Bear/Bull Market

Highlights Asian and European natural gas prices will remain well bid as the Northern Hemisphere winter approaches. An upgraded probability of a second La Niña event this winter will keep gas buyers scouring markets for supplies (Chart of the Week). The IEA is pressing Russia to make more gas available to European consumers going into winter. While Russia is meeting contractual commitments, it is also trying to rebuild its inventories. Gas from the now-complete Nord Stream 2 pipeline might not flow at all this year. High natgas prices will incentivize electric generators to switch to coal and oil. This will push the level and costs of CO2 emissions permits higher, including coal and oil prices. Supply pressures in fossil-fuel energy markets are spilling into other commodity markets, raising the cost of producing and shipping commodities and manufactures. Consumers – i.e., voters – experiencing these effects might be disinclined to support and fund the energy transition to a low-carbon economy. We were stopped out of our long Henry Hub natural gas call spread in 1Q22 – long $5.00/MMBtu calls vs short $5.50/MMBtu calls in Jan-Feb-Mar 2022 – and our long PICK ETF positions with returns of 4.58% and -10.61%. We will be getting long these positions again at tonight's close. Feature European natural gas inventories remain below their five-year average, which, in the event of another colder-than-normal winter in the Northern Hemisphere, will leave these markets ill-equipped to handle a back-to-back season of high prices and limited supply (Chart 2).1 The probability of a second La Niña event this winter was increased to 70-80% by the US Climate Prediction Center earlier this week.2 This raises the odds of another colder-than-average winter. As a result, markets will remain focused on inventories and flowing natgas supplies from the US, in the form of Liquified Natural Gas (LNG) cargoes, and Russian pipeline shipments to Europe as winter approaches. Chart of the WeekSurging Natural Gas Prices Intensify Competition For Supplies Chart 2Natgas Storage Remains Tight US LNG supplies are being contested by Asian buyers, where gas storage facilities are sparse, and European buyers looking for gas to inject into storage as they prepare for winter. US LNG suppliers also are finding ready bids in Brazil, where droughts are reducing hydropower availability. In the first six months of this year, US natgas exports averaged 9.5 bcf/d, a y/y increase of more than 40%. Although Russia's Nord Stream 2 pipeline has been completed, it still must be certified to carry natgas into Germany. This process could take months to finish, unless there is an exemption granted by EU officials. Like the US and Europe, Russia is in the process of rebuilding its natgas inventories, following a colder-than-normal La Niña winter last year.3 Earlier this week, the IEA called on Russia to increase natgas exports to Europe as winter approaches. The risk remains no gas will flow through Nord Stream 2 this year.4 Expect Higher Coal, Oil Consumption As other sources of energy become constrained – particularly UK wind power in the North Sea, where supplies went from 25% of UK power in 2020 to 7% in 2021 – natgas and coal-fired generation have to make up for the shortfall.5 Electricity producers are turning more towards coal as they face rising natural gas prices.6 Increasing coal-fired electric generation produces more CO2 and raises the cost of emission permits, particularly in the EU's Emissions Trading System (ETS), which is the largest such market in the world (Chart 3). Prices of December 2021 ETS permits, which represent the cost of CO2 emissions in the EU, hit an all-time high of €62.75/MT earlier this month and were trading just above €60.00/MT as we went to press. Chart 3Higher CO2 Emissions Follow Lower Renewables Output Going into winter, the likelihood of higher ETS permit prices increases if renewables output remains constrained and natgas inventories are pulled lower to meet space-heating needs in the EU. This will increase the price of power in the EU, where consumers are being particularly hard hit by higher prices (Chart 4). The European think tank Bruegel notes that even though natgas provides about 20% of Europe's electricity supply, it now is setting power prices on the margin.7 Chart 4EU Power Price Surge Is Inflationary Elevated natgas prices are inflationary, according to Bruegel: "On an annual basis, a doubling of wholesale electricity prices from about €50/megawatt hour to €100/MWh would imply that EU consumers pay up to €150 billion (€50/MWh*3bn MWh) more for their electricity. … Drastic increases in energy spending will shrink the disposable income of the poorest households with their high propensity to consume." This is true in other regions and states, as well. Is the Natgas Price Surge Transitory? The odds of higher natgas and CO2 permit prices increase as the likelihood of a colder-than-normal winter increases. Even a normal winter likely would tax Europe's gas supplies, given the level of inventories, and the need for Russia to replenish its stocks. However, at present, even with the odds of a second La Niña event this winter increasing, this is a probable event, not a certainty. The global natgas market is evolving along lines similar to the crude oil market. Fungible cargoes can be traded and moved to the market with the highest netback realization, after accounting for transportation. High prices now will incentivize higher production and a stronger inventory-injection season next year. That said, prices could stay elevated relative to historical levels as this is occurring. Europe is embarked on a planned phase-out of coal- and nuclear-powered electricity generation over the next couple of years, which highlights the risks associated with the energy transition to a low-carbon future. China also is attempting to phase out coal-fired generation in favor of natgas turbines, and also is pursuing a buildout of renewables and nuclear power. Given the extreme weather dependence on prices for power generated from whatever source, renewables will remain risky bets for modern economies as primary energy sources in the early stages of the energy transition. When the loss of wind, for example, must be made up with natgas generation and that market is tight owing to its own fundamental supply-demand imbalance, volatile price excursions to high levels could be required to destroy enough demand to provide heat in a cold winter. This would reduce support for renewables if it became too-frequent an event. This past summer and coming winter illustrate the risk of too-rapid a phase out of fossil-fueled power generation and space-heating fuels (i.e., gas and coal). Frequent volatile energy-price excursions, which put firms and households at risk of price spikes over an extended period of time, are, for many households, material events. We have little doubt the commodity-market effects will be dealt with in the most efficient manner. As the old commodity-market saw goes, "High prices are the best cure for high prices, and vice versa." All the same, the political effects of another very cold winter and high energy prices are not solely the result of economic forces. Inflation concerns aside, consumers – i.e., voters – may be disinclined to support a renewable-energy buildout if the hits to their wallets and lifestyles become higher than they have been led to expect. Investment Implications The price spike in natgas is highly likely to be a transitory event. Another surge in natgas prices likely would be inflationary while supplies are rebuilding – so, transitory.  Practically, this could stoke dissatisfaction among consumers, and add a political element to the transition to a low-carbon energy future. This would complicate capex decision-making for incumbent energy suppliers – i.e., the fossil-fuels industries – and for the metals suppliers, which will be relied upon to provide the literal building blocks for the renewables buildout.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish US crude oil inventories fell 3.5mm barrels in the week ended 17 September 2021, according to the US EIA. Product inventories built slightly, led by a 3.5mm-build in gasoline stocks, which was offset by a 2.6mm barrel draw in distillates (e.g., diesel fuel). Cumulative average daily crude oil production in the US was down 7% y/y, and stood at 10.9mm b/d. Cumulative average daily refined-product demand – what the EIA terms "Product Supplied" – was estimated at 19.92mm b/d, up almost 10% y/y. Brent prices recovered from an earlier sell-off this week and were supported by the latest inventory data (Chart 5). Base Metals: Bullish Iron ore prices have fallen -55.68% since hitting an all-time high of $230.58/MT in May 12, 2021 (Chart 6). This is due to sharply reduced steel output in China, as authorities push output lower to meet policy-mandated production goals and to conserve power. Even with the cuts in steel production, overall steel output in the first seven months of the year was up 8% on a y/y basis, or 48mm MT, according to S&P Global Platts. Supply constraints likely will be exacerbated as the upcoming Olympic Games hosted by China in early February approach. Authorities will want blue skies to showcase these events. Iron ore prices will remain closer to our earlier forecast of $90-$110/MT than not over this period.8 Precious Metals: Bullish The Federal Open Market Committee is set to publish the results of its meeting on Wednesday. In its last meeting in June, more hawkish than expected forecasts for interest rate hikes caused gold prices to drop and the yellow metal has been trading significantly lower since then. Our US Bond Strategy colleagues expect an announcement on asset purchase tapering in end-2021, and interest rate increases to begin by end-2022.9 Rate hikes are contingent on the Fed’s maximum employment criterion being reached, as expected and actual inflation are above the Fed criteria. Tapering asset purchases and increases in interest rates will be bearish for gold prices. Chart 5 Chart 6       Footnotes 1     Equinor, the Norwegian state-owned energy-supplier, estimates European natgas inventories will be 70-75% of their five-year average this winter.  Please see IR Gas Market Update, September 16, 2021. 2     Please see "ENSO: Recent Evolution, Current Status and Predictions," published by the US Climate Prediction Center 20 September 2021.  Earlier this month, the Center gave 70% odds to a second La Niña event in the Northern Hemisphere this winter.  Please see our report from September 9, 2021 entitled NatGas: Winter Is Coming for additional background. 3    Please see IEA calls on Russia to send more gas to Europe before winter published by theguardian.com, and Big Bounce: Russian gas amid market tightness.  Both were published on September 21, 2021. 4    Please see Nord Stream Two Construction Completed, but Gas Flows Unlikely in 2021 published 14 September 2021 by Jamestown.org. 5    Please see The U.K. went all in on wind power. Here’s what happens when it stops blowing, published by fortune.com on 16 September 2021.  Argus Media this week reported wind-power output fell 56% y/y in September 2021 to just over 2.5 TWh. 6    Please see UK power firms stop taking new customers amid escalating crisis, published by Aljazeera; Please see UK fires up coal power plant as gas prices soar, published by BBC. 7     Please see Is Europe’s gas and electricity price surge a one-off?, published by Bruegel 13 September 2021. 8    Please see China's Recovery Paces Iron Ore, Steel, which we published on November 5, 2020. 9    Please see 2022 Will Be All About Inflation and Talking About Tapering, published on September 22, 2021 and on August 10, 2021 respectively.     Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights The odds of a stronger recovery in EM oil demand next year are rising, as vaccines using mRNA technology are manufactured locally and become widely available.1 This will reduce local lock-down risks in economies relying on less efficacious COVID-19 vaccines – or lacking them altogether – thereby increasing mobility, economic activity and oil demand. Our global crude oil balances estimates are little changed to the end of 2023, which leaves our price expectations mostly unchanged: 4Q21 Brent prices are expected to average $70.50/bbl, while 2022 and 2023 prices average $75 and $80/bbl, respectively (Chart of the Week). The balance of risks to the crude oil market remain to the upside in our estimation. In addition to a higher likelihood of better-than-expected EM demand growth, we expect OPEC 2.0 production discipline to hold, and for the price-taking cohort outside the coalition to continue prioritizing investors' interests. We remain long commodity index exposure – S&P GSCI and COMT – and, at tonight's close, will be getting long the DFA Dimensional Emerging Core Equity Market ETF (DFAE) on the back of increasing local mRNA vaccine production in EM economies. Feature As local production of COVID-19 vaccines employing mRNA technology spreads throughout EM economies, the odds of a stronger-than-expected recovery in oil demand next year will increase. The buildout of production and distribution facilities for this technology is progressing quickly in Asia – e.g., Chinese mRNA tech joint ventures are expected to be in production mode in 4Q21 – Latin America, Africa, and the Middle East.2 Accelerated availability of more efficacious vaccines globally will address the "fault lines" identified by the IMF in its July 2021 update. In that report, the Fund notes a major downside risk to its global GDP growth expectation of 6% this year remains slower-than-expected vaccine rollouts to emerging and developing economies.3 The other major risk identified by the Fund is too-rapid a winddown of policy support in DM economies, which would lead to tighter financial conditions globally. Our global demand expectation is driven by GDP estimates from the IMF and World Bank. The implication of that assumption is the powerful recovery in DM oil demand seen this year will slow while EM demand picks up next year (Chart 2). We proxy DM oil demand with OECD oil consumption and EM demand with non-OECD consumption. We continue to expect overall oil demand to recover by just over 5.0mm b/d this year and 4.4mm b/d next year (Table 1). Chart of the WeekOil Forecasts Hold Steady Chart 2Higher EM Oil Demand Expected in 2022 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Global Oil Supply To Remain Steady Hurricane Ida will have removed ~ 30mm barrels of US offshore oil output by the time losses are fully tallied, based on IEA estimates. Even so, in line with the US EIA, we expect offshore US oil production will recover from the damage caused by the storm in 4Q21 and be back at ~ 1.7mm b/d on average over the quarter. This will allow oil prices to ease slightly from current elevated levels over the balance of the year. Inland, US shale-oil output remains on track to average ~ 9.06mm b/d this year, 9.55mmb/d in 2022 and 9.85mmb/d in 2023, in our modeling (Chart 3). We expect production in the Lower 48 states of the US to remain mostly steady going forward. Production from finishing drilled-but-uncompleted (DUCs) shale-oil wells is the lowest it's been since 2013.  Output from these wells will remain relatively low for the rest of the year. This supply was developed during the COVID-19 pandemic, as it was cheaper to bring on than new drilling. For 2022 and 2023 overall, our model points to a slow build-up in US shale-oil output as drilling increases. Going into 2022, we expect continued production discipline from OPEC 2.0, and for the coalition to continue to manage output in line with actual demand it sees from its customers. The 400k b/d being returned monthly to the market over August 2021 to mid-2022 will accommodate demand increases. However, it will be monitored closely in the event demand fails to materialize, as has been OPEC 2.0's wont over the course of the pandemic. Chart 3US Shale-Oil Output Mostly Stable Oil Markets To Remain Balanced We see markets remaining balanced to the end of 2023, with OPEC 2.0 maintaining its production-management strategy – keeping the level of supply just below the level of demand – and the price-taking cohort led by US shale-oil producers remaining focused on maintaining margins so as to provide competitive returns to investors. On the demand side, EM growth will pick up as DM growth slows. Given our fundamental view, global crude oil balances estimates are little changed to the end of 2023 (Chart 4). This allows inventories to continue to draw this year and next, then to slowly rebuild as production increases toward the end of 2023 (Chart 5). Falling inventories will keep the Brent forward curve backwardated – i.e., prompt-delivery oil will trade higher than deferred-delivery oil. Chart 4Markets Remain Balanced... Chart 5...And Oil Inventory Continues To Draw The backwardated forward curve means OPEC 2.0 producers will continue to realize higher delivered prices on their crude oil than the marginal shale-oil producer, which hedges its production 1-2 years forward to stabilize revenue. This is the primary benefit to the member states in the producer coalition: a backwardated curve pricing closer to marginal cost limits the amount of revenue available to shale-oil producers, and thus restrains output to that which is profitable at the margin. Investment Implications Our supply-demand outlook keeps our price expectations mostly unchanged from last month's forecast. We expect 4Q21 Brent prices to average $70.50/bbl, while 2022 and 2023 prices average $75 and $80/bbl, respectively, as can be seen in the Chart of the Week. WTI prices will continue to trade $2-$4/bbl below Brent over this interval. With fundamentals continuing to support a backwardated forward curve in Brent and WTI, we continue to favor long commodity-index exposure, which benefits from this structure.4 Therefore, we remain long the S&P GSCI and the COMT ETF, which is an optimized version of the GSCI that concentrates on positioning in backwardated futures contracts. The upside risk to oil prices resulting from increasing local production of mRNA vaccines in EM economies that had relied on less efficacious vaccines undoubtedly will increase mobility and raise oil demand, if, as appears likely, the impact of this localization is realized in the near term. This also could boost commodity demand generally, if it allows trade and GDP growth to accelerate in EM economies, which supports our long commodity-index view. The rollout of mRNA technology into EM economies also suggests EM GDP growth could increase at the margin with locally produced mRNA vaccines becoming more available. This would redound to the benefit of trade and economic activity generally.5 It also could help unsnarl the movement of goods globally. The wider implications of a successful expansion of locally produced mRNA vaccines leads us to recommend EM equity exposure on a tactical basis. At tonight's close, we will be getting long the DFA Dimensional Emerging Core Equity Market ETF (DFAE). As this is tactical, we will use a tight stop (10%) for this recommendation.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish Natural gas demand is surging globally. Record-breaking heat waves in the US are driving demand for gas-fired generation required to meet space-cooling demand. In addition, in the June-August period, the US saw record LNG exports. Europe and Asia are competing for the fuel as both prepare for winter. Brazil also has been a strong bid for LNG, as drought there has reduced hydropower supplies. In Europe, natural gas inventories were drawn hard this past winter as LNG supplies were bid away to Asia to meet space-heating demand. This is keeping Europe well bid now as winter approaches (Chart 6). The US Climate Prediction Center last week gave 70-80% odds of a second La Niña for the Northern Hemisphere winter. Should it materialize, it could again drive cold artic air into their markets, as it did last winter, and push natgas demand higher. Our recommendation to get long 1Q22 $5.00/MMBtu calls vs short 1Q22 $5.50/MMBtu calls last week was up 17% as of Tuesday's close. We remain long. Base Metals: Bullish The slide in iron ore prices from its ~ $230/MT peak earlier this year can be attributed to weak Chinese demand, and the possibility of its persistence through the winter and into next year (Chart 7). The world’s largest steel-producing nation is aiming to limit steel output to no higher than 2020 levels, in a bid to reduce industrial pollution. According to mining.com, provincial governments have directly asked local steel mills to curb output. Regulation in this sector in China will continue to reduce prices of iron ore, a key raw material in steel production. Precious Metals: Bullish The lower-than-expected reading on the US core CPI earlier this week weighed on the USD, and propelled gold prices above the $1,800/oz mark. While markets expected lower consumer prices for August to diminish the Fed’s resolve to taper asset purchases by year-end, we do not think the lower month-on-month CPI number will delay tapering. The timing of the Fed's initial rate hike – expected by markets to occur after the tapering of the central bank's asset-purchase program – will depend on the US labor force reaching "maximum employment." According to BCA Research's US Bond Strategy, this criterion will be met in late-2022 or early-2023. Low-interest rates, coupled with persistent inflation until then, will be bullish for gold prices. Chart 6 Chart 7   Footnotes 1     Please see Everest to bring Canadian biotech's potential Covid shots to China, other markets published on September 13, 2021 by indiatimes.com. 2     Examples of this include Brazil's Eurofarma to make Pfizer COVID-19 shots for Latin America, published by reuters.com; Biovac Institute to be first African company to produce mRNA vaccines, published be devex.com; and mRNA Vaccines Mark a New Era in Medicine, posted by supertrends.com. The latter report also discusses the application of mRNA technology to other diseases like malaria. 3    Please see Fault Lines Widen in the Global Recovery published 27 July 2021 by the Fund. 4    Backwardation is the source of roll yield for long-index exposure.  This is due to the design of these index products, which buy forward then – in backwardated markets – roll out of futures contract as they approach physical delivery at a higher level and re-establish their exposure in a deferred contract. 5    The lower realized efficacy of Sinopharm and Sinovac COVID-19 vaccines and high reinfection rates in economies using these vaccines are one of the key risks to our overall bullish commodity view.  Please see Assessing Risks To Our Commodity Views, which we published on July 8, 2021. It is available at ces.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Feature Chart 1Chinese Offshore Stocks Tumbled Amid Regulatory Crackdowns Relative to the global equity index, onshore and offshore Chinese stocks have fallen by 18% and 32%, respectively, since their peaks in mid-February (Chart 1). The panic sell-off in the offshore market, which saw greater losses due to its high concentration in internet stocks, appears to be overdone and may technically rebound in the near term. However, any short-term bounce in Chinese stocks from oversold levels will likely be short-lived (Chart 2). The crackdown on new economy companies reflects socio-political and economic shifts in China, which raises the odds that the restrictions will continue with further actions focused on social welfare and healthcare. August’s official PMIs and economic data indicate a broad-based softening in China’s domestic demand and production. However, compared with 2018/19 when the US-China trade war exacerbated the deterioration in an already slowing economy, the economy now remains well supported by strong exports. Moreover, the magnitude of the slowdown has not exceeded policymakers’ pain thresholds (Chart 3). Chart 2Tactical Bounce Was Short-Lived In Previous Downturns Chart 3China's Economic Recovery Losing Steam, But From An Elevated Level In 2018/19, stimulus was measured and the authorities did not meaningfully relax limits on bank lending standards and shadow banking. Furthermore, China recently reiterated its cross-cycle macro policy setting, which means that policymakers will not use significant stimulus to achieve high and short-term economic growth. Given financial stability measures that aim to contain risks associated with the housing market and hidden local government debt, any monetary and fiscal easing will likely help to stabilize credit growth instead of substantially boosting it this year. For the time being, China’s financial assets continue to face downside risks stemming from a confluence of a weakening business cycle and ongoing regulatory tightening. Thus, we recommend investors maintain an underweight allocation to Chinese equities within a global equity portfolio. Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com     A Shining Moment For Chinese Small And Medium Caps Small and medium-cap (SMID-cap) stocks have outperformed large-caps since February and the recent regulatory restrictions have intensified the situation. The CSI500 index, which comprises 500 SMID-cap companies, has outperformed the large-cap CSI300 by 34% since mid-February (Chart 4, top panel). Uncertainties surrounding the pandemic and corporate earnings growth have fueled extreme dislocations between large-cap and SMID-cap stocks last year. Large-cap stocks were the main contributors to China’s stock rallies in the second half of last year, while the valuation premia in small cap stocks was compressed to near decade lows (Chart 4, bottom panel). Chart 4A Low Valuation Premia And More Policy Support May Further Lift Prices Of SMID-Caps Chart 5SMID-Caps Tend To Outperform Large-Caps In Late Business Cycle Historically, SMID-caps tend to outperform large-caps in the late cycle of an economic recovery (Chart 5). The spate of regulatory changes aimed at monopolistic behaviors in various sectors has curbed investors’ appetite for the industry leaders. In addition, the government’s increasing efforts to support small and medium corporates (SMEs) will help to shore up confidence in those companies. Therefore, small and medium caps will likely continue to outperform large-cap stocks this year.   Fiscal Support: How Much Room In 2H? The July Politburo meeting pledged more fiscal support for the economy later in 2021 and into 2022. We expect local government bond (LGB) issuance to accelerate: a 4.47 trillion RMB new local government bond issuance quota was approved for 2021, including 820 billion in general bonds and 3.65 trillion in special purpose bonds (SPBs). By end-August, 2.37 trillion new local government bonds had been issued, which was only 53% of the entire year’s goal. However, there are some constraints that will likely reduce the reflationary effects on the economy. First, the quota for LGB issuance approved by the National People’s Congress is 16% lower than last year, but the amount of LGBs maturing this year is 30% higher. Therefore, even though this year’s gross LGB issuance has kept pace with that of last year, more than half of the LGBs issued from January to August was used for debt repayment (Chart 6).  The move by local governments to use a large portion of their bond issuance quota to pay off existing debt resembles the situation in 2018 when a financial de-risking campaign encouraged local governments to reduce the stockpile of their leverage. As noted in last week’s report, infrastructure investment and the economy did not rebound in 2H2018, even though LGB issuance picked up (Chart 7). Chart 6More Than Half Of LGBs Issued This Year Has Been Used For Debt Repayment Chart 7Improvement In Infrastructure Investment Was Short-Lived In 2019 Even if we assume that local governments will use all of their remaining bond quota by year end, the gross monthly average in local government bond issuance will be around 580 billion, only slightly higher than in 2H 2020. Secondly, infrastructure investment is discouraged by stringent regulations to approve projects (including project assessment and debt repayment ability) and the accountability of local officials for project failures. Approvals for infrastructure projects remain at the lowest level since March last year (Chart 8). Finally, SPBs made up only about 15% of overall infrastructure spending in the past three years, while the majority came from public-private partnerships (PPP) financing, revenues from government-managed funds, government budgets and bank loans. Falling proceeds from land transfers have dragged down government-managed funds (Chart 9). In addition, government expenditures show no signs of a material increase (Chart 9, bottom panel). Chart 8Infrastructure Investment Will Remain Subdued Chart 9Government Expenditures Remain Muted As discussed in previous reports, local government bonds issuance only accounts for 12% of total social financing. As such, without a sizeable acceleration in bank loans, enhanced LGB issuance would not be enough to prompt a substantial increase in infrastructure investment growth. Our argument is underscored by the structural downshift in infrastructure investment since 2017 (Chart 7, top panel). Therefore, additional local government bond issuance this year will help to stabilize but not boost credit growth. August PMIs Confirm Slowing Economic Activity China's official PMIs eased further in August. The non-manufacturing index fell to contractionary territory of 47.5, below the expectation of a more muted 1.3-point decline to 52.0. Similarly, the manufacturing PMI eased by 0.3 points to 50.1, which is a hair above the 50 boom-bust line. Together, weakness in both sectors pushed down the composite index to 48.9 (Chart 10). Stringent restrictions designed to halt rising rates in COVID-19 infections explain much of the deterioration in China’s service-sector activity. The sector will likely rebound in September with the easing in infection levels (Chart 11). Chart 10PMIs Show Slowing Economic Activity Chart 11Lingering COVID Effects Curb Service-Sector Recovery In 2H21   Meanwhile, the construction PMI surprisedly rebounded sharply in August (Chart 10, bottom panel). However, investors should be cautious not to read too much into the idiosyncratic month-on-month moves suggested by the construction PMI. Instead, construction activity has moderated significantly and is set to slow further, hinting at plunged excavator sales and real estate investment in construction (Chart 12). Chart 12Construction Activity Is Unlikely To Pick Up Meaningfully This Year It is clear that China’s economy is losing momentum, but greater economic weakness will be needed for policymakers to stimulate meaningfully. Export Sector Remains A Bright Spot China’s exports remain robust. Export growth picked up in August from July on a year-over-year basis. Although the improvement in August reflects a base effect, exports in level reached a new high (Chart 13). Both skyrocketed exports container freight index and strong Korean exports suggest that global demand for Chinese manufacturing goods remains resilient (Chart 14). Even though manufacturing PMIs from developed markets have rolled over, they remain elevated and should continue to support China’s exports (Chart 15). Chart 13Chinese August Exports In Level Reached A New High Chart 14Exports Will Remain Robust In The Rest Of The Year... In contrast to resilient exports, China’s official PMI export new orders subindex has declined for five consecutive months. Even though falling PMI new export orders subindex heralds a slowing in exports growth, a reading of below the 50 boom-bust threshold in the former does not suggest a contraction in the growth rate of the latter. Furthermore, the month-over-month nature of PMI new export orders subindex tends to overstate the volatility in exports. The divergence between the PMI new export orders subindex and real export growth also occurred in 2018/19 during the height of the US-China trade war when export orders were volatile (Chart 16). Chart 15...And Will Continue To Benefit From Strong Global Demand Chart 16A Divergence Between PMI New Export Orders And Export Growth Regulatory Tightening In Real Estate Sector Stringent regulations in housing since the beginning of the year have started to cool the sector (Chart 17). However, home prices inflation in tier-one cities is still elevated (Chart 18). Thus, we expect the controls on housing and among property developers will remain in place for the next 6 to 12 months. Chart 17Housing Sector Is Cooling... Chart 18...But Housing Prices In First-Tier Cities Keep Rising At A Faster Rate Industrial Profits: Rising Prices, Falling Production China’s industrial profit growth remained solid in July despite the waning low base effect. Manufacturing producer prices continued to rise, offsetting weaker production growth (Chart 19). In addition, a low interest-rate environment helped to lift profits in the manufacturing sector by reducing debt servicing costs. While we expect weakening domestic demand and peaking producer prices to weigh on corporate profits in the rest of this year, profit growth is rolling over from a lofty height and will not likely drop sharply in the coming months (Chart 20). In addition, producer prices will likely remain at a historically high level in the next six months given robust global demand for raw materials and persistent global supply shortages. Chart 19Rising Prices And Low Interest Rates Helped To Offset Falling Industrial Production Chart 20Peaking Producer Prices Will Weigh On Corporate Profits Meanwhile, there is a large gap between the prices for producer goods and consumer goods, suggesting that manufacturers in mid-to-downstream industries have not been able to fully pass on rising input costs to domestic consumers (Chart 21). Profit growth continues to be disproportionally stronger in the upstream industrial producers than in the downstream industries, while the profit margin in the manufacturing sector remains much more muted (Chart 22).  Chart 21Inflation Passthrough From Manufacturers To Domestic Consumers Remains Limited Chart 22Profit Growth In Upstream Industries Still Outpaces Manufacturing Sector Table 1 Table 2 Footnotes   Market/Sector Recommendations Cyclical Investment Stance

Highlights The US government issued its first-ever water-shortage declaration for the Colorado River basin in August, due to historically low water levels at the major reservoirs fed by the river (Chart of the Week). The drought producing the water shortage was connected to climate change by US officials.1 Globally, climate-change remediation efforts – e.g., carbon taxes – likely will create exogenous shocks similar to the oil-price shock of the 1970s. Remedial efforts will compete with redressing chronic underfunding of infrastructure. The US water supply infrastructure, for example, faces an investment shortfall of ~ $3.3 trillion over the next 20 years to replace aging plants and equipment, based on an analysis by the American Society of Civil Engineers (ASCE).  This will translate to a $6,000 per-capita cost by 2039 if the current funding gap persists. Fluctuating weather and the increasing prevalence of droughts and floods will increase volatility in markets such as agriculture which rely on stable climate and precipitation patterns.We are getting long the FIW ETF at tonight's close. The ETF tracks the performance of equities in the ISE Clean Edge Water Index, which covers firms providing potable water and wastewater treatment technologies and services. This is a strategic recommendation. Feature A decades-long drought in the US Southwest linked by US officials to climate change will result in further water rationing in the region. The drought has reduced total Colorado River system water-storage levels to 40% of capacity – vs. 49% at the same time last year. It has drawn attention to the impact of climate change on daily life, and the acute need for remediation efforts. The US Southwest is a desert. Droughts and low water availability are facts of life in the region. The current drought began in 2012, and is forcing federal, state, and local governments to take unprecedented conservation measures. The first-ever water-shortage declaration by the US Bureau of Reclamation sets in motion remedial measures that will reduce water availability in the Lower Colorado basin starting in October (Map 1). Chart 1Drought Hits Colorado River Especially Hard Map 1Colorado River Basin The two largest reservoirs in the US – Lake Powell and Lake Meade, part of the massive engineering projects along the Colorado – began in the 1930s and now supply water to 40mm people in the US Southwest. Half of those people get their water from Lake Powell. Emergency rationing began in August, primarily affecting Arizona, but will be extended to the region later in the year. Lake Powell is used to hold run-off from the upper basin of the Colorado River from Colorado, New Mexico, Utah and Wyoming. Water from Powell is sent south to supply the lower-basin states of California, Arizona, and Nevada. Reduced snowpack due to weather shifts caused by climate change has reduced water levels in Powell, while falling soil-moisture levels and higher evaporation rates, contribute to the acceleration of droughts and their persistence down-river. Chart 2Southwests Exceptionally Hard Drought Steadily increasing demand for water from agriculture, energy production and human activity brought on by population growth and holiday-makers have made the current drought exceptional (Chart 2). Most of the Southwest has been "abnormally dry or even drier" during 2002-05 and from 2012-20, according to the US EPA. According to data from the National Oceanic and Atmospheric Administration, most of the US Southwest was also warmer than the 1981 – 2010 average temperature during July (Map 2). The Colorado River Compact of 1922 governing the water-sharing rights of the river expires in 2026. Negotiations on the new treaties already have begun, as the seven states in the Colorado basin sort out their rights alongside huge agricultural  interest, native American tribes, Mexico, and fast-growing urban centers like Las Vegas. Map 2Most Of The US Southwest Is Warmer Than Average Global Water Emergency States around the globe are dealing with water crises as a result of climate change. "From Yemen to India, and parts of Central America to the African Sahel, about a quarter of the world's people face extreme water shortages that are fueling conflict, social unrest and migration," according to the World Economic Forum. Droughts, and more generally, changing weather patterns will make agricultural markets more volatile. Food production shortages due to unpredictable weather are compounding lingering pandemic related supply chain disruptions, leading to higher food prices (Chart 3). This could also fuel social unrest and political uncertainty. Floods in China’s Henan province - a key agriculture and pork region - inundated farms. Drought and extreme heat in North America are destroying crops in parts of Canada and the US. While flooding in July damaged Europe’s crops, the continent’s main medium-term risk, will be water scarcity.2  Droughts and extreme weather in Brazil have deep implications for agricultural markets, given the variety and quantity of products it exports. Water scarcity and an unusual succession of polar air masses caused coffee prices to rise earlier this year (Chart 4). The country is suffering from what national government agencies consider the worst drought in nearly a century. According to data from the NASA Earth Observatory, many of the agricultural states in Brazil saw more water evaporate from the ground and plants’ leaves than during normal conditions (Map 3). Chart 3The Pandemic and Changing Weather Patterns Will Keep Food Prices High Chart 4Unpredictable Weather Will Increase Volatility In Markets For Agricultural Commodities Map 3Brazil Is Suffering From Its Worst Drought In Nearly A Century Agriculture itself could be part of a longer-term and irreversible problem – i.e. desertification. Irrigation required for modern day farming drains aquifers and leads to soil erosion. According to the EU, nearly a quarter of Spain’s aquifers are exploited, with agricultural states, such as Andalusia consuming 80% of the state’s total water. Irrigation intensive farming, the possibility of higher global temperatures and the increased prevalence of droughts and forest fires are conducive to soil infertility and subsequent desertification. This is a global phenomenon, with the crisis graver still in north Africa, Mozambique and Palestinian regions. Changing weather patterns could also impact the production of non-agricultural goods and services. One such instance is semiconductors, which are used in machines and devices spanning cars to mobile phones. Taiwan, home to the Taiwan Semiconductor Manufacturing Company – the world’s largest contract chipmaker - suffered from a severe drought earlier this year (Chart 5). While the drought did not seriously disrupt chipmaking, in an already tight market, the event did bring the issue of the impact of water shortages on semiconductor manufacturing to the fore. According to Sustainalytics, a typical chipmaking plant uses 2 to 4 million gallons of water per day to clean semiconductors. While wet weather has returned to Taiwan, relying on rainfall and typhoons to satisfy the chipmaking sector’s water needs going forward could lead to volatility in these markets. Chart 5Taiwan Faced Its Worst Drought In History Earlier This Year Climate Change As A Macro Factor The scale of remediating existing environmental damage to the planet and the cost of investing in the technology required to sustain development and growth will be daunting. Unfortunately, there is not a great deal of research looking into how much of a cost households, firms and governments will incur on these fronts. Estimates of the actual price of CO2 – the policy variable most governments and policymakers focus on – range from as little as $1.30/ton to as much as $13/ton, according to the Peterson Institute for International Economics.3 PIIE's Jean Pisani-Ferry estimates the true cost is around $10/ton presently, after accounting for a lack of full reporting on costs and subsidies that reduce carbon costs. The cost of carbon likely will have to increase by an order of magnitude – to $130/ton or more over the next decade – to incentivize the necessary investment in technology required to deal with climate change and to sufficiently induce, via prices, behavioral adaptations by consumers at all levels. The PIIE notes, "… the accelerated pace of climate change and the magnitude of the effort involved in decarbonizing the economy, while at the same time investing in adaptation, the transition to net zero is likely to involve, over a 30-year period, major shifts in growth patterns." These are early days for assessing the costs and global macro effects of decarbonization. However, PIIE notes, these costs can be expected to "include a significant negative supply shock, an investment surge sizable enough to affect the global equilibrium interest rate, large adverse consumer welfare effects, distributional shifts, and substantial pressure on public finances." Much of the investment required to address climate change will be concentrated on commodity markets. Underlying structural issues, such as lack of investment in expanding supplies of metals and hydrocarbons required during the transition to net-zero CO2 emissions, will impart an upward bias to base metals, oil and natural gas prices over the next decade. We remain bullish industrial commodities broadly, as a result. Investment Implications Massive investment in infrastructure will be needed to address emerging water crises around the world. The American Society of Civil Engineers (ASCE) projects an investment shortfall of ~ $3.3 trillion over the next 20 years to replace aging water infrastructure in the US alone. This will translate to a $6,000 per-capita cost by 2039 if the current funding gap persists.4 At tonight's close we will be getting long the FIW ETF, which is focused on US-based firms providing potable water and wastewater treatment services. This ETF provides direct investment exposure to water remediation efforts and needed infrastructure modernization in the US. We also remain long commodity index exposure – the S&P GSCI and the COMT ETF – as a way to retain exposure to the higher commodity-price volatility that climate change will create in grain and food markets. This volatility will keep the balance of price risks to the upside.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish Hurricane Ida shut in ~ 96% of total US Gulf of Mexico (GoM) oil production. Colonial Pipeline, a major refined product artery for the US South and East coast closed a few of its lines due to the hurricane but has restarted operations since then. Since the share of US crude oil from this region has fallen, WTI and RBOB gasoline prices have only marginally increased, despite virtually zero crude oil production from the GoM (Chart 6). Prices are, however, likely to remain volatile, as energy producers in the region check for damage to infrastructure. Power outages and a pause in refining activity in the region will also feed price volatility over the coming weeks. Despite raising the 2022 demand forecast and pressure from the US, OPEC 2.0 stuck to its 400k b/d per month production hike in its meeting on Wednesday.     Base Metals: Bullish A bill to increase the amount of royalties payable by copper miners in Chile was passed in the senate mining committee on Tuesday. As per the bill, taxes will be commensurate with the value of the red metal. If the bill is passed in its current format, it will disincentivize further private mining investments in the nation, warned Diego Hernandez, President of the National Society of Mining (SONAMI). Amid a prolonged drought in Chile during July, the government has outlined a plan for miners to cut water consumption from natural sources by 2050. Increased union bargaining power - due to higher copper prices -, a bill that will increase mining royalties, and environmental regulation, are putting pressure on miners in the world’s largest copper producing nation.   Precious Metals: Bullish Jay Powell’s dovish remarks at the Jackson Hole Symposium were bullish for gold prices. The chairman of the US Central Bank stated the possibility of tapering asset purchases before the end of 2021 but did not provide a timeline. Powell reiterated the absence of a mechanical relationship between tapering and an interest rate hike. Raising interest rates is contingent on factors, such as the prevalence of COVID, inflation and employment levels in the US. The fact that the US economy is not close to reaching the maximum employment level, according to Powell, could keep interest rates lower for longer, supporting gold prices (Chart 7). Ags/Softs: Neutral The USDA crop Progress Report for the week ending August 29th reported 60% of the corn crop was good to excellent quality, marginally down by 2% vs comparable dates in 2020. Soybean crop quality on the other hand was down 11% from a year ago and was recorded at  56%. Chart 6 Chart 7     Footnotes 1     Please see Reclamation announces 2022 operating conditions for Lake Powell and Lake Mead; Historic Drought Impacting Entire Colorado River Basin. Released by the US Bureau of Reclamation on August 16, 2021. 2     Please refer to Water stress is the main medium-term climate risk for Europe’s biggest economies, S&P Global, published on August 13, 2021. 3    Please see 21-20 Climate Policy is Macroeconomic Policy, and the Implications Will Be Significant by Jean Pisani-Ferry, which was published in August 2021.  4    Please see The Economic Benefits of Investing in Water Infrastructure, published by the ASCE and The Value of Water Campaign on August 26, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights Regulatory changes affecting Chinese platform companies are structural – rather than transitory – in nature. These companies might become quasi-SOEs and could be used by the government to achieve its national and geopolitical objectives. China’s regulatory clampdown will produce structurally lower corporate profitability and, thereby, reduce equity valuations for Chinese TMT companies. Chinese policymakers have begun easing monetary and fiscal policies. Money and credit growth will likely bottom in December or so. However, as in H2 2018 and H1 2019, policy will be eased only gradually. During this period EM ex-TMT stocks and industrial metal prices performed poorly. Mainstream EM (countries outside North Asia) will continue suffering from weak growth and rising political volatility, warranting a higher risk premium. The risk-reward tradeoff for EM financial markets is poor. Feature Over the past several days, I have held calls and roundtables with clients located in the EMEA region. In this report, we will share our answers to the most common client questions. Many clients were asking if the selloff in Chinese platform companies is nearing its end or whether much more weakness is to be expected. It is not surprising that with the Hang Seng Tech index down 35% from its February highs, there is great temptation to engage in bottom fishing. So, we start with questions relating to this topic. Chart 1Is This Time Different For Chinese TMT Stocks? Question: In 2018, the regulatory clampdown on Tencent and other video game companies lasted several months and created a major pullback in their share prices (Chart 1). However, authorities ultimately removed restrictions and these stocks rallied to new highs. Do you expect the same dynamics to emerge this time around? And if not, why? We are witnessing a structural regime shift in the Chinese government’s approach toward platform companies. These changes are much more profound and long lasting than those in 2018. They herald structurally lower corporate profitability and equity multiples for Chinese TMT companies. For these stocks, a bounce from oversold levels is possible over the near term and it could be sharp. However, the rebound will be short-lived, i.e., a cyclical or secular rally is unlikely. Investors – who have not sold – should use this rebound to pare back exposure to Chinese TMT stocks. Chart 2Chinese SOEs: Lackluster Share Price Performance Going forward, these platform companies will be managed in a similar fashion to Chinese state-owned enterprises (SOEs): with the interest of the entire nation in mind, and shareholder interests will take a back seat. China’s SOEs trade at very low multiples and their share prices have been treading water since 2009 (Chart 2). The secular bull market in Chinese TMT share prices is over and more de-rating is likely for the following reasons: Chinese platform/new economy companies possess unique big data that are important to the country’s development. Protecting big data becomes a priority in an era of US-China geopolitical confrontation and amid the elevated risk of cyber attacks. As a result, it is essential for the Chinese government to control companies that possesses big data. Limiting foreign shareholders’ access and decision making in regard to big data is also imperative. We do not believe that Chinese authorities will ever allow these new economy companies to operate as freely as they have in the past. Given platform company importance to both the domestic economy and geopolitical confrontation with the US, we will not be surprised if the government eventually establishes effective control over these platform companies – probably via its affiliated entities. Many of these platform companies are natural monopolies or oligopolies and their profitability should be regulated by authorities according to free market economic textbooks. We discussed this point in the recent report titled Chinese TMT Stocks: A Bad Dream Or A New Reality? Please click on the link to open the report. Going forward, return on equity will be lower than in the past for these stocks, heralding lower valuation multiples. Stocks of many Chinese platform companies trade in the US and are largely owned by US/international (non-Chinese) investors. Neither US nor Chinese authorities want to see shares of Chinese TMT companies trade in the US, albeit for completely different reasons. Chinese authorities want these companies to release little information to their foreign shareholders, especially regarding big data. In turn, the US securities regulator is keen for US investors not to be exposed to the risks of owning Chinese stocks for two main reasons: (1) these companies do not disclose full information and (2) China’s government meddles with the management of these enterprises. Given that authorities from both countries do not support the trading of Chinese stocks in the US, odds are high that the trading of Chinese TMT companies will move from the US to Hong Kong. Moreover, US authorities may recommend US funds avoid owing Chinese stocks. In short, increased government control over Chinese TMT companies and rising geopolitical tensions between the US and the Middle Kingdom may prompt many foreign investors to reduce their exposure to these stocks. This will have negative ramifications on their share prices. Chart 3Little Volatility Spillover From Offshore Into China's Onshore Markets Question: Don’t you think Chinese authorities may reverse their regulatory clampdown given that Chinese share prices have already dropped a great deal and further weakness could hurt investor and business sentiment? Chinese authorities will not reverse regulatory tightening on platform companies. If investor and business confidence on the mainland is hurt materially, regulators will reduce the intensity of their reforms but will not reverse them. Importantly, the carnage has so far been limited to Chinese offshore financial markets (Chart 3). Neither the onshore equity indexes, nor onshore corporate bonds have sold off much (Chart 3). The majority of platform companies are listed offshore and plunging share prices hurt foreign shareholders more than domestic retail and institutional investors. There is little reason for Chinese policymakers to worry about losses among foreign investors so long as the carnage does not spread to onshore markets. Question: Why would Chinese authorities damage their largest and most successful companies in the new economy sectors? Are they not critical amidst the US-China confrontation? Chinese policymakers understand the importance of platform companies to the country’s domestic growth outlook as well as its geopolitical ambitions. This explains why Chinese authorities seek to establish effective control over decision making in these companies. We elaborated on the strategic importance of big data above. Also, the largest platform companies, such as Alibaba, Tencent and Meituan, have in recent years been acquiring stakes in numerous businesses in Southeast Asia. Beijing might be thinking of using these platform companies to raise its geopolitical influence over other Asian nations and beyond. Many Asian nations will play a prominent role in the US-China confrontation. Whether they side with China or the US will affect the balance of geopolitical power in the region. In this context, having control over soft infrastructure (payment and data systems, among others) in these Asian economies will give Beijing a chance to influence their geopolitical choices, thereby giving China an advantage over the US. Therefore, the Chinese central government might be aiming to establish an effective control over these companies’ strategic decisions. In such a case, shareholder interests will take a back seat in these companies. Question: What about common prosperity initiatives and policies that the Chinese leadership has unveiled in recent weeks? Why now? President Xi will be elected for his third term in the fall of 2022. This constitutes a major political precedent in the Middle Kingdom’s modern history. President Xi wants to secure his support from the bulk of the population. Common prosperity policies entail income and wealth distribution from high-income to middle- and low-income households. Chart 4 and Chart 5 illustrate that there has so far been no equalization of income and wealth distribution. Chart 4China: Income Disparity Has Not Been Narrowing Chart 5Wealth Concentration Remains High In China   It is imperative for President Xi to achieve a meaningful change in income and wealth distribution in the next 12 months before his third term. President Xi’s power stems not from the top 10% of the population but from the remaining (and less wealthy) 90%. Hence, there will be little easing in the push toward common prosperity. If anything, the pace of these initiatives could escalate going forward. As a part of the common prosperity initiatives, companies with excess profitability will be compelled to perform a national duty in the form of financing social programs or providing donations. Large platform companies have already begun making large donations. This trend will intensify in the months ahead. In brief, profits will be distributed away from shareholders of these companies in favor of the general well-being of society. The positive is that low- and middle-income consumer spending in China will be supported by income transfer from companies and wealthy individuals. As a result, investors should favor the companies that sell to low- and middle-income households. Chart 6Chinese Growth Stocks Are Not Yet Cheap Going forward, the model of SOEs in China or Russia will be applicable to Chinese platform companies. SOEs in China, Russia and other EM countries often perform national duties at the expense of shareholders. Not surprisingly, their stocks have been trading at much lower multiples than private companies. Presently, Chinese TMT/growth stocks trade at a trailing P/E ratio of 33.5 (Chart 6). We do not expect platform companies’ P/E ratio to drop to the level of SOEs. However, a trailing P/E ratio of 33.5 for China’s TMT companies is still high given: the uncertainty around future business models; a lack of clarity around (still evolving) new regulation; government involvement in their management; the prioritization of national and geopolitical objectives over shareholder interest. Chart 7Mind These Gaps Question: Isn’t the slowdown in China’s business cycle already well known and priced in related financial markets? Yes, it is well known but we do not think it has been priced in China-exposed plays. There are several market relationships and indicators that lead us to believe so. Both panels in Chart 7 illustrate that industrial metals prices have diverged from the Chinese manufacturing PMI and onshore government bond yields. The latter two variables project the Chinese business cycle. Such a decoupling is unsustainable given that China accounts for 55% of global industrial metal consumption. We continue to expect meaningful downside in industrial metals prices which would hurt EM countries exporting commodities. China’s credit and fiscal spending impulse leads its business cycle by nine months and suggests that economic data will be weakening until Q2 2022 (Chart 8). Finally, net EPS revisions for EM-listed companies remain elevated (Chart 9). Chart 8China's Business Cycle Will Continue Decelerating Well Into Q1 2022 Chart 9EM EPS Growth Expectations Have Not Yet Been Downgraded   That said, one sentiment indicator that has dropped significantly and is now near its level during previous EM equity lows is the Sentix European investor sentiment index on EM equities (Chart 10). Chart 10European Investor Sentiment On EM Stocks Is Back To Its Previous Lows Net-net, the risk-reward tradeoff for EM equities and credit markets is not yet attractive. Chinese TMT stocks are vulnerable for reasons discussed above while EM financial markets exposed to China’s old economy are at risk due to decelerating Chinese economic growth. Question: When will authorities in China ease policy? What does it imply for Chinese and EM financial markets? Shouldn’t investors buy China/EM assets now in anticipation of macro policy easing in China? Yes, China has already started easing credit and fiscal policy and will ease more in the coming months. Chart 11 reveals that banks’ excess reserves at the PBOC have turned up and they lead the credit impulse by six months. In turn, the Chinese credit impulse in turn leads EM share price cycles by nine months (Chart 12). Chart 11China's Credit Impulse Will Bottom In Late 2021 Chart 12EM Equities Are Not Yet Out Of The Woods   All in all, even though Chinese policymakers have begun easing credit and fiscal policy, financial markets leveraged to the mainland’s old economy could still suffer as growth continues to disappoint in the months to come. Chart 13Chinese Easing In H2 2018 And H1 2019 Did Not Help Much EM Stocks And Metal Prices Importantly, policy easing will be implemented gradually, as in H2 2018 and H1 2019. During this period EM ex-TMT stocks and industrial metal prices performed poorly despite policy easing in China (Chart 13). Question: Given improvements in vaccine availability worldwide, will EM countries close their vaccination gap with developed countries in the coming months? If yes, wouldn’t it allow their economies to catch up, and their financial markets to outperform their DM peers? EM vaccination rates will rise as vaccines become available to developing countries. However, mainstream EM vaccination rates will still remain below those of advanced economies. This gap is due to higher levels of mistrust toward governments in developing countries than in advanced ones. Therefore, the pandemic will continue capping economic activity in mainstream EM. Importantly, the lack of fiscal stimulus, monetary policy tightening and weak banking systems in mainstream EM (i.e., excluding China, Korea and Taiwan) herald weak income and domestic demand growth in these economies. Years of poor income growth and lasting pandemic damage have caused political volatility to flare-up in some countries such as Colombia, Peru, Brazil, South Africa and Malaysia. This trend will likely continue foreshowing a higher risk premium in EM financial markets. Question: What is your inflation outlook for mainstream EM (excluding North Asia)? Will inflation continue to surprise to the upside and will their central banks hike rates enough so that their currencies do not depreciate? We discussed the inflation dynamics and the outlook for local rates for EM in the August 12 report. While commodity price inflation will subside, renewed currency deprecation is the key risk to the inflation outlook in mainstream EM. EM currencies will depreciate because China’s continued slowdown is bearish for EM currencies but bullish for the greenback. The basis is that the US sells little to China while EM are exposed to the Chinese business cycle. Also, domestic demand in mainstream EM will disappoint. That, along with rising political volatility, is negative for their currencies. Finally, high local rates in mainstream EM have often coincided with currency depreciation rather than appreciation. Question: What is the biggest risk in your view? The biggest risk to our view has been and remains TINA (There Is No Alternative). We have strong conviction on fundamentals but very little conviction on fund flows. Given that DM equity and credit markets are expensive and their government bond yields are very depressed, portfolio capital can go into EM financial markets that offer lower valuation than their DM counterparts even though they are not cheap in absolute terms. Our methodology is that fundamentals drive flows in the medium- to-long term. However, with the global financial system flush with liquidity, the importance of fundamentals has declined in recent years. Therefore, we are cognizant that EM markets might not sell off a lot and could bottom at a higher level than warranted by fundamentals. Still, we expect more downside in the coming months because fundamentals are much worse than most investors realize. Chart 14EM Credit Will Continue Underperforming Their US Peers Question: What is your recommended strategy across EM equities, currencies, and fixed-income markets? Global equity portfolios should continue underweighting EM, a recommendation from March 25, 2021. Within the EM equity universe, our overweights are Korea, India, China (preferring onshore to offshore equities), Mexico and Chile. Our underweights are Brazil, Colombia, Peru, South Africa, Turkey, the Philippines and Indonesia.  The risk-reward tradeoff for EM currencies remains poor. We continue shorting a basket of BRL, CLP, COP, PEN, ZAR, TRY, PHP, THB and KRW versus the US dollar. Within local markets we overweight Mexico, Russia, Korea, Malaysia, India, China and Chile. Regarding sovereign and corporate credit, we have downgraded EM credit versus US credit on March 25 and this strategy remains intact (Chart 14). The lists of our overweights, underweights and the ones warranting neutral allocation in EM equity, domestic bonds and credit portfolios are presented below and can always be found on the EMS website. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Special Report

Highlights Commodity markets will face growing supply challenges over the next decade as the US and China prepare for war, if only to deter war. Chinese President Xi Jinping's push for greater self-reliance at home and supply chain security abroad is reinforced by the West’s focus on the same interests. The erosion of a single rules-based global trade system increases the odds of economic and even military conflict. The competition for security is precipitating a reforging of global supply chains and a persistent willingness to use punitive measures, which can escalate into boycotts, embargoes, and even blockades (i.e. not only Huawei). The risk of military engagements will rise, particularly along global chokepoints and sea lanes needed to transport vital commodities. Import dependency and supply chain risk are powerful drivers of decarbonization efforts, especially in China. On net, geopolitical trends will keep the balance of commodity-price risks tilted to the upside. Commodity and Energy Strategy remains long commodity index exposure on a strategic basis via the S&P GSCI and the COMT ETF.  Note: Even in the short term, a higher geopolitical risk premium is warranted in oil prices due to US-Iran conflict. Feature The Chinese Communist Party (CCP) under President Xi Jinping has embarked on a drive toward autarky, or economic self-sufficiency, that has enormous implications, especially for global commodities. Beijing believes it can maintain central control, harness technology, enhance its manufacturing prowess, and grow at a reasonable rate, all while bulking up its national security. The challenge is to maintain social stability and supply security through the transition. China lives in desperate fear of the chaos that reigned throughout most of the twentieth and twenty-first centuries, which also enabled foreign domination (Chart 1). The problem for the rest of the world is that Chinese nationalism and assertive foreign policy are integral aspects of the new national strategy. They are needed to divert the public from social ills and deter foreign powers that might threaten China’s economy and supply security. Chart 1China Fears Any Risk Of Another ‘Century Of Humiliation’ The chief obstacle for China is the United States, which remains the world leader even though its share of global power and wealth is declining over time. The US is formally adopting a policy of confrontation rather than engagement with China. For example, the Biden administration is co-opting much of the Trump administration's agenda. Infrastructure, industrial policy, trade protectionism, and the “pivot to Asia” are now signature policies of Biden as well as Trump (Table 1).1 Table 1US Strategic Competition Act Highlights Return Of Industrial Policy, Confrontation With China Many of these policies are explicitly related to the strategic aim of countering China’s rise, which is seen as vitiating the American economy and global leadership. Biden’s Trump-esque policies are a powerful indication of where the US median voter stands and hence of long-term significance (Chart 2). Thus competition between the US and China for global economic, military, and political leadership is entering a new phase. China’s drive for self-reliance threatens the US-led global trade system, while the US’s still-preeminent geopolitical power threatens China’s vital lines of supply. Chart 2US Public’s Fears Are China-Centric Re-Ordering Global Trade The US’s and China’s demonstrable willingness to use tariffs, non-tariff trade barriers, export controls, and sanctions cannot be expected to abate given that they are locked in great power competition (Chart 3). More than likely, the US and China will independently pursue trade relations with their respective allies and partners, which will replace the mostly ineffective World Trade Organization (WTO) framework. The WTO is the successor to the rules-based and market-oriented system known as the General Agreement on Tariffs and Trade (GATT), which was formed following World War II. The GATT’s founders shared a strong desire to avoid a repeat of the global economic instability brought on by World War I, the Great Crash of 1929, and the retreat into autarky and isolationism that led to WWII. Chart 3US and China Imposing Trade Restrictions This inter-war period saw domestically focused monetary policies and punishing tariffs that spawned ruinous bouts of inflation and deflation. Minimizing tariffs, leveling the playing field in trading markets, and reducing subsidization of state corporate champions were among the GATT's early successes. The WTO, like the GATT before it, has no authority to command a state to change its economy or the way it chooses to organize itself. At its inception the GATT's modus vivendi was directed at establishing a rules-based system free of excessive government intrusion and regulation. If governments agreed to reduce their domestic favoritism, they could all improve their economic efficiency while avoiding a relapse into autarky and the military tensions that go with it.2 The prime mover in the GATT's founding and early evolution – the USA – firmly believed that exclusive trading blocs had created the groundwork for economic collapse and war. These trading blocs had been created by European powers with their respective colonies. During the inter-war years the revival of protectionism killed global trade and exacerbated the Great Depression. After WWII, Washington was willing to use its power as the global hegemon to prevent a similar outcome. Policymakers believed that European and global economic integration would encourage inter-dependency and discourage protectionism and war. The fall of the Soviet Union reinforced this neoliberal Washington Consensus. Countries like India and China adopted market-oriented policies. The WTO was formed along with a range of global trade deals. Ultimately the US and the West cleared the way for China to join the trading bloc, hoping that the transition from communism to capitalism would eventually be coupled with social and even political liberalization. The world took a very different turn as the United States descended into a morass of domestic political divisions and foreign military adventures. China seized the advantage to expand its economy free of interference from the US or West. The West failed to insist that liberal economic reforms keep pace.3 Moreover, when China joined the WTO in 2001, the organization was in a state of "regulatory stalemate," which made it incapable of dealing with the direct challenges presented by China.4 Today President Xi has consolidated control over the Communist Party and directs its key economic, political, and military policymaking bodies. He has deepened party control down to the management level of SOEs – hiring and firing management. SOEs have benefited from Xi’s rule (Chart 4). But now the West is also reasserting the role of the state in the economy and trade, which means that punitive measures can be brought to bear on China’s SOEs. Chart 4State-Owned Enterprises Benefit From Xi Administration What Comes After The WTO? The CCP has shown no interest in coming around to the WTO's founding beliefs of government non-interference in the private sector. For example, it is doubling down on subsidization and party control of SOEs, which compete against firms in other WTO member states. Nor has the party shown any inclination to accept a trade system based on the GATT/WTO founding members' Western understanding of the rule of law. These states represent market-based economies with long histories of case law for settling disputes. Specifically, China’s fourteenth five-year plan and recent policies re-emphasize the need to upgrade the manufacturing sector rather than rebalancing the economy toward household consumption. The latter would reduce imbalances with trade deficit countries like the US but China is wary of the negative social consequences of too rapidly de-industrializing its economy. It wants to retain its strategic and economic advantage in global manufacturing and it fears the social and political consequences of fully adopting consumer culture (Chart 5). Chart 5China’s Economic Plans Re-Emphasize Manufacturing, Not Consumption The US, EU, and Japan have proposed reform measures for the WTO aimed at addressing “severe excess capacity in key sectors exacerbated by government financed and supported capacity expansion, unfair competitive conditions caused by large market-distorting subsidies and state owned enterprises, forced technology transfer, and local content requirements and preferences.”5 But these measures are unlikely to succeed. China disagrees with the West’s characterization. In 2018-19, during the trade war with the US, Beijing contended that WTO members must “respect members’ development models.” China formally opposes “special and discriminatory disciplines against state-owned enterprises in the name of WTO reform.”6 In bilateral negotiations with the US this year, China’s first demand is that the US not to oppose its development model of “socialism with Chinese characteristics” (Table 2). Table 2China’s Three Diplomatic Demands Of The United States (2021) Yet it is hard for the US not to oppose this model because it involves Beijing using the state’s control of the economy to strengthen national security strategy, namely by the fusion of civil and military technology. Going forward, the Biden administration will violate the number one demand that Chinese diplomats have made: it will attempt to galvanize the democracies to put pressure on China’s development model. China’s demand itself reflects its violation of the US primary demand that China stop using the state to enhance its economy at the expense of competitors. If a breakdown in global trading rules is replaced by the US and China forming separate trading blocs with their allies and partners, the odds of repeating the mistakes of the inter-bellum years of 1918-39 will significantly increase. Tariff wars, subsidizing national champions, heavy taxation of foreign interests, non-tariff barriers to trade, domestic-focused monetary policies, and currency wars would become more likely. China’s Strategic Vulnerability The CCP has delivered remarkable prosperity and wealth to the average Chinese citizen in the 43 years since it undertook market reforms, and especially since its accession to the WTO in 2001 (Chart 6). China has transformed from an economic backwater into a $15.4 trillion (2020) economy and near-peer competitor to the US militarily and economically.7 This growth has propelled China to the top of commodity-importing and -consuming states globally for base metals and oil. We follow these markets closely, because they are critical to sustaining economic growth, regardless of how states are organized. Production of and access to these commodities, along with natural gas, will be critical over the next decade, as the world decarbonizes its energy sources, and as the US and China address their own growth and social agendas while vying for global hegemony. Decarbonization is part of the strategic race since all major powers now want to increase economic self-sufficiency and technological prowess. Chart 6CCPs Remarkable Success In Growing Chinas Economy Over recent decades China has become the largest importer of base metals ores (Chart 7) and the world's top refiner of many of these metals. In addition, it is the top consumer of refined metal (Chart 8). Chart 7China Is World’s Top Ore Importer Chart 8China Is Worlds Top Refined Metal Consumer By contrast, the US is not listed among ore importers or metals consumers in the Observatory of Economic Complexity (OEC) databases we used to map these commodities. This reflects not only domestic supplies but also the lack of investment and upgrades to the US's critical infrastructure over 2000-19.8 Going forward, the US is trying to invest in “nation building” at home. An enormous change has taken shape in strategic liabilities. In the oil market, the US went from being the world's largest importer of oil in 2000, accounting for more than 24% of imports globally, to being the largest oil and gas producer by 2019, even though it still accounted for more than 12% of the world's imports (Chart 9). In 2000, China accounted for ~ 3.5% of the world's oil imports and by 2019 it was responsible for nearly 21%. China is far behind per capita US energy consumption, given its large population, but it is gradually closing the gap (Chart 10). Overall energy consumption in China is much higher than in the US (Chart 11). Chart 9US Oil Imports Collapse As Shale Production Grows Chart 10Energy Use Per Capita In China Far From US Levels... Chart 11China Is World’s Largest Primary Energy Consumer China's impressive GDP growth in the twenty-first century is primarily responsible for China's stunning growth in imports and consumption of oil (Chart 12) and copper (Chart 13), which we track closely as a proxy for the entire base-metals complex. Chart 12Global Oil Demand Forecast Remains Steady Chinas GDP Drives Oil Consumption, Imports Chart 13Global Oil Demand Forecast Remains Steady Chinas GDP Drives Refined Copper Consumption And Ore Imports China’s importance in these markets points to an underlying strategic weakness, which is its dependency on imports. This in turn points to the greatest danger of the breakdown in US-China relations and the global trade system. The Road To War? China is extremely anxious about maintaining supply security in light of these heavy import needs. Its pursuit of economic self-sufficiency, including decarbonization, is driven by its fear of the US’s ability to cut off its key supply lines. China’s first goal in modernizing its military in recent years was to develop a naval force capable of defending the country from foreign attack, particularly in its immediate maritime surroundings. Historically China suffered from invaders across the sea who took advantage of its weak naval power to force open its economy and exploit it. Today China is thought to have achieved this security objective. It is believed to have a high level of capability within the “first island chain” that surrounds the coast, from the Korean peninsula to the Spratly Islands, including southwest Japan and Taiwan (Map 1).9 China’s militarization of the South China Sea, suppression of Hong Kong, and intimidation of Taiwan shows its intention to dominate Greater China, which would put it in a better strategic position relative to other countries. Map 1China’s Navy Likely Achieved Superiority Within The First Island Chain China’s capability can be illustrated by comparing its naval strength to that of the United States, the most powerful navy in the world. While the US is superior, China would be able to combine all three of its fleets within the first island China, while the US navy would be dispersed across the world and divided among a range of interests to defend (Table 3). China would also be able to bring its land-based air force and missile firepower to bear within the first island chain, as opposed to further abroad.10 Table 3China’s Naval Growth Enables Primacy Within First Island Chain In this sense China is militarily capable of conquering Taiwan or other nearby islands. President Xi Jinping had in fact ordered China’s armed forces be capable of doing so by 2020.11 Taiwan continues to be the most significant source of insecurity for the regime. True, a military victory would likely be a pyrrhic victory, as Taiwan’s wealth and tech industry would be destroyed, but China probably has the raw military capability to defeat Taiwan and its allies within this defined space. However, this military capability needs to be weighed against economic capability. If China seized military control of Taiwan, or Okinawa or other neighboring territories, the US, Japan, and their allies would respond by cutting off China’s access to critical supplies. Most obviously oil and natural gas. China’s decarbonization has been impressive but the reliance on foreign oil is still a fatal strategic vulnerability over the next few years (Chart 14). China is rapidly pursuing a Eurasian strategy to diversify away from the Middle East in particular. But it still imports about half its oil from this volatile region (Chart 15). The US navy is capable of interdicting China’s critical oil flows, a major inhibition on China’s military ambitions within the first island chain. Chart 14Chinas Energy Diversification Still Leaves Vulnerabilities Of course, if the US and its allies ever blockaded China, or if China feared they would, Beijing could be driven to mount a desperate attack to prevent them from doing so, since its economic, military, and political survival would be on the line. Chart 15China Still Dependent On Middle East Energy Supplies The obvious historical analogy is the US-Japan conflict in WWII. Invasions that lead to blockades will lead to larger invasions, as the US and Japan learned.12 However, the lesson from WWII for China is that it should not engage the US navy until its own naval power has progressed much further. In the event of a conflict, the US would be imposing a blockade at a distance from China’s naval and missile forces. When it comes to the far seas, China’s naval capabilities are extremely limited. Military analysts highlight that China lacks a substantial naval presence in the Indian Ocean. China relies on commercial ports, where it has partial equity ownership, for ship supply and maintenance (Table 4). This is no substitute for naval basing, because dedicated military facilities are lacking and host countries may not wish to be drawn into a conflict. Table 4China’s Network Of Part-Owned Ports Across The World: Useful But Not A Substitute For Military Bases Further, Beijing lacks the sea-based air power necessary to defend its fleets should they stray too far. And it lacks the anti-submarine warfare capabilities necessary to defend its ships.13 These capabilities are constantly improving but at the moment they are insufficient to overthrow US naval control of the critical chokepoints like the Strait of Hormuz or Strait of Malacca. While China’s naval power is comparable to the US’s Asia Pacific fleet (the seventh fleet headquartered in Japan), it is much smaller than the US’s global fleet and at a much greater disadvantage when operating far from home. China’s navy is based at home and focused on its near seas, whereas US fleet is designed to operate in the far seas, especially the Persian Gulf, which is precisely the strategic area in question (Chart 16).14 China is gradually expanding its navy and operations around the world, so over time it may gain the ability to prevent the US from cutting off its critical supplies in the Persian Gulf. But not immediately. The implication is that China will have to avoid direct military conflict with the United States until its military and naval buildup has progressed a lot further. Chart 16China’s Navy At Huge Disadvantage In Distant Seas Meanwhile Beijing will continue diversifying its energy sources, decarbonizing, and forging supply chains across Eurasia via the Belt and Road Initiative. What could go wrong? We would highlight a few risks that could cause China to risk war even despite its vulnerability to blockade: Chart 17China’s Surplus Of Males Undergirds Rise In Nationalism Domestic demographic pressure. China is slated to experience a dramatic bulge in the male-to-female ratio over the coming decade (Chart 17).15 A surfeit of young men could lead to an overshoot of nationalism and revanchism. This trend is much more important than the symbolic political anniversaries of 2027, 2035, and 2049, which analysts use to predict when China’s military might launch a major campaign. Domestic economic pressure. China’s turn to nationalism reflects slowing income growth and associated social instability. An economic crisis in China would be worrisome for regional stability for many reasons, but such pressures can lead nations into foreign military adventures. Domestic political pressure. China has shifted from “consensus rule” to “personal rule” under Xi Jinping. This could lead to faulty decision-making or party divisions that affect national policy. A leadership that carefully weighs each strategic risk could decay into a leadership that lacks good information and perspective. The result could be hubris and belligerence abroad. Foreign aggression. Attempts by the US or other powers to arm China’s neighbors or sabotage China’s economy could lead to aggressive reaction. The US’s attempt to build a technological blockade shows that future embargoes and blockades are not impossible. These could prompt a war rather than deter it, as noted above. Foreign weakness. China’s capabilities are improving over time while the US and its allies lack coordination and resolution. An opportunity could arise that China’s strategists believe they cannot afford to miss. Afghanistan is not one of these opportunities, but a US-Iran war or another major conflict with Russia could be. The breakdown in global trade is concerning because without an economic buffer, states may resort to arms to resolve disputes. History shows that military threats intended to discourage aggressive behavior can create dilemmas that incentivize aggression. The behavior of the US and China suggests that they are preparing for war, even if we are generous and assume that they are doing so only to deter war. Both countries are nuclear powers so they face mutually assured destruction in a total war scenario. But they will seek to improve their security within that context, which can lead to naval skirmishes, proxy wars, and even limited wars with associated risks of going nuclear. Investment Takeaways The pursuit of the national interest today involves using fiscal means to create more self-sufficient domestic economies and reduce international supply risks. Both China and the West are engaged in major projects to this end, including high-tech industrialization, domestic manufacturing, and decarbonization. These trends are generally bullish for commodities, even though they include trends like military modernization and naval expansion that could well be a prelude to war. War itself leads to commodity shortages and commodity price inflation, but of course it is disastrous for the people and economies involved. Fortunately, strategic deterrence continues to operate for the time being. The underlying geopolitical trend will put commodity markets under continual pressure. A final urgent update on oil and the Middle East: The US attempt to conduct a strategic “pivot” to Asia Pacific faces a critical juncture. Not because of Afghanistan but because of Iran. The Biden administration will have trouble unilaterally lowering sanctions on Iran after the humiliating Afghanistan pullout. The new administrations in both Iran and Israel are likely to establish red lines and credible threats. A higher geopolitical risk premium is thus warranted immediately in global oil markets. Beyond short-term shows of force, everything depends on whether the US and Iran can find a temporary deal to avoid the path to a larger war. But for now short-term geopolitical risks are commodity-bullish as well as long-term risks.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1     There are also significant differences between Biden and Trump in other areas such as redistribution, immigration, and social policy. 2     See Ravenhill, John (2020), Regional Trade Agreements, Chapter 6 in Global Political Economy, which he edited for Oxford University Press, particularly pp. 156-9. 3    “As time went by, the United States realized that Communism not only did not retreat, but also further advanced in China, with the state-owned economy growing stronger and the rule of the Party further entrenched in the process." See Henry Gao, “WTO Reform and China Defining or Defiling the Multilateral Trading System?” Harvard International Law Journal 62 (2021), p. 28, harvardilj.org.  4    See Mavroidis, Petros C. and Andre Sapir (2021), China and the WTO, Why Multilateralism Still Matters (Princeton University Press) for discussion.  See also Confronting the Challenge of Chinese State Capitalism published by the Center for Strategic & International Studies 22 January 2021. 5    Gao (2021), p. 19. 6    Gao (2021), p. 24. 7     Please see China's GDP tops 100 trln yuan in 2020 published by Xinhuanet 18 January 2021. 8    We excluded 2020 because of the COVID-19 pandemic's effects on supply and demand for these ores, metals and crude oil. 9    See Captain James Fanell, “China’s Global Navy Strategy and Expanding Force Structure: Pathway To Hegemony,” Testimony to the US House of Representatives, May 17, 2018, docs.house.gov. 10   Fanell (2018), p. 13. 11    He has obliquely implied that his vision for national rejuvenation by 2035 would include reunification with Taiwan. Others suggest that the country’s second centenary of 2049 is the likely deadline, or the 100th anniversary of the People’s Liberation Army. 12    The US was a major supplier of oil to Japan, and in 1941 it froze Japan's assets in the US and shut down all oil exports, in response to Japan's military incursion into China in the Second Sino-Japanese War of 1937-45.  Please see Anderson, Irvine H. Jr. (1975), "The 1941 De Facto Embargo on Oil to Japan: A Bureaucratic Reflex," Pacific Historical Review, 44:2, pp. 201-231.  13   See Jeffrey Becker, “Securing China’s Lifelines Across the Indian Ocean,” China Maritime Report No. 11 (Dec 2020), China Maritime Studies Institute, digital-commons.usnwc.edu. 14   See Rear Admiral Michael McDevitt, “Becoming a Great ‘Maritime Power’: A Chinese Dream,” Center for Naval Analyses (June 2016), cna.org. 15   For discussion see Major Tiffany Werner, “China’s Demographic Disaster: Risk And Opportunity,” 2020, Defense Technical Information Center, discover.dtic.mil.  

Highlights Last week’s market gyrations do not mark the end of China’s structural reforms. The country’s macro policy setting has shifted to allow a higher tolerance for short-term pain in exchange for long-term gain. Chinese policymakers will temporarily put the brakes on its reform agenda if policy measures threaten domestic economic stability; a spillover from the equity market rout to the currency market and private-sector investment will be a pressure point for the authorities. Messages from last week’s Politburo meeting were only marginally more positive than in April. While policymakers seem to be paying more attention to the economic slowdown, they do not appear to be in a rush to rescue the economy. We present three scenarios describing how the equity markets and policy may develop in the coming months. In all the scenarios, investors should avoid trying to catch a falling knife. Feature July was an extraordinarily difficult time for Chinese stocks and last week’s steep slide intensified as a slew of announced regulatory changes spooked market participants (Chart 1). Chart 1Chinese Stocks Had A Tough MonthWe have repeatedly outlined the risks to Chinese equities in the past month. Since the PBoC cut the reserve requirement ratio in early July, the negative impact on the financial markets from tightening industry policies has outweighed the limited positive effects from a slightly more dovish central bank policy stance.  Chart 2Chinese TMT Stock Prices Were Hammered Is now a good time to buy Chinese stocks? Multiple compressions have made Chinese equities, particularly the hard-hit technology, media & telecom (TMT) stocks in the offshore market, appear cheap compared with their global counterparts (Chart 2). In this report we present three scenarios how China’s equity market and policies will likely evolve. In our view, more than a week of stock selloffs will be needed for policymakers to halt reforms. Furthermore, even if the pace of reforms eases and policymakers start to reflate the economy, it will likely take between 6 and 12 months for stock prices to find a bottom.  In light of escalating uncertainty over China’s financial market performance, the China Investment Strategy and Global Asset Allocation services will jointly publish a Special Report on August 18. We will examine how global investors can improve the risk-reward profile of their multi-asset portfolios with exposure to Chinese assets.   Three Scenarios While the regulatory landscape is unclear, we can draw on previous experience to analyze how China’s equity market and policy directions may evolve. In the first scenario, which is our baseline case, the economy would weaken, but would not cross policymakers’ pain threshold. There would be marginal policy easing action to alleviate market anxiety and monetary policy would be slightly loosened along with polices on some non-core sectors, such as infrastructure investment. In this scenario, structural reforms could continue for another 6 to 12 months, as suggested by colleagues at the BCA Geopolitical Strategy services. Investors should resist the urge to buy on the dip. Investors would be kept on edge by a confluence of a slowing economy (even though the slowdown is measured) and heighted regulatory oversight. The market would oscillate between technical rebounds when macro policy eases and selloffs when industry regulations tighten. There are two reasons why the pace of regulatory tightening will not moderate in the near term. First, China’s economic policy has shifted from setting an annual economic growth target to multi-year planning. This allows policymakers to have a higher tolerance for near-term distress in exchange for long-term benefits. Despite a deep dive in stock prices last week, China’s bond and currency markets have been stable relative to the market gyrations in both 2015 and 2018 (Chart 3A and 3B).  Furthermore, the newly released PMIs and recent economic data show that the China’s economic activity is weakening, but the speed of softening seems to be within the policymakers’ comfort zone (Chart 4). Chart 3AChinese Bond And Currency Markets Have Been Relatively Calm Despite Equity Market Selloffs Chart 3BChinese Bond And Currency Markets Have Been Relatively Calm Despite Equity Market Selloffs Chart 4Economic Pain Has Not Crossed Policymakers' Threshold Secondly, the new rules imposed on industries - ranging from internet, property, education, healthcare to capital markets - are part of China’s long-term structural reform agenda outlined in the 14th Five-Year Plan (FYP).  As China transitions from building a "moderately prosperous society" by 2020 to becoming a "great modern socialist nation" by 2049, the country’s policy priority has shifted from a rapid accumulation of wealth to addressing income inequality and social welfare for average households.  The policy objective is not only to close regulatory loopholes and end the disorderly expansion of capital and market shares, but also assign a larger weight of social equality and responsibility to the private sector’s business practices. The pace in achieving this overarching goal will only moderate when China’s economy and financial markets show meaningful signs of stress. The second possibility would be if policymakers fail to restore investors’ confidence. Foreign and domestic investors would reassess China’s policy directions and reprice the outlook for corporate profit growth. Market selloffs would continue, like in 2015 and 2018 following policy shocks,1 equity market gyrations would spill over to the currency market through capital outflows and real economic sectors through dwindling investment (Chart 5). In this scenario, Chinese policymakers would likely abandon their reform agenda, at least temporarily, and decisively shift policy to reflate the economy (Chart 6). Chart 5Financial Market Panic Spilled Over To Other Sectors In Both 2015 and 2018... Chart 6...Triggering Decisive Reflationary Policy Responses A third scenario would be if China is challenged by the external environment, either due to a significant increase in geopolitical conflicts or a widespread resurgence of new COVID cases. Both aspects would pose sizable downside risks to China’s economic activity. The risks would force authorities to shift to an easier stance and slow the pace of domestic reforms. Chart 7It Took 6 To 12 Months (And Sizable Stimulus) For Stock Prices To Bottom Out In the second and third scenarios, the rout in the equity market would likely deepen in the near term, before prices bottom in response to a halt in regulatory crackdowns and a decisive turn to reflationary measures. As illustrated in Chart 7, in both 2015 and 2018, it took 6 to 12 months and significant stimulus for Chinese stock prices to bottom in absolute terms. Bottom Line: Our baseline scenario suggests a continuation of structural reforms. Investors should refrain from jumping into the market until there are firm signs that regulatory tightening is over and reflationary measures have started. Key Messages From The Politburo Meeting Last week’s much-anticipated Politburo meeting, chaired by President Xi Jinping, adopted a slightly more dovish tone towards macroeconomic policy than in April, but also indicated that the leadership will stick to its long-term reform agenda. The stance was mildly positive for the overall economy and financial markets. Macro policies in some non-core sectors, such as infrastructure investment, will likely ease at the margin during the rest of the year. However, the meeting’s statement warned “a more complex and challenging external environment” lies ahead, which indicates that heightened concerns over geopolitical tensions will only exacerbate regulatory oversights in data and national security.  Regarding fiscal policy in 2H21, the authorities seem to be growing more concerned about growth outlook.  The meeting mentioned that fiscal support should make “reasonable progress” later this year and early next year. The pace of local government special purpose bond (SPB) issuance will pick up in Q3 and into Q4. However, we maintain our view that without a significant rise in bank credit growth, an acceleration in SPB issuance will only provide a moderate boost to local infrastructure spending. The reference to cross-cycle policy adjustment from the meeting readout is also in line with our view that policymakers may save their fiscal ammunition for next year when the economy comes under greater downward pressure. Odds are rising that the authorities will allow a frontloading of SPBs in Q1 2022 before the National People’s Congress in March next year. The statement also notably mentioned that government officials shall “ensure the supply of commodities and stabilize prices" and called for a more rational pace in carbon reduction. We think this message implies a temporary easing of production curbs in some heavy industries, such as steel, coal, and possibly a further release of strategic reserves of industrial metals (Chart 8A and 8B). The supply-side policy shift should add downward pressure on global industrial prices in addition to the ongoing slowdown in demand from China (Chart 9). Chart 8ASome Backpaddling Likely In Decarbonization Progress Chart 8BSome Backpaddling Likely In Decarbonization Progress Chart 9Downward Pressure On Commodity Prices From China's Weakening Demand And Rising Domestic Production Meanwhile, the meeting repeated the "three stabilization” policy, which targets stabilizing land prices, housing prices and property market expectations. This sends a strong signal that policymakers are unwilling to soften the tone on restrictions in the housing market. Bottom Line: The July Politburo meeting’s messaging was only modestly more dovish than three months ago. Investment Implications Chinese offshore stocks have fallen by 26% from their February peak, compared with approximately 14% for onshore stocks. The offshore TMT stocks are approaching their long-term technical resistance, measured by the three-year moving average in prices (Chart 10). While the magnitude of last week’s stock price decline seems excessive relative to previous market selloffs, the multiple compression reflects considerable uncertainty surrounding the outlook for China’s policy direction. New antitrust regulations in China are intended to limit the monopolistic business practices of internet companies. As a result, these companies’ operational costs will rise and profit growth will decline, and their valuations will converge with those of non-TMT companies. The trailing P/E ratio in Chinese investable TMT stocks is still elevated, making the equities vulnerable to further regulatory tightening and multiple compressions (Chart 11). Chart 10Chinese TMT Stocks: On The Verge Of Breaking Below Their Technical Resistance... Chart 11...But Still Vulnerable To Further Multiple Compression     Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1On August 11, 2015, the PBOC surprised the market with three consecutive devaluations of the Chinese yuan, knocking over 3% off its value. On April 3, 2018 former US President Donald Trump unveiled plans for 25% tariffs on about $50 billion of Chinese imports. Market/Sector Recommendations Cyclical Investment Stance