD assets. This will dovetail nicely with the ascension of the RMB in global FX reserves. Feature Chart 1The RMB Often Moves With Relative Rates The RMB Often Moves With Relative Rates The RMB Often Moves With Relative Rates The appreciation in the Chinese yuan has been a boon for global bond, equity and currency investors. With extremely low volatility, the yuan has appreciated by approximately 10% since its May 2020 lows. This places the rise in the RMB on par with what we saw in the 2017/2018 period. It also makes the yuan one of the best performing emerging market currencies this year. One of the key drivers of the yuan’s stellar performance has been the interest rate gap between China and the US (Chart 1). The Chinese economy was one of the first to emerge from the pandemic-driven lockdown. As economic activity recovered, so did local bond yields. With global bond yields now on the rise, this raises the specter that Sino-global bond yield spreads will narrow. The implications for the path of the Chinese yuan are worth monitoring. On the other hand, structural factors also argue that the path of least resistance for the US dollar over the next few years is down. This is positive for the Chinese yuan. Which force will dominate the path of the RMB going forward? In this Special Report, we discuss the intersection between the People’s Bank of China (PBoC) monetary policy and the global environment, and what that means for the Chinese yuan on a 12-month horizon. China And The Global Cycle The evolution of the global economic cycle has important implications for the yuan exchange rate in particular, because the RMB is a pro-cyclical currency. The USD/CNY has been moving tick for tick with emerging market equities, Asian currencies and commodity prices (Chart 2). Meanwhile, China has also been a major engine for global growth. Ever since the global financial crisis, the money and credit cycle in China has led the global recovery (Chart 3). With the authorities set to modestly decelerate the pace of credit creation, it will be important to gauge if this is a risk to global growth and, by extension, the path of the RMB. Chart 2The RMB Has Traded Like A Pro-cyclical Currency The RMB Has Traded Like A Pro-cyclical Currency The RMB Has Traded Like A Pro-cyclical Currency Chart 3The Chinese Impulse Leads ##br##The Global Cycle The Chinese Impulse Leads The Global Cycle The Chinese Impulse Leads The Global Cycle     In our view, while the credit impulse in China will roll over, the impact will be to slow the pace of RMB appreciation rather than reverse it, because: The interest rate gap between China and the rest of the world will remain very wide. The current level of 10-year yields in China is 3.3% versus 1.4% in the US. In a world of very low nominal interest rates, a differential of almost 200 basis points makes all the difference. Our base case is that the Chinese credit impulse could slow to 30% of GDP. If past is prologue, this could compress the yield spread to 1.5% but will still provide a meaningful yield pickup for foreign investors (Chart 4). Meanwhile, the real rate differential between China and the US might not narrow much if China continues to reign in credit growth, while the US pursues inflationary policies. Already, inflation in China is collapsing relative to the US, which supports relative real rates in China.   The credit impulse tends to lead the economy by six to nine months, thus, for much of 2021, Chinese growth will remain robust. Overall industrial production is picking up meaningfully, with the production of electricity and steel, and all inputs into the overall manufacturing value chain inflecting higher. This will continue to support bond yields in China (Chart 5). In recent weeks, both steel and iron ore prices have been soaring. While supply bottlenecks are playing a role, it is evident from both the manufacturing data and the trend in prices that demand is also a key driver (Chart 6). Chart 4The China-US Spread Will Stay Positive The China-US Spread Will Stay Positive The China-US Spread Will Stay Positive Chart 5Underlying Economic Activity Is Resilient Underlying Economic Activity Is Resilient Underlying Economic Activity Is Resilient Chart 6Strong Chinese Demand For Commodities Strong Chinese Demand For Commodities Strong Chinese Demand For Commodities China has had a structurally higher productivity growth rate compared to the US or Europe for many years, which will continue. It is also the reason why the fair value of the currency has been rising over the last two decades (Chart 7). Higher productivity growth suggests the neutral rate of interest in China will remain high for many years and will attract further fixed income inflows. China is running a basic balance surplus, which indicates that the RMB does not need to cheapen to entice capital inflows (Chart 8). Chart 7The RMB Is Not Overvalued The RMB Is Not Overvalued The RMB Is Not Overvalued Chart 8A Basic Balance Surplus A Basic Balance Surplus A Basic Balance Surplus Chinese bonds are gaining wider investor appeal. Following their inclusion in the Bloomberg Barclays Global Aggregate Index (BBGA) since April 2019, and in the JP Morgan Government Bond - Emerging Market Index (GBI-EM) since February 2020, FTSE Russell announced the inclusion of Chinese government bonds in the FTSE World Government Bond Index (WGBI) as of October 2021. The inclusion of Chinese government bonds in all of the world’s three major bond indices is a seminal milestone in the process of liberalizing the Chinese fixed-income market. Based on both the US$2-4 trillion in AUM, tracking the WGBI index and a 5-6% weight of Chinese bonds, an additional US$150 billion in foreign investments will flow into China’s bond market following the WGBI inclusion. Moreover, the JPMorgan Global Index team predicts that the inclusion of Chinese bonds in the world’s three major bond indices will bring RMB inflows of up to US$250-300 billion. This will be particularly true if Chinese bonds are perceived as a better hedge against equity volatility (Chart 9). Finally, currencies respond to relative rates of return, which include equity returns in addition to fixed income ones. The relative performance of the Chinese equity market in common currency terms has also moved neck and neck with the performance of the RMB (Chart 10). Chart 9Chinese Bonds Could Become The Perfect Hedge Chinese Bonds Could Become The Perfect Hedge Chinese Bonds Could Become The Perfect Hedge Chart 10The RMB Follows Domestic Equity Relative Performance The RMB Follows Domestic Equity Relative Performance The RMB Follows Domestic Equity Relative Performance Bottom Line: Even though the Chinese credit impulse will continue to roll over, bond investors will still benefit from enticing real interest rates in China as its neutral rate of interest is higher. Equity investors will also benefit from a cheaper market, as well as exposure to sectors that are primed to benefit as the global economy reopens. This combination will sustain the pace of foreign capital inflows (Chart 11). Chart 11Inflows Into China Remain Strong Inflows Into China Remain Strong Inflows Into China Remain Strong The Dollar Versus The RMB          The path of the RMB in the short-term will follow relative growth dynamics between China and the rest of the world, but structural factors such as the dollar’s reserve status will also dictate its longer-term trend. What China (and other countries for that matter) decide to do with their war chest of US Treasuries is of critical importance.  In recent years, foreign investors have been fleeing the US Treasury market at an exceptional pace. On a rolling 12-month total basis, the US saw an exodus of about US$500 billion in bond flows from foreigners, the largest on record (Chart 12). Vis-à-vis official flows, China has become the number one contributor to the US trade deficit. Concurrently, Beijing has been destocking its holdings of Treasuries, if only as retaliation against past US policies, or perhaps to make room for the internationalization of the RMB (Chart 13). Chart 12An Exodus From US Treasurys An Exodus From US Treasurys An Exodus From US Treasurys Chart 13China Destocking Of Treasurys China Destocking Of Treasurys China Destocking Of Treasurys Data from the International Monetary Fund (IMF) shows that the allocation of global foreign exchange reserves towards the US dollar peaked at about 72% in the early 2000s and has been in a downtrend since. Meanwhile, allocation to other currencies, including the RMB, is surging. Moreover, foreign central banks have been amassing tremendous gold reserves, notably Russia and China, almost to the tune of the total annual output of the yellow metal. A diversification away from dollars and into other currencies such as the RMB and gold will be a key factor in dictating currency trends in the next few years (Chart 14). Chart 14The RMB Rises In Global Currency Reserves The RMB Rises In Global Currency Reserves The RMB Rises In Global Currency Reserves The US dollar will remain the reserve currency of the world for years to come, but that exorbitant privilege is clearly fraying at the edges. This is especially the case as balance-of-payments dynamics are deteriorating. Rising US twin deficits have usually been synonymous with a cheapening dollar. Bottom line: For one reason or another, foreign central banks are diversifying out of dollars. This could be a long-term trend, which will dictate the path of the dollar (and by extension the RMB) in the years to come. Other Considerations Chart 15A Forward Discount On The RMB A Forward Discount On The RMB A Forward Discount On The RMB The RMB has historically suffered from capital outflows, especially illicit flows. This is less risky today than in 2015-2016.1  Nonetheless, investors must monitor this possibility. Typically, offshore markets have anticipated the yuan’s depreciation. Back in 2014, offshore markets started pricing in a rising USD/CNY rate, and maintained that view all the way through to 2018, when the yuan eventually bottomed. Right now, 12-month non-deliverable forwards expect a modest depreciation in the yuan (Chart 15). Offshore markets in Hong Kong and elsewhere can be prescient because more often than not, they are the destination for illicit flows out of China. However, this time might be different. First, higher relative interest rates in China have lowered the forward RMB rate investors will receive to hedge currency exposure. Second, junkets (key operators in Macau casinos) have been one of the often-rumored vehicles used for Chinese money to leave the country.2 These junkets bankroll their Chinese clients in Macau while collecting any debts in China, allowing for illicit capital outflows. This was particularly rampant before the Chinese 2015-2016 corruption clampdown, when Macau casino equities were surging while equity prices in China were subdued. This time around, with tourism taking a backseat, the Chinese MSCI index is heavily outpacing the performance of Macau casino stocks, suggesting little evidence of hot money outflows (Chart 16). Chart 16China Versus Macau Stocks: Little Hot Money Outflows Like In 2013/2014 China Versus Macau Stocks: Little Hot Money Outflows Like In 2013/2014 China Versus Macau Stocks: Little Hot Money Outflows Like In 2013/2014 Sino-US trade relations will also affect the exchange rate. China remains the biggest contributor to the US trade deficit, even though the gap has narrowed (Chart 17). There is little evidence that the Biden administration will engage in an all-out trade war with China, but the case for subtle skirmishes exists. Chart 17The US Trade Deficit With China Remains Wide The US Trade Deficit With China Remains Wide The US Trade Deficit With China Remains Wide In a broader sense, the pandemic might have supercharged the de-globalization trend witnessed since 2011. The stability and self-sufficiency in the production capacity of any country's core supply chain have become paramount. From the perspective of the US, this means introducing more policies that attract investment into domestic manufacturing, such as clean energy. US multinational companies may also continue to diversify production risk away from China to other emerging countries, among them Vietnam, Myanmar, and India. This will curtail FDI flows into China at the margin (previously mentioned Chart 8). Concluding Thoughts Chart 18The RMB And The Trade-Weighted Dollar The RMB And The Trade-Weighted Dollar The RMB And The Trade-Weighted Dollar While USD/CNY could bounce in the near term, it is likely to reach 6.2 in the next 12 months. Interest rate spreads at the long end already overtook their 2017 highs and are near cyclically elevated levels. The bond market tends to lead the currency market by a few months, since China does not yet have a fully flexible and open capital account. Meanwhile, the path of the US dollar will also be critical for the USD/CNY exchange rate. We expect the USD to keep depreciating, which will boost the RMB (Chart 18).3 A slower pace of RMB appreciation will fend off interventionist policies by the PBoC. While the exchange rate has appreciated sharply since mid-2020, the CFETS rate has not deviated much from the onshore USD/CNY rate. This will remain the case if the pace of RMB appreciation moderates.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Chinese Investment Special Report, titled “Monitoring Chinese Capital Outflows,” dated March 20, 2019, available at fes.bcaresearch.com. 2 Please see Reuters article “Factbox: How Macau’s casino junket system works,” available at reuters.com. 3 Please see Foreign Exchange Strategy Special Report, titled “2021 Key Views: Tradeable Themes,” dated December 4, 2020, available at bcaresearch.com. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Dear client, On behalf of the China Investment Strategy team, I would like to wish you a very happy, healthy, and prosperous Chinese New Year of the Ox (Bull)! Gong Xi Fa Chai, Jing Sima, China Strategist   Highlights A projected 8% increase in China’s real GDP for 2021 will not be an acceleration from the V-shaped economic recovery from the second half of last year. Excluding an exceptionally strong year-over-year economic expansion in Q1, the average growth in the rest of this year will be slower than in 2H20, which implies China’s economic growth momentum has already passed its peak. On a quarter-over-quarter basis, an expected 18% annual growth in Q1 would mean that China’s economic growth momentum has moderated from Q4 last year. Chinese policymakers are not in a hurry to press the stimulus accelerator again, with good reason. Commodity and risk-asset prices will be the most vulnerable to a weakened demand growth.   Feature China’s real GDP is expected to grow by more than 8% this year, which would be a significant improvement over last year’s 2.3%.1 However, it is misleading to compare this year’s growth with that of 2020 as a whole. The first three months of this year will undergo an exceptionally high year-on-year growth (YoY) rate due to the deep contraction experienced in Q1 last year. An 8% annual growth for 2021 would imply that the rate of economic expansion in the rest of this year will be slower than the sharp recovery in 2H20.  From a policy perspective, an 8% real GDP growth in 2021 implies an average rate of 5% over the 2020-2021 period, within the long-term growth range targeted in China’s 14th Five-Year Plan - this removes policymakers’ incentives to further stimulate the economy. The annual National People's Congress (NPC) in early March should provide clues about the government's growth priorities and policy directions. If policymakers set 2021’s real GDP growth target at around 8%, our interpretation is that Chinese leaders are not looking to accelerate growth beyond where it ended in 2020. Major equity indexes are already richly valued. A moderating growth momentum from China will weigh on commodity and risk asset prices, both in China and globally.  We reiterate our view that downside risks are high in the near term; the market could take the easing demand growth from China as a reason for a long overdue correction. A Perspective On Growth In 2021 Investors should put this year’s GDP growth projections into perspective given last year’s distortions in China’s economic conditions and data. On a YoY basis, data in the first quarter this year will be artificially boosted due to the deep contraction in Q1 last year. The market consensus is that Q1 2021 will register an 18% YoY rate of real GDP expansion. If we assume the economy can expand by 8% this year over 2020, then the YoY GDP growth rates in the rest of this year will average less than 6%. This would be below the 6.5% YoY rate in the fourth quarter of 2020 – meaning that on a YoY basis, China’s growth momentum has peaked (Chart 1). Importantly, sequential growth, such as month-over-month (MoM) and quarter-over-quarter (QoQ), drives the financial markets. On a QoQ basis, Q1 business activities are typically weaker due to the Chinese New Year. However, when we compare the rate of QoQ slowdown in Q1 this year with previous years, an 18% YoY increase would mean China’s output in the first three months of 2021 would be one of the worst in the past 20 years (Chart 2).  Chart 1Q1 GDP Growth Will Be Artificially Boosted, On A YoY Basis Q1 GDP Growth Will Be Artificially Boosted, On A YoY Basis Q1 GDP Growth Will Be Artificially Boosted, On A YoY Basis Chart 2…But Will Be On The Weaker Side, On A QoQ Basis Understanding China’s Growth Arithmetic For 2021 Understanding China’s Growth Arithmetic For 2021 The moderating growth momentum in Q1 this year was already reflected in high-frequency data in January. Most major components in last week’s PMI surveys in both the manufacturing and service sectors had larger setbacks than in January of previous years. Prices in major commodities as well as the Baltic Dry Index softened (Chart 3). Cyclical sector stocks in China’s onshore market, which is highly sensitive to domestic economic policies, have halted their outperformance relative to defensive stocks (Chart 4).  Chart 3Chinese Economic Growth May Be Showing Signs Of Moderation Chinese Economic Growth May Be Showing Signs Of Moderation Chinese Economic Growth May Be Showing Signs Of Moderation Chart 4Outperformance In Onshore Cyclical Stocks Is Rolling Over Outperformance In Onshore Cyclical Stocks Is Rolling Over Outperformance In Onshore Cyclical Stocks Is Rolling Over Furthermore, it is useful to look past the growth outliers in the previous four quarters to gain insight into the status of China’s business cycle. On a two-year smoothed term, an 8% annual output growth in 2021 would represent a continuation of China’s downward economic growth trend (Chart 5). Chart 5This Years Rebound In Headline GDP Growth Does Not Alter Chinas Structural Downtrend This Years Rebound In Headline GDP Growth Does Not Alter Chinas Structural Downtrend This Years Rebound In Headline GDP Growth Does Not Alter Chinas Structural Downtrend Bottom Line:  It is misleading to consider an 8% YoY real GDP growth rate in 2021 as an acceleration in China’s economic recovery. On a quarterly basis, Q1 will undergo a moderation in growth momentum. The economy in the rest of the year will remain on a downward growth trend. No Rush To Stimulate Anew If Q1 growth turns out to be weaker than the market anticipates, then will Beijing continue to dial back stimulus? Or, will it become concerned about the underlying fragility in the economy and provide more support? So far, all signs point to a continuation of a stimulus pullback. Chart 6Tighter Monetary Conditions are Starting To Bite the Economy Tighter Monetary Conditions are Starting To Bite the Economy Tighter Monetary Conditions are Starting To Bite the Economy The resurgence of domestic COVID-19 cases contributed significantly to January’s shaky demand. However, tighter monetary conditions in 2H20 are likely another reason for the growth moderation (Chart 6). Here are some factors that may have prompted Chinese authorities to stay on track to scale back stimulus: Policymakers appear to consider the massive fiscal stimulus last year overdone. In contrast with the previous two years, local governments are not issuing special-purpose bonds (SPBs) before the NPC sets its quota in early March. China’s broader fiscal budgetary deficit widened to 11% of GDP in 2020 from 6% in 2019. Local governments issued nearly 70% more SPBs in 2020 than in the previous year (Chart 7). SPBs are mostly used for investing in infrastructure projects and last year’s fiscal support along with substantial credit expansion helped to speed up infrastructure investment. However, towards the end of last year local governments reportedly experienced a shortage in profitable investment projects and thus, parked more than 400 billion yuan of proceeds from last year’s SPB issuance at the central bank (Chart 8). This will likely convince the central government to reduce the SPB quota by a large margin this year. Chart 7Fiscal Stimulus Last Year May Be Overdone Fiscal Stimulus Last Year May Be Overdone Fiscal Stimulus Last Year May Be Overdone Chart 8Local Governments Reportedly Ran Out Of Profitable Infrastructure Projects To Invest Last Year Local Governments Reportedly Ran Out Of Profitable Infrastructure Projects To Invest Last Year Local Governments Reportedly Ran Out Of Profitable Infrastructure Projects To Invest Last Year In addition, government revenues in 2020 were surprisingly strong and spending was well below budgeted annual expenditures, resulting in 2.5 trillion yuan in idle funds (Chart 9). Based on China’s fiscal budget laws, any unspent funds from the previous year will be carried over to the next year. In other words, the 2.5 trillion yuan will contribute to fiscal deficit reduction this year and are not extra savings that can be distributed.  In addition, asset price bubbles are a perennial concern. Land sales and housing demand for top-tier cities roared back last year due to cheap loans and a relaxed policy environment (Chart 10). In our opinion, Chinese leaders allowed the real estate market to temporarily heat up last year to avoid a deep economic recession. As the economy recovered to its pre-pandemic level by late 2020, policymakers have sharply reduced their tolerance for the booming housing market and substantially tightened restrictions in the real estate sector. Chart 9Unspent Fiscal Stimulus Checks Do Not Lead To Higher Government Spending Next Year Unspent Fiscal Stimulus Checks Do Not Lead To Higher Government Spending Next Year Unspent Fiscal Stimulus Checks Do Not Lead To Higher Government Spending Next Year Chart 10Housing Market Heats Up Again Housing Market Heats Up Again Housing Market Heats Up Again The domestic labor market has been surprisingly resilient, removing the leadership’s political constraints and incentives to further stimulate the economy.  Labor market conditions and household income are improving. The gap between household disposable income and spending growth has narrowed, the unemployment rate is back to its pre-pandemic level and consumer confidence has rebounded (Chart 11). More importantly, China’s labor market in urban areas is tightening again, with migrant workers receiving higher pay than prior to the pandemic (Chart 12).  Chart 11Labor Market Is On The Mend Labor Market Is On The Mend Labor Market Is On The Mend Chart 12China’s Urban Labor Market Is Tightening Again Understanding China’s Growth Arithmetic For 2021 Understanding China’s Growth Arithmetic For 2021 Bottom Line: Growth rates will moderate, but policymakers will wait for more evidence of a pronounced slowdown in economic conditions before they ease policies. Concerns about financial risks and excesses in the property market entail authorities to allow stimulus of 2020 to relapse. It will take a much deeper slowdown in the business cycle before easing is re-introduced. Investment Implications Our baseline view indicates that credit growth will decelerate by two to three percentage points in 2021 from 2020, and the local government SPB quota will drop by 10%. The projected pullbacks on stimulus are small and more measured than the last policy tightening cycle in 2017/18. Nevertheless, a smaller stimulus and tighter policy environment will consequently lead to moderating growth momentum in China’s domestic economy and demand, particularly in the second half of this year.   Chart 13How Far Can Chinas Inventory Restocking Cycle Go Without More Policy Tailwinds How Far Can Chinas Inventory Restocking Cycle Go Without More Policy Tailwinds How Far Can Chinas Inventory Restocking Cycle Go Without More Policy Tailwinds Commodity prices may be at high risk of easing demand. The strong rebound in China’s commodity imports in 2H20 was not only due to a recovery in domestic consumption, but also inventory restocking from an extremely low level. Chart 13 shows that the change in China’s industrial inventories relative to exports has risen substantially from a two-year contraction. Going forward, the pace of inventory accumulation will slow following a weaker policy tailwind and growth momentum, which will weigh on the demand for and prices of key industrial raw materials. Corporate profits should continue to recover, albeit at a slower rate than in 2H20. At the same time, risks are tilted to the downside, and policy initiatives should be closely monitored going forward. As such, we maintain a cautious view on Chinese stocks.    Jing Sima China Strategist jings@bcaresearch.com   Footnote: 1     IMF World Economic Outlook and World Bank Global Outlook, January 2021   Footnotes Cyclical Investment Stance Equity Sector Recommendations

Highlights GameStop & Bond Yields: The reflationary conditions that helped create a backdrop highly conducive to the wild stock market speculation on display last week – namely, aggressive monetary and fiscal policy stimulus to fight the pandemic – remain bearish for global government bonds and bullish for risk assets like global corporate credit. Remain overweight the latter versus the former. Italy: The latest bout of political uncertainty in Italy has only paused the medium-term spread compression story for BTPs versus core European government bonds, for two reasons: a) this political battle has, to date, had far less of the fiscal populism and anti-Europe flavor of past conflicts; and b) the ECB has shown that it will aggressively use its balance sheet to prevent a spike in Italian bond yields. Maintain an overweight stance on Italy in global bond portfolios, even with early elections likely later this year. Feature Dear Client, The next Global Fixed Income Strategy publication will be a Special Report on Canada, jointly published with our colleagues at Foreign Exchange Strategy on Friday, February 12. We will return to our regular publishing schedule on Tuesday, February 16. Rob Robis, Chief Global Fixed Income Strategist Chart of the WeekExpect More Bubbles & GameStop-Like Silliness Expect More Bubbles & GameStop-Like Silliness Expect More Bubbles & GameStop-Like Silliness The “Reddit Retail Revolution” has exposed the dangers of staying too long in crowded short positions for equities like GameStop, but bond markets were unfazed by the wild moves in stocks last week. US Treasury yields actually crept upwards as the mother of all short squeezes became the top news story in America. Corporate credit spreads worldwide were essentially unchanged, despite the pickup in US equity volatility measures like the VIX. Bond investors recognize that, while the sideshow of rebel traders taking on mighty hedge funds makes for great theater, the underlying reflationary global policy backdrop remains the main driver of global bond yields and credit risk premia (Chart of the Week). Global fiscal policy risks are increasingly tilted towards more stimulus than currently projected, even as the pace of new COVID-19 cases is starting to slow in the US and much of Europe. Vaccine rollouts in many countries are going far slower than expected, which has forced global central banks to commit to maintaining highly accommodative policies - zero interest rates, quantitative easing (QE) and cheap bank funding – for longer. As Fed Chair Jerome Powell noted in his press conference following last week’s FOMC meeting, “There’s nothing more important to the economy now than people getting vaccinated.” Chart 2Vaccine Rollout Critical For Fed/ECB/BoE Policy The Revolution Will Be Monetized The Revolution Will Be Monetized On that front, the largest economies on both sides of the Atlantic continue to perform poorly. According to data from the Duke Global Health Innovation Center, vaccination coverage (defined as actual vaccination doses acquired on a per person basis) in the US, UK and European Union remains low relative to the intensity of COVID-19 cases within the population (Chart 2) – especially compared to the experience of other major Western countries.1 As we discussed in last week’s report, it is far too soon for investors to fear a hawkish move by global central banks towards tapering asset purchases and signaling future interest rate hikes.2 The GameStop episode may cause some policymakers to worry about the financial stability risks resulting from cheap money policies, but not before the greater risks to global growth from the COVID-19 pandemic are contained. Until vaccination rates rise to levels where there is the potential for herd immunity to be reached, central banks will have little choice by to maintain 0% (or lower) policy rates for longer with continued expansion of their balance sheets (Chart 3). Policy makers will even likely respond with more QE in the event of broad financial market turmoil occurring before inflation expectations return to central bank targets (Chart 4). Chart 3Expect More Global QE ... The Revolution Will Be Monetized The Revolution Will Be Monetized Chart 4...To Moderate Reflationary Pressure On Bond Yields ...To Moderate Reflationary Pressure On Bond Yields ...To Moderate Reflationary Pressure On Bond Yields We continue to recommend the following medium-term positioning for reflation-based themes in global fixed income markets: below-benchmark overall duration exposure, favoring lower-quality corporate bonds versus government debt, and underweighting US Treasuries within global government bond portfolios. Bottom Line: The reflationary conditions that have helped create a backdrop highly conducive to the wild stock market speculation on display last week – namely, aggressive monetary and fiscal policy stimulus to fight the pandemic – remain bearish for global government bonds and bullish for risk assets like global corporate credit. Italy: ECB Policy Trumps Political Uncertainty One of our highest conviction fixed income investment recommendations over the past year has been to overweight Italian government bonds (BTPs). We have maintained that bullish stance with an expectation that Italian bond yields (and spreads over German debt) would converge to the levels of Spain, restoring a relationship last seen sustainably in 2016 (Chart 5). Chart 5A Small Response To Italian Political Uncertainty A Small Response To Italian Political Uncertainty A Small Response To Italian Political Uncertainty The recent collapse of the coalition government of Prime Minister Giuseppe Conte would, in a more “normal” time, represent a serious threat to the stability of the Italian bond market and our bullish view. Yet the response so far has been muted, with the spread between 10-year BTPs and German Bunds up only 11bps from the mid-January lows. The current political drama stemmed from a disagreement within the ruling coalition over how the government was planning to use Italy’s share of the €750bn EU Recovery Fund. As we go to press, the survival of the current government hangs in the balance, with President Sergio Mattarella testing whether the political parties can form a government with a majority. The initial announcement of that Recovery Fund was considered to be a major reason for a reduced risk premium on Italian government bonds, as it represented a potential step towards greater fiscal integration within Europe. Unfortunately, it took the COVID-19 crisis to get the rest of Europe to offer help to the more economically fragile countries like Italy. The country suffered one of the world’s worst initial waves of the virus and the late-2020 surge has also hit hard – although, more recently, Italy has fared far better than Southern European neighbors Spain and Portugal with a slower pace of new cases and hospitalizations (Chart 6). Italy’s economy has struggled under the weight of some of the most stringent restrictions on activity within Europe to stop the spread of the virus, according to the Oxford COVID-19 database (Chart 7). Domestic spending on retail and recreation activities is estimated to be down nearly 50% from the start of the pandemic, a hit to the economy made worse by the collapse of tourism revenue that will take years to fully recover. In other words, Italy desperately needs the money from the EU Recovery Fund. Chart 6Italy's COVID-19 Situation Is Slowly Improving Italy's COVID-19 Situation Is Slowly Improving Italy's COVID-19 Situation Is Slowly Improving Chart 7A Big Economic Hit To Italy From COVID-19 A Big Economic Hit To Italy From COVID-19 A Big Economic Hit To Italy From COVID-19 Former Prime Minister Matteo Renzi and his Italia Viva party precipitated the crisis by withdrawing their support from Conte’s coalition, but are in a weak position electorally. They claim that the funds should be handled by parliament, rather than a technocratic council overseen by Conte, and devoted to long-term structural reform rather than short-term fixes. Renzi’s withdrawal from the ruling coalition, however, is not grounded in substantial disagreements over fiscal spending: First, the EU recovery fund requires all member states to use 30% of the funds on climate change initiatives and 25% on digitizing the economy, and none of the major parties oppose this use of the €209 billion coming their way. Second, Prime Minister Conte adjusted his spending plans, nearly doubling the allocations for health, education, and culture, in response to Renzi’s criticisms that not enough spending focused on structural needs. Third, Renzi wants to tap €36 billion from the European Stability Mechanism in addition to taking recovery funds, but this would come with austerity measures attached (which is self-defeating) and would be opposed by the left-wing populist Five Star Movement, a linchpin in the ruling coalition. Even if the immediate political turmoil passes, there will still be an elevated risk of an early election as the various parties jockey for power in the wake of the cataclysmic pandemic, and as they eye control of the presidency, which is up for grabs in 2022. The only real change on the fiscal front would come if the populist League and Brothers of Italy ended up winning a majority and control of government in the eventual elections, as they favor much greater fiscal largesse. It is possible that Conte will survive as his personal support has increased throughout the crisis. Otherwise, former ECB President Mario Draghi could replace him, although he is now less popular than Conte. President Mattarella is not eager to dissolve parliament given that the combined strength of right-wing anti-establishment parties is greater than that of the centrist and left-wing parties in the ruling coalition judging by public opinion polls (Chart 8). Yet sooner rather than later, a new election looms. The country already completed an electoral reform via a referendum in September 2020 that cleared the way for a new election to be held. Chart 8Unstable Coalition Wants To Delay Election As Populist Right Slightly Ahead Unstable Coalition Wants To Delay Election As Populist Right Slightly Ahead Unstable Coalition Wants To Delay Election As Populist Right Slightly Ahead Chart 9Waning Immigration Undercuts Italian Populists (For Now) The Revolution Will Be Monetized The Revolution Will Be Monetized The current crisis is different than past bouts of Italian political uncertainty as there is less of a question over Italy’s commitment to the euro - which in the past has resulted in higher Italian bond yields and wider BTP-Bund spreads as markets had to price in euro breakup risk. The current coalition, and any new coalition cobbled out of the current morass to prevent a snap election, are united in their opposition to the populist League and the Brothers of Italy. They will strive to remain in power to distribute the EU recovery funds and secure the Italian presidency for an establishment political elite – one, like Mattarella, who will act as a check on the power of any future populist government and its cabinet choices, just as Mattarella himself hobbled the League’s most radical proposals from 2018-19. Chart 10Italian Support For EU & The Euro Sufficient But Not Ironclad The Revolution Will Be Monetized The Revolution Will Be Monetized While the right-wing “sovereigntist” parties lead in the opinion polls, the League has lost support since its leader Matteo Salvini’s failed bid to trigger an election in August 2019 and especially since the COVID-19 outbreak has boosted the establishment parties and coalition members. Anti-immigration sentiment, a key support of this faction, has subsided as the EU has cut down the influx of immigrants (Chart 9). Salvini and his supporters have also compromised their euroskepticism to appeal to a broader audience as 60% of the populace still approves of the euro – although this support is falling again and bears monitoring (Chart 10). Another economic shock or a new wave of immigration could put the right-wing populists into power. Moreover, an unstable ruling coalition will lose support over time in what will be a difficult post-pandemic environment. Thus, the risk of euroskepticism and fiscal populism will persist over the coming two years, even though they are most likely contained at the moment. Has The ECB Removed The Tail Risk Of BTPs? The ECB has shown they are willing to use their balance sheet via QE and cheap bank funding tools like TLTROs to support the euro area’s weakest link – Italy. Thus, any upward pressure on Italian bond yields/spreads from the current political fracas will almost certainly be met by a more aggressive ECB response (more QE for longer, new TLTROs), limiting the damage to the Italian bond market. Chart 11What Would Italian Loan Growth Be WITHOUT ECB Support? What Would Italian Loan Growth Be WITHOUT ECB Support? What Would Italian Loan Growth Be WITHOUT ECB Support? The ECB’s TLTROs appear to have been helpful for Italy, whose LTRO allotments represent 14.7% of total bank lending (Chart 11). Yet Spanish banks have relied on cheap ECB funding to a similar degree, while the growth of bank lending in Italy has substantially lagged that of Spain since the start of the pandemic in 2020 – even with Italy having less restrictive lending standards according to the ECB’s Bank Lending Survey. The ECB has also helped Italy by being more flexible with its purchases of Italian government bonds within both the Public Sector Purchase Program (PSPP) and the Pandemic Emergency Purchase Program (PEPP) that began in response to COVID-19. ECB data show that, after the worst days of the COVID-19 market rout last spring when the 10-year Italian bond yield soared from 1% to 2.4% over just three weeks, the ECB increased the Italy share of its bond buying to levels well above the Capital Key weighting scheme that “officially” governs the bond purchases. This was true within both the PSPP (Chart 12) and the PSPP (Chart 13). Chart 12ECB Paying Less Attention To The Capital Key In The PSPP ... The Revolution Will Be Monetized The Revolution Will Be Monetized Chart 13… And The PEPP The Revolution Will Be Monetized The Revolution Will Be Monetized Chart 14Stay Overweight Italian Government Bonds Stay Overweight Italian Government Bonds Stay Overweight Italian Government Bonds The ECB’s actions helped stabilize Italian bond yields, sowing the seeds of the major decline in yields that took place between April and September. Once Italian bond yields fell back to pre-pandemic levels, the ECB slowed the pace of its purchases of Italian bonds to levels at or below the Capital Key weights. Thus, the ECB was willing to deviate from its own self-imposed rules for its bond purchase schemes in order to ease financial conditions in Italy during a pandemic. There is no reason to believe that would not occur again if yields rise because of a growing political risk premium while the pandemic was still raging. A prolonged period of political uncertainty in Italy, especially one that ends with fresh elections, could even force the ECB to maintain or extend its full current mix of policies and not just QE. For example, a new TLTRO could be initiated later this year, or the subsidized cost of banks borrowing from existing TLTROs could be reduced further, all in an effort to help boost Italian lending activity. More likely, the PEPP could be expanded in size or extended beyond the current March 2022 expiration, or the PSPP could be upsized to allow for more purchases of Italian debt (Chart 14). From an investment strategy perspective, there is still a strong case for overweighting Italian government bonds in global fixed income portfolios, even with the current political uncertainty. The weight of ECB policy actions removes much of the usual upside risk to BTP yields. However, investors will likely be more reluctant to drive Italian yields (and spreads versus Germany) to fresh lows if there is a risk of early elections, as we expect. Italian bonds are now more of a pure carry with yields trapped between politics and QE, but that still justifies an overweight stance - especially given the puny levels of alternative sovereign bond yields available elsewhere in the euro area. Bottom Line: The latest bout of political uncertainty in Italy has only paused the medium-term spread compression story for BTPs versus core European government bonds, for two reasons: a) this political battle has, to date, had far less of the fiscal populism and anti-Europe flavor of past conflicts; and b) the ECB has shown that it will aggressively use its balance sheet to prevent a spike in Italian bond yields. Maintain an overweight stance on Italy in global bond portfolios, even with early elections likely later this year.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 The Duke Global Health Innovation Center data on COVID-19 can be found here: https://launchandscalefaster.org/COVID-19. 2 Please see BCA Research Global Fixed Income Strategy Report, "A Pause, Not A Peak, In Global Bond Yields", dated January 26, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Revolution Will Be Monetized The Revolution Will Be Monetized Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns