Real Estate

August PPI reading came in at 8.3%. Naturally, many investors are wondering whether the companies will be able to pass their soaring input costs to the customers. An in-depth analysis of margins and pricing power requires a significant research effort. However, below are some examples illustrating our thinking process on the topic. We also included pricing power sector charts in the Appendix.   Companies’ ability to hike prices is a function of the elasticity of demand, which is heterogeneous across industries and products. It also depends on product differentiation and competition in the industry. For some categories, such as consumer durables, pricing power has declined as prices reached the upper limit of affordability (Chart 1). As a result, durables goods manufacturers’ pricing power has peaked, and this sector is at a higher risk of margin squeeze. Margins of the Health Care sector have been under pressure for years (Chart 2). This can be tied back to Pharma being under perennial pressure from both politicians aiming to lower prescription drug prices, and from competition from the generics. Meanwhile, the Consumer Discretionary sector is in better shape thanks to pent-up demand for services and discretionary goods – consumers are in good financial health and are able to tolerate marginal prices increases. We expect discretionary and services industries to be able to maintain their margins. Bottom Line: The ability to exert pricing power and pass on costs to customers is highly industry-specific and can not be generalized. CHART 1 CHART 1 CHART 1 CHART 2 CHART 2 CHART 2 Appendix CHART 3 CHART 3 CHART 4 CHART 4  

Highlights The Evergrande crisis is not China’s Lehman moment. Nonetheless, Chinese construction activity will decelerate further in response to this shock. Global equities are frothy enough that a weaker-than-expected Chinese construction sector will remain a near-term risk to stocks prices. European markets are more exposed to this risk than US ones. Tactically, this creates a dangerous environment for cyclicals in general and materials in particular. Healthcare and Swiss stocks would be the winners. Despite these near-term hurdles, we maintain a pro-cyclical portfolio stance, which we will protect with some temporary hedges. We will lift these hedges if the EURO STOXX corrects into the 430-420 zone. A busy week for European central banks confirms our negative stance on EUR/GBP, EUR/SEK, and EUR/NOK. While EUR/CHF has upside, Swiss stocks should outperform Euro Area defensives. Stay underweight UK Gilts in fixed-income portfolios. Feature The collapse of property developer Evergrande creates an important risk for European markets. It threatens to slow Chinese construction activity further, which affects European assets that are heavily exposed to the Chinese real estate sector, directly and indirectly. This risk is mostly frontloaded, as Chinese authorities cannot afford a complete meltdown of the domestic property sector. Moreover, this economy has slowed significantly and more policy support is bound to take place. Additionally, forces outside China create important counterweights that will allow Europe to thrive despite the near-term clouds. While we see more short-term risk for European stocks and cyclical sectors, the 18-month cyclical outlook remains bright. Similarly, European stocks will not outperform US ones when Chinese real estate activity remains a source of downside surprise; but they will afterward. China’s Construction Slowdown Is Not Over The Evergrande crisis is not China’s Lehman moment. Beijing has the resources to prevent a systemic meltdown and understands full well what is at stake. At 160% of GDP, China’s nonfinancial corporate debt towers well above that of other major emerging markets and even that of Japan in the 1980s (Chart 1). If an Evergrande bankruptcy were allowed to topple this debt mountain, China would experience the kind of debt-deflation trap that proved so disastrous in the 1930s. A further deterioration of conditions in Chinese real estate activity is nonetheless in the cards, even if the country avoids a global systemic financial shock. First, the inevitable restructuring of Evergrande will result in losses for bond holders, especially foreign ones. Consequently, risk premia in the Chinese off-shore corporate bonds market will remain wide following the resolution of the Evergrande debacle. While Chinese banks are likely to recover a large proportion of the funds they lent to the real estate giant, they too will face higher risk premia. At the margin, the rising cost of capital will curtail the number of projects real estate developers take on over the coming two to three years. Second, the eventual liquidation of Evergrande will hurt confidence among real estate developers. This process may take many forms, but, as we go to press, the most discussed outcome is a breakup and restructuring where state-owned enterprises and large local governments absorb Evergrande’s operations. Evergrande’s employees, suppliers, and clients who have deposited funds while pre-ordering properties will be made whole one way or the other. However, shareholders and management will not. Wiping out shareholders and senior management will send a message to the operators of other developers, which will negatively affect their risk taking (Chart 2). Chart 1China Cannot Afford A Lehman Moment China Cannot Afford A Lehman Moment China Cannot Afford A Lehman Moment Chart 2Downside To Chinese Construction Activity Downside To Chinese Construction Activity Downside To Chinese Construction Activity   Third, one of President Xi Jinping’s key policy objectives is to tame rampant income inequality in the Chinese economy. Rapidly rising real estate prices and elevated unaffordability only worsen this problem. Hence, Beijing wants to avoid blind stimulus that mostly pushes house prices higher but that would have also boosted construction activity. Thus, if credit growth is pushed through the system, the regulatory tightening in real estate will not end. This process is likely to result in further contraction in floor space sold and started. Bottom Line: The Evergrande crisis is unlikely to morph into China’s Lehman moment. However, its fallout on the real estate industry means that Chinese construction activity will continue to contract in the coming six to twelve months or so. Chinese Construction Matters For European Equities The risk of further contraction in Chinese construction activity implies a significant near-term risk for European equities, especially relative to US ones. Even after the volatility of the past three weeks, global equities remain vulnerable to more corrective action. Speculative activity continues to grip the bellwether US market. Our BCA Equity Speculation Index is still around two sigma. Previous instances of high readings did not necessarily herald the end of bull markets; however, they often resulted in sideways and volatile trading, until the speculative excesses dissipated (Chart 3). The case for such volatile trading is strong. The Fed is set to begin its taper at its November meeting. Moreover, an end of the QE program by the middle of next year and the upcoming rotation of regional Fed heads on the FOMC will likely result in a first rate hike by the end of 2022. Already, the growth rate of the global money supply has declined, and the real yield impulse is not as supportive as it once was. Therefore, the deterioration in our BCA Monetary Indicator should perdure (Chart 4), which will heighten the sensitivity of global stocks to bad news out of China. Chart 3Rife With Speculation Rife With Speculation Rife With Speculation Chart 4Liquidity Deterioration At The Margin Liquidity Deterioration At The Margin Liquidity Deterioration At The Margin Chart 5Still Too Happy Still Too Happy Still Too Happy Investor sentiment is also not as washed out as many news stories ascertain. The AAII survey shows that the number of equity bulls has fallen sharply, but BCA’s Complacency-Anxiety Index, Equity Capitulation Indicator and Sentiment composite are still inconsistent with durable market bottoms. Moreover, the National Association of Active Investment Managers’ Exposure Index is still very elevated. When this gauge is combined with the AAII bulls minus bears indicator, it often detects floors in the US dollar-price of the European MSCI index (Chart 5). For now, this composite sentiment measure is flashing further vulnerability for European equities, especially if China remains a source of potential bad news in the coming months. Economic linkages reinforce the tactical risk to European stocks. Chinese construction activity affects the Euro Area industrial production because machinery and transportation goods represent 50% of Europe’s export to China (Chart 6). This category is very sensitive to Chinese real estate activity. Moreover, Europe’s exports to other nations are also indirectly affected by the demand from Chinese construction. Financial markets bear this footprint. Excavator sales in China are a leading indicator of construction activity. Historically, they correlate well with both the fluctuations of EUR/USD and the performance of Eurozone stocks relative to those of the US (Chart 7). Hence, if we anticipate that the problems Evergrande faces will weigh on excavator sales in the coming months, then the euro will suffer and Euro Area stocks could continue to underperform. Chart 6Europe's Exports To China Are Sensitive To Construction Activity Europe's Exports To China Are Sensitive To Construction Activity Europe's Exports To China Are Sensitive To Construction Activity Chart 7A Near-Term Risk To European Assets A Near-Term Risk To European Assets A Near-Term Risk To European Assets   Similarly, the fallout from Evergrande’s problem will extend to the performance of European equity sectors. The sideways corrective episode in cyclical relative to defensive shares is likely to continue in the near term. This sector twist remains frothy, and often declines when Chinese credit origination is soft (Chart 8). Materials stocks are the most likely to suffer due to their tight correlation with Chinese excavator sales (Chart 9); meanwhile, healthcare equities will reap the greatest benefit as a result of their appealing structural growth profile and their strong defensive property. Geographically, Swiss stocks should perform best (Chart 9, bottom panel), because they strongly overweigh healthcare and consumer staple names. Moreover, as we recently argued, the SNB’s monetary policy is an advantage for Swiss stocks compared to Eurozone defensives.1 Additionally, Dutch equities, with their 50% weighting in tech and their small 12% combined allocation to industrials and materials, could also enjoy a near-term outperformance as investors digest the sectoral impact of weaker Chinese construction activity. Chart 8The Vulnerability Of Cyclicals/Defensives Remains The Vulnerability Of Cyclicals/Defensives Remains The Vulnerability Of Cyclicals/Defensives Remains Chart 9Responses To Weaker Construction Responses To Weaker Construction Responses To Weaker Construction   Bottom Line: No matter how the Evergrande story unfolds, its consequence on Chinese construction activity may still cause market tremors. Global equity benchmarks may be rebounding right now, but, ultimately, they remain vulnerable to this slowdown. Any negative surprise out of China is likely to cause Europe to underperform because of its greater exposure to Chinese construction activity. Investment Conclusion: This Too Shall Pass The risks to the European equity market and its cyclicals sectors will prove transitory and will finish by the end of the year. Beijing will tolerate some pain to the real estate sector, but the stakes are too high to let the situation fester for long. The main problem is China’s large debt. Already sequential GDP growth in the first half of 2021 was worse than the same period in 2020, and credit accumulation is just as weak as in early 2018 (Chart 10). In this context, if real estate activity deteriorates too much, aggregate profits will contract and, in turn, will hurt the corporate sector’s ability to service its debt. Employment and social tensions create another stress point that will force Beijing’s hand. At 47, the non-manufacturing PMI employment index is already well into the contraction zone (Chart 11). Weakness in construction activity will hurt the labor market further. In an environment where protests have been springing up all over China, the Communist Party does not want to see more stress applied to workers. Chart 10In The End, Stimulus Will Come In The End, Stimulus Will Come In The End, Stimulus Will Come Chart 11Worsening Chinese Employment Conditions Worsening Chinese Employment Conditions Worsening Chinese Employment Conditions   These two constraints will force Beijing to alleviate the pain caused by a weaker construction sector. As a result, we still expect the Chinese credit and fiscal impulse to re-accelerate by Q2 2022. Developments outside of China will create another important offset that will allow risk assets to thrive once their immediate froth has receded. Strong DM capex will be an important driver of global activity next year. As Chart 12 shows, capex intentions in the US and the Euro Area are rapidly expanding, which augurs well for global investments. Moreover, re-building depleted inventories (Chart 13) will be a crucial component of the solution to global supply bottlenecks. Both activities will add to global demand. As an example, ship orders are already surging. Chart 12DM Capex Intentions Are Firming DM Capex Intentions Are Firming DM Capex Intentions Are Firming Chart 13Don't Forget About Inventories Don't Forget About Inventories Don't Forget About Inventories     We maintain a pro-cyclical stance in European markets after weighing the near-term negatives against the underlying positive forces. For now, hedging the tactical risk still makes sense and our long telecommunication / short consumer discretionary equities remain the appropriate vehicle – so does being long Swiss stocks versus Euro Area defensives. However, we will use any correction in the EURO STOXX (Bloomberg: SXXE Index) to the 430-420 zone to unload this protection. Bottom Line: The potential market stress created by a slowdown in Chinese construction activity will be a temporary force. Beijing will not tolerate a much larger hit to the economy, especially as tensions are rising across the country. Thus, even if the stimulus response to the Evergrande crisis will not be immediate, it will eventually come, which will support Chinese economic activity. Additionally, the capex upside and inventory rebuilding in advanced economies will create an offset for slowing Chinese growth. Consequently, while we maintain a pro-cyclical bias over the medium term, we are also keeping in place our hedges in the near term, looking to shed them if SXXE hits the 430-420 zone. A Big Week For Central Banks Chart 14The BoE's Is Listening To The UK's Economic Conditions... The BoE's Is Listening To The UK's Economic Conditions... The BoE's Is Listening To The UK's Economic Conditions... Last week, four European central banks held their policy meetings: The Riksbank, the Swiss National Bank, the Norges Bank, and the Bank of England. No major surprises came out of these meetings, with central banks discourses and policy evolving in line with their respective economies. The BoE veered on the hawkish side, highlighting that rates could rise before its QE program is over. This implies a small possibility of a rate hike by the end of 2021. However, our base case remains that the initial hike will be in the first half of 2022. The BoE is behaving in line with the message from our UK Central Bank Monitor (Chart 14). Moreover, the combination of rapid inflation and strong house price appreciation is incentivizing the BoE to remove monetary accommodation, especially because UK financial conditions are extremely easy (Chart 14, bottom panel). One caution advanced by the MPC is the uncertainty surrounding the impact of the end of the job furlough scheme this month. However, the global economy will be strong enough next spring to mitigate the risks to the UK. The results of last week’s MPC meeting and our view on the global and UK business cycles support the short EUR/GBP recommendation of BCA’s foreign exchange strategist,2 as well as the underweight allocation to UK Gilts of our Global Fixed Income Strategy group.3 The Norges Bank is the first central bank in the G-10 to hike rates and is likely to do so again later this year. While Norwegian core inflation remains low, house prices are strong, monetary conditions are extremely accommodative, and our Norway Central Bank Monitor is surging (Chart 15). The Norwegian central bank will continue to focus on these positives, especially in light of our Commodity and Energy team’s view that Brent will average more than $80/bbl by 2023.4 In this context, we anticipate the NOK to outperform the euro over the coming 24 months. Nonetheless, the near-term outlook for Norwegian stocks remains fraught with danger. Materials account for 17% of the MSCI Norway index and are the sector most vulnerable to a deterioration in Chinese construction activity. The Riksbank continues to disregard the strength of the Swedish economy. Relative to economic conditions, it is one of the most dovish central banks in the world. The Swedish central bank is completely ignoring the message from our Sweden Central Bank Monitor, which has never been as elevated as it is today (Chart 16). Moreover, the inexpensiveness of the SEK means that Swedish financial conditions are exceptionally accommodative. At first glance, this picture is bearish for the SEK. However, easy monetary conditions will cause Sweden’s real estate bubble to expand. Expanding real estate prices and transaction volumes will boost the profits of Swedish financials, which account for 27% of the MSCI Sweden index. Moreover, Swedish industrials remain one of our favorite sectors in Europe, and they represent 38% of the same index. As a result, equity flows into Sweden should still hurt the EUR/SEK cross. Chart 15...And The Norges Bank, To Norway's ...And The Norges Bank, To Norway's ...And The Norges Bank, To Norway's Chart 16The Riksbank Is Blowing Real Estate Bubbles The Riksbank Is Blowing Real Estate Bubbles The Riksbank Is Blowing Real Estate Bubbles Chart 17The CHF Still Worries The SNB The CHF Still Worries The SNB The CHF Still Worries The SNB Finally, the SNB proved reliably dovish. Our Switzerland Central Bank Monitor is rising fast as inflation and house prices improve (Chart 17). However, the SNB is rightfully worried about the expensiveness of the CHF, which generates tight Swiss financial conditions (Chart 17, bottom panel). Consequently, the SNB will keep fighting off any depreciation in EUR/CHF. Thus, the SNB will be forced to expand its balance sheet because the ECB is likely to remain active in asset markets longer than many of its peers. This process will be key to the outperformance of Swiss stocks relative to other European defensive equities.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1 Please see European Investment Strategy “The ECB’s New Groove,” dated July 19, 2021, available at eis.bcarsearch.com 2 Please see Foreign Exchange Strategy “Why Are UK Interest Rates Still So Low?,” dated March 10, 2021, available at fes.bcarsearch.com 3 Please see European Investment Strategy “The UK Leads The Way,” dated August 11, 2021, available at eis.bcarsearch.com 4 Please see Commodity & Energy Strategy “Upside Price Risk Rises For Crude,” dated September 16, 2021, available at fes.bcarsearch.com   Tactical Recommendations Europe’s Evergrande Problem Europe’s Evergrande Problem Cyclical Recommendations Europe’s Evergrande Problem Europe’s Evergrande Problem Structural Recommendations Europe’s Evergrande Problem Europe’s Evergrande Problem Closed Trades Europe’s Evergrande Problem Europe’s Evergrande Problem Currency Performance Fixed Income Performance Equity Performance

Today we take a close look at the historical GICS1 level performance following the taper event in 2013.  Chart 1 provides an overview of a price action of the 10-year US Treasury yield, the US dollar, and gold to provide context, while Charts 2 - 4 summarize performance of the S&P sectors.   Chart 1 CHART 1 CHART 1 Chart 2 CHART 2 CHART 2 Chart 3 CHART 3 CHART 3 Chart 4 CHART 4 CHART 4 The Fed’s decision to modestly reduce the pace of its asset purchases in December of 2013 was a risk-off event which triggered a decline in Treasury yields and put upward pressure on the dollar. S&P 500 sectors followed the script from a risk-off “playbook” with Technology outperforming on the back of falling Treasury rates, while Financials underperformed.  A spike in USD also led to underperformance of the Energy sector. The Consumer Discretionary sector was a notable outlier underperforming the S&P 500 by 6%.  However, empirical analysis is hardly helpful in this case as in 2013 Amazon constituted 7.05% of the sector weight compared to 40% today. Finally, the performance of the defensive sectors was mixed as while tapering was perceived by the market as a clear risk-off event, it was also a sign that the economy is strong, and the Fed is comfortable with withdrawing the liquidity crutch. Bottom Line: Investors should not worry about the Fed and tapering as in the US its effect was short-lived and many more years of the bull market have ensued after it.    

Please note that next Friday September 24 at 10am EDT, we will host a webcast featuring a debate between my colleague Peter Berezin and me. The topic of debate is whether investors should overweight EM in a global portfolio. Please join us by registering via this link.   Highlights Chinese internet companies’ ROE will drop, warranting lower equity valuations. However, their ROE and equity multiples will not fall to the levels of listed state-owned enterprises (SOEs). Evergrande’s partial default on its liabilities will likely reinforce credit tightening that has been underway in China over the past 12 months. EM ex-TMT stocks also remain vulnerable. Continue underweighting EM in global equity and credit portfolios. Feature This is the September issue of Charts That Matter. We begin by addressing the issues concerning Chinese internet companies that have been subject to intense debate among investors. We then present key charts on overall EM and various asset classes along with brief commentary. Are Chinese Internet Stocks Investable? There is an ongoing debate in the investment community as to whether Chinese equities in general and Chinese TMT stocks in particular will remain investable. Our short answer is: they will remain investable but mind their valuations. In our opinion, “investable” means that they will from time to time offer medium- and long-term investment opportunities. Our hunch is that they may do so in the future. Nevertheless, we do not think that Chinese TMT stocks presently offer a good buying opportunity. In fact, their share prices have material downside from current levels. In our recent report and webcast, we identified the primary risks to Chinese platform companies: Higher uncertainty about their business model = a higher equity risk premium. Government regulating their profitability like those of mono- and oligopolies = low multiples. These companies performing their social duties in the form of redistributing profits from shareholders to Chinese peoples. Beijing’s involvement in their management and in the prioritization of national and geopolitical objectives over shareholder interests. Risks of delisting from US stock exchanges. Although these companies will remain investable, investors should bear these risks in mind and give careful consideration to what multiples they pay for such stocks. Going forward, Chinese platform companies’ return on equity will be considerably lower than they have been or what their current multiplies imply. A lower return on equity warrants a lower equity multiple. Chart 1Chinese Growth Stocks Are Not Cheap Chinese Growth Stocks Are Not Cheap Chinese Growth Stocks Are Not Cheap On the whole, the current valuations of Chinese internet stocks are still high. Chart 1 shows trailing and 12-month forward P/E ratios for Chinese MSCI Growth Investable Index at 34 and 31, respectively. A downshifting return on equity and high uncertainty around these businesses herald lower equity valuations to come. Besides, in the case of several companies, there are also political underpinnings of this regulatory crackdown. In the case of Alibaba, a mainland government official has recently noted that Alibaba’s chairman, Jack Ma, has been acquiring media companies across the country, and now owns nearly 30 provincial-level media companies, as well as the South China Morning Post in Hong Kong. Beijing will not tolerate the control of or influence over domestic media from anyone outside the inner leadership circle. In this context, it is probable that Alibaba’s businesses will remain subject to severe regulatory pressures. How much lower should these companies’ multiples drop to become attractive? Meaningfully lower, but not to the level of multiples of listed state-owned enterprises (SOEs). Here are two reasons why these platform companies will not trade at multiples of SOEs in China: First, many existing SOEs operate in cyclical industries – commodities, industrials, autos, and banks – that structurally have low equity multiples. By contrast, platform companies operate in non-cyclical sectors that structurally have lower business cycle volatility and, therefore, should trade at higher equity multiples than cyclical industries. Second, many SOEs often had losses because they operated in non-oligopolistic industries. Faced with intense competition they had to cut prices to support volumes and employment. By contrast, platform companies’ profitability will be suppressed and capped by new government policies, but they will remain profitable because they operate in oligopolistic industries. In short, platform companies’ ROEs will be higher than those of traditional/”old-economy” SOEs. All in all, our bias is that platform companies’ valuation multiples will contract further but will not be as low as Chinese, Russian, or Brazilian SOEs have been. Bottom Line: Investors should be mindful of further de-rating in Chinese TMT/platform company stocks. These stocks are not yet out of woods. On Property Market Clampdown And Evergrande's Default Evergrande will likely default on some of its liabilities but there will be a bailout or roll-over of its other debt.  Is the partial default by Evergrande, a very large Chinese property developer, a sign of a bottom in Chinese offshore equity and bond markets or will it produce a full-blown credit crisis in China? This is a valid question because both outcomes are possible: a partial bankruptcy can be a culmination of all existing negatives and can trigger policy stimulus that will produce an economic recovery and a major rally (an example of this is the LTCM crisis in the US in 1998); or  a partial bankruptcy can lead to a credit crunch escalation becoming a systemic event. An example of this is Lehman Brothers’ bankruptcy in 2008. We will assign the highest probability to a third scenario: the well-telegraphed Evergrande default might not create a systemic crisis or crash. However, it will likely reinforce chronic credit tightening that has been underway in China over the past 12 months. This is negative for China and EM risk assets. Predicting the trajectory and speed of market adjustments – a crisis (wholesale selloff) versus a regular bear market interrupted by short-term rebounds – is impossible. That said, investors should stay put for now. On another note, during our webcast last week, a client asked whether restrictions on property developers’ leverage will hinder their ability and willingness to build. In turn, limited property supply will likely push up property prices, which is contrary to Beijing’s goals of curbing property price inflation. So, why are authorities pursuing this clampdown on property developers? Chart 2Property Starts And Prices Are Positively Correlated Property Starts And Prices Are Positively Correlated Property Starts And Prices Are Positively Correlated This is a very good question, and we have the following observations. In our view, authorities are clamping down on property developers’ leverage because historically there was a strong positive correlation between property starts and house prices (Chart 2). The basis for this positive correlation is that when property developers start more projects, they raise expectations via aggressive marketing of higher prices in future. As a result, people become more inclined to buy houses. In fact, more supply has not precluded property prices from surging and vice versa, as shown in Chart 2. Provided housing valuations (the house price-to-income ratios) are exceptionally high in China and high-income households have been buying multiple apartments, we can argue that (speculative) expectations for higher prices in the future have often been an important driver of demand. So, authorities are probably hoping to break this speculative cycle where higher prices breed higher prices. Aggressive marketing on the part of property developers – creating an atmosphere of euphoria around new property launches – has been an essential driver for surging house price expectations. Hence, authorities’ reasoning is that curbing property developers’ relentless debt financed expansion activity is essential for both (1) to restrain excessive house prices inflation (a social stability goal) and (2) to reduce risks of a future credit crisis (a financial stability goal). Finally, with many households/investors who own multiple properties (that are vacant rather than rented out), authorities hope that diminished expectations for future house price appreciation will bring some of these vacant properties to the market. If this occurs, the supply of residential properties for sale and rent will not drop dramatically despite lower starts by property developers. It is also critical to assess the implications of the ongoing carnage in Chinese offshore corporate bonds, where the epicenter of the selloff is property companies. The fact that property developers are experiencing a credit crunch and will be forced to deleverage has implications for China’s business cycle and other EM economies. Chart 3 illustrates that the periods of rising emerging Asian USD corporate bond yields (shown inverted on the chart) coincide with lower emerging Asian ex-TMT share prices. The link is as follows: the ongoing credit stress and deleveraging by mainland property developers means less construction and diminished demand for raw materials and industrial goods as well as possibly household white goods. There are thus negative implications not only for emerging Asian non-TMT stocks but also for overall EM. Bottom Line: Property construction in China will continue contracting (Chart 4). This will weigh on raw materials and industrial goods demand in China and beyond it. Chart 3Rising Emerging Asian Corporate Bond Yields Point To Lower Asian ex-TMT Stocks Rising Emerging Asian Corporate Bond Yields Point To Lower Asian ex-TMT Stocks Rising Emerging Asian Corporate Bond Yields Point To Lower Asian ex-TMT Stocks Chart 4Chinese Housing: Sales And Starts Are Contracting Chinese Housing: Sales And Starts Are Contracting Chinese Housing: Sales And Starts Are Contracting   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Have EM Stocks Bottomed? Investor sentiment on EM equities has plunged close to its previous lows. However, this is a necessary but not sufficient condition to issue a buy recommendation. Critically, EM narrow money growth points to EPS deceleration in the next nine months. Yet, analysts’ net EPS revisions remain elevated and have not yet dropped to negative levels. Our bias is that EM net EPS revisions will be downgraded in the coming months. From a technical perspective, the EM equity index has failed to break above its 200-day moving average. This is a negative technical signal.  Chart 5 Have EM Stocks Bottomed? Have EM Stocks Bottomed? Chart 6 Have EM Stocks Bottomed? Have EM Stocks Bottomed? Chart 7 Have EM Stocks Bottomed? Have EM Stocks Bottomed? Chart 8 Have EM Stocks Bottomed? Have EM Stocks Bottomed? EM Underperformance Is Broad-Based Not only have EM TMT stocks massively underperformed their global peers, but also EM ex-TMT stocks have been underperforming their global counterparts. Besides, the EM equal-weighted stock index has failed to break above its previous highs. Failure to break above a resistance line is often a bad omen. Finally, EM ex-TMT share prices correlate with the average of AUD, NZD and CAD, and the latter remains in a corrective phase.  Chart 9 EM Underperfomance Is Broad-Based EM Underperfomance Is Broad-Based Chart 10 EM Underperfomance Is Broad-Based EM Underperfomance Is Broad-Based Chart 11 EM Underperfomance Is Broad-Based EM Underperfomance Is Broad-Based Red Flags For EM Periods of rising EM USD corporate bond yields coincide with lower EM share prices. EM corporate USD bond yields are rising (shown inverted below) and we expect more upside. Either US Treasury bond yields will rise and EM corporate spreads will stay broadly constant, or EM credit spreads will widen and US Treasury yields will stay range-bound. Either of these scenarios will produce higher EM corporate bond yields and, thereby, herald lower EM equity prices. Further, a breakdown in platinum prices is also raising a red flag for EM risk assets.  Chart 12 Red Flags For EM Red Flags For EM Chart 13 Red Flags For EM Red Flags For EM Have Chinese And Asian Stocks Hit An Air Pocket? Relative performance of emerging Asian equities versus the global stock index has broken below its previous lows. Technically, this entails a protracted period of underperformance. Neither emerging Asian ex-TMT nor Chinese investable ex-TMT share prices have been able to break above their major resistance lines. Failure to break above a resistance line is often a bad omen. Meantime, Chinese onshore stocks and corporate bonds have not sold off enough so that authorities panic and stimulate aggressively.  Chart 14 Have Chinese And Asian Stocks Hit An Air Pocket? Have Chinese And Asian Stocks Hit An Air Pocket? Chart 15 Have Chinese And Asian Stocks Hit An Air Pocket? Have Chinese And Asian Stocks Hit An Air Pocket? Chart 16 Have Chinese And Asian Stocks Hit An Air Pocket? Have Chinese And Asian Stocks Hit An Air Pocket? Chart 17 Have Chinese And Asian Stocks Hit An Air Pocket? Have Chinese And Asian Stocks Hit An Air Pocket? The US Dollar As A Litmus Test EM risk assets negatively correlate with the US dollar. The broad trade-weighted US dollar is holding above its 200-day moving average. Plus, investor sentiment on the greenback remains negative. Finally, the US dollar moves inversely with relative performance of global cyclical sectors versus global defensives (the dollar is shown inverted on chart below). The ongoing slowdown in China is bullish for the US dollar because the US economy is the least vulnerable to China’s economy. Overall, we expect the US dollar to continue firming in the coming months. Chart 18 The US Dollar As A Litmus Test The US Dollar As A Litmus Test Chart 19 The US Dollar As A Litmus Test The US Dollar As A Litmus Test Chart 20 The US Dollar As A Litmus Test The US Dollar As A Litmus Test Global Mining Stocks, Commodity Currencies And Commodity Prices The share prices of BHP and Rio Tinto have fallen dramatically in absolute terms. This reflects the plunge in iron ore prices and might also be a harbinger of a broader selloff in industrial metals. Further, the average of AUD, NZD and CAD also signals a correction in the broad commodities price index.  Chart 21 Global Mining Stocks, Commodity Currencies And Commodity Prices Global Mining Stocks, Commodity Currencies And Commodity Prices Chart 22 Global Mining Stocks, Commodity Currencies And Commodity Prices Global Mining Stocks, Commodity Currencies And Commodity Prices Chart 23 Global Mining Stocks, Commodity Currencies And Commodity Prices Global Mining Stocks, Commodity Currencies And Commodity Prices Is This Decoupling Sustainable? Industrial metals prices were historically correlated with the Chinese business cycle but have decoupled since early this year. Several commodity prices – like coal, steel and aluminum – have shot up due to production shutdowns as a part of the Chinese government’s decarbonization policies. However, it will be extraordinary if commodity prices continue advancing amid a protracted slowdown in China’s old economy.   Chart 24 Is This Decoupling Sustainable? Is This Decoupling Sustainable? Chart 25 Is This Decoupling Sustainable? Is This Decoupling Sustainable? Chinese Commodity Imports Have Contracted Reflecting a demand slowdown and the government’s willingness to dampen commodity price inflation, China has been shrinking its imports of several commodities. It has also released some of its strategic reserves for oil and certain industrial metals. High commodity prices are hurting profit margins of manufacturing and industrial companies leading them to lower output. Beijing is determined to curb and bring down key commodity prices to lessen the negative impact on overall growth and employment.  Chart 26 Chinese Commodity Imports Have Contracted Chinese Commodity Imports Have Contracted Chart 27 Chinese Commodity Imports Have Contracted Chinese Commodity Imports Have Contracted Chinese Stimulus: How Fast And How Large? In recent months, China has been injecting more liquidity into the banking system. Rising commercial banks’ excess reserves at the PBOC point to a bottom in the credit impulse in Q4 of this year. However, the credit impulse leads the business cycle by about nine months. This implies that the economy will not revive before Q2 next year at best. In fact, the aggregate building floor area started and the installation of electricity transmission lines are already contracting and will continue shrinking till Q2 next year.   Chart 28 Chinese Stimulus: How Fast And How Large? Chinese Stimulus: How Fast And How Large? Chart 29 Chinese Stimulus: How Fast And How Large? Chinese Stimulus: How Fast And How Large? Chart 30 Chinese Stimulus: How Fast And How Large? Chinese Stimulus: How Fast And How Large? Chart 31 Chinese Stimulus: How Fast And How Large? Chinese Stimulus: How Fast And How Large? An Inflation Dichotomy Between China And The US In China, consumer price inflation remains largely contained. However, in the US core consumer price inflation measures are still rising and are above 2%. An optimal exchange rate adjustment to redistribute inflation pressures from the US into China will require a stronger US dollar and a weaker RMB.  Chart 32 An Inflation Dichotomy Between China And The US An Inflation Dichotomy Between China And The US Chart 33 An Inflation Dichotomy Between China And The US An Inflation Dichotomy Between China And The US Inflation And Monetary Tightening In EM ex-China Core measures of inflation have been rising in many Eastern European and Latin American economies. Their central banks will hike interest rates further. This will hurt their domestic demand at a time when the recovery in these economies has been underwhelming. Monetary and fiscal tightening will offset benefits from reopening as their vaccination rates ameliorate.  Chart 34 Inflation And Monetary Tightening In EM ex-China Inflation And Monetary Tightening In EM ex-China Chart 35 Inflation And Monetary Tightening In EM ex-China Inflation And Monetary Tightening In EM ex-China Chart 36 Inflation And Monetary Tightening In EM ex-China Inflation And Monetary Tightening In EM ex-China Chart 37 Inflation And Monetary Tightening In EM ex-China Inflation And Monetary Tightening In EM ex-China What Drives EM Credit Markets? We downgraded our allocation to EM credit, currencies and equities from neutral to underweight on March 25, 2021. This strategy remains intact. The outlook for the key drivers of EM credit – EM/China business cycles and EM exchange rates – remains downbeat. In fact, EM credit markets – both investment grade and high-yield – have been underperforming their US counterparts and this trend will persist.  Chart 38 What Drives EM Credit Markets? What Drives EM Credit Markets? Chart 39 What Drives EM Credit Markets? What Drives EM Credit Markets? Chart 40 What Drives EM Credit Markets? What Drives EM Credit Markets? Chart 41 What Drives EM Credit Markets? What Drives EM Credit Markets? Our Relative Equity Value Strategies We have been recommending investors go long Chinese A shares / short Chinese investable stocks since March 4, 2021 and this strategy has been extremely profitable. The same is true for the short Chinese property developers / long overall index and short Chinese investable value stocks versus global value stocks strategies. Finally, our recommendation to be long global industrials / short global materials has so far been flat but we expect it to play out for the reasons elaborated in the linked report.  Chart 42 Our Relative Equity Value Strategies Our Relative Equity Value Strategies Chart 43 Our Relative Equity Value Strategies Our Relative Equity Value Strategies Chart 44 Our Relative Equity Value Strategies Our Relative Equity Value Strategies Chart 45 Our Relative Equity Value Strategies Our Relative Equity Value Strategies Retail Equity Mania In Korea And Taiwan The retail mania continues in the Korean and Taiwanese stock markets. Retail investors are the main buyers while foreign investors and domestic institutional investors have been scaling back their exposure. Surging margin loans and equity trading volumes in Korea confirm ongoing equity euphoria. We continue overweighting Korean stocks and are neutral on Taiwanese stocks within an EM equity portfolio. The difference in our strategy is due to the potential geopolitical risks that Taiwan is facing. Chart 46 Retail Equity Mania In Korea And Taiwan Retail Equity Mania In Korea And Taiwan Chart 47 Retail Equity Mania In Korea And Taiwan Retail Equity Mania In Korea And Taiwan Chart 48 Retail Equity Mania In Korea And Taiwan Retail Equity Mania In Korea And Taiwan Chart 49 Retail Equity Mania In Korea And Taiwan Retail Equity Mania In Korea And Taiwan The Semi Cycle And Risks To The Absolute Performance Of Korean And Taiwanese Stocks DRAM and NAND prices have rolled over. This is a near-term risk to the absolute performance of Korean tech stocks. However, if global industrial stocks outperform, as we expect, Korean share prices will outperform the EM equity benchmark because the KOSPI is a good proxy play on global industrials within the EM universe. Although global semiconductor shortages remain widespread, the 6-month outlook for Taiwanese technology companies has rolled over too.  Chart 50 The Semi Cycle And Risks To The Absolute Performance Of Korean And Taiwanese Stocks The Semi Cycle And Risks To The Absolute Performance Of Korean And Taiwanese Stocks Chart 51 The Semi Cycle And Risks To The Absolute Performance Of Korean And Taiwanese Stocks The Semi Cycle And Risks To The Absolute Performance Of Korean And Taiwanese Stocks Chart 52 The Semi Cycle And Risks To The Absolute Performance Of Korean And Taiwanese Stocks The Semi Cycle And Risks To The Absolute Performance Of Korean And Taiwanese Stocks Chart 53 The Semi Cycle And Risks To The Absolute Performance Of Korean And Taiwanese Stocks The Semi Cycle And Risks To The Absolute Performance Of Korean And Taiwanese Stocks Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations