Business Cycles

Executive Summary Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation Inflation is not about oil, food or used car prices. Looking at prices of individual components of a consumer basket is akin to missing the forest for the trees. Despite the latest drop in US headline inflation, various core CPI measures continue trending up and registered considerable month-on-month rises in July. Wages and, more specifically, unit labor costs are the true measure of genuine and persistent inflation. US wage growth is very elevated, and the pace of unit labor cost gains has surged to a 40-year high. The conditions for sustainable and persistent disinflation in the US are not yet present. US inflation will prove to be much stickier and more entrenched than many market participants presently believe. The recovery in China will be U- rather than V-shaped, with risks tilted to the downside. The mainland’s property market breakdown is structural, not cyclical. Excesses are very large, and problems are snowballing, rendering the enacted policy stimulus insufficient. Bottom Line: US core inflation lingering above 4% and easing financial conditions will compel the Fed to continue hiking rates. This will cap global risk asset prices and put a floor under the US dollar.  We continue to recommend an underweight allocation to EM in global equity and credit portfolios. Consistently, we are also reluctant to chase EM currencies higher. Feature The bullish macro narrative circulating in the investment community is that conditions for a cyclical rally in global risk assets have fallen into place. Specifically: US inflation will drop sharply as US growth has crested and commodity prices have plunged; The Fed is nearing the end of a tightening cycle; China has stimulated sufficiently, and its economy is about to recover, which will boost economic conditions among its trading partners in general and EM in particular. These assumptions along with the fact that the S&P 500 index has found support at a 3-year moving average – a proven line of defense – suggest that US share prices have likely bottomed (Chart 1). Are we witnessing déjà vu of the 2011, 2016, 2018 and 2020 market bottoms? Chart 1Déjà Vu? Is 2022 Like The 2011, 2016 And 2018 Bottoms In The S&P 500? We have reservations about all of the above fundamental conjectures. We elaborate on these reservations in this report. On the whole, we contend that the current environment is different, and the roadmaps of all post-2009 equity market bottoms are not necessarily currently applicable. BCA’s Emerging Markets Strategy team believes that (1) US consumer price inflation is much more entrenched and will prove stickier than is commonly believed; and (2) the Chinese property market’s breakdown is structural, not cyclical; hence, the recovery will not gain traction easily.  Is This The End Of The US Inflation Problem? Not Quite This week’s US inflation data confirmed that headline CPI inflation has probably peaked: prices in several categories plunged. However, inflation is not about oil, food or used car prices. Chart 2 reveals that historically there have been several episodes whereby core inflation remains elevated despite plunging oil prices. Chart 2US Core Inflation Does Not Always Follow Oil Prices Looking at price dynamics among the individual components of the CPI basket is akin to missing the forest for the trees. Inflation is a very inert and persistent phenomenon. Underlying inflation does not change its direction often and/or quickly. That is why we believe that it is premature to celebrate the end of the US inflation problem. A few observations on this matter: Despite the drop in US headline inflation, various core CPI measures − like trimmed-mean CPI, median CPI and core sticky CPI − all continue trending up and registered substantial month-on-month rises in July (Chart 3). The range of core inflation based on these annual and month-month annualized rates is between 4-7%. In brief, the rate of genuine/sticky inflation is well above the Fed’s 2% target. Given its unconditional commitment to bringing inflation down to 2%, the Fed will continue hiking interest rates ceteris paribus. Chart 3US Core CPI Measures Are Still Very High Chart 4US Wages Growth Has Been Surging   We continue to emphasize that wages and, more specifically, unit labor costs are the true measures of persistent and genuine inflation. We have written at length about why wages and unit labor costs are more important to inflation than oil or food prices. US wage growth is very elevated and is accelerating (Chart 4). Unit labor costs, calculated as hourly wages divided by productivity, have also been surging to a 40-year high (Chart 5, top panel). Chart 5Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation The reason for this very strong wage growth and swelling unit labor costs is the very tight labor market. The bottom panel of Chart 5 demonstrates that labor demand is still outpacing labor supply by a wide margin. Hence, wage inflation will not subside until the unemployment rate rises meaningfully. Bottom Line: Conditions for sustainable and persistent disinflation in the US are not yet present.  Inflation will prove to be much stickier and more entrenched than many market participants presently believe. Core inflation lingering above 4% and easing financial conditions will compel the Fed to continue hiking rates. This will cap risk asset prices and put a floor under the US dollar.   China: Is This Time Different? If one believes that China’s current business cycle is similar to all previous ones seen since 2009, odds are that a buying opportunity in China-related financial markets is at hand. Chart 6 illustrates that the credit and fiscal spending impulse leads the business cycle by about nine months. Given that this impulse bottomed late last year, a trough in the Chinese business cycle is due. Chart 6Is A Recovery In China's Business Cycle Imminent? It is always risky to suggest that this time is different. Nevertheless, at the risk of being wrong, we contend that a combination of (1) property markets woes, (2) an impending export contraction, and (3) the dynamic zero-COVID policy will reduce the multiplier effect of current stimulus measures. Hence, a meaningful recovery in economic activity will likely fail to materialize in the coming months. The challenges facing the mainland property market are now well known. Yet, excesses are very large, and problems are snowballing, making policy stimulus insufficient. In particular: Authorities are contemplating bailout funds for property developers in the range of RMB 300-400 billion to enable them to complete housing that has been pre-sold. This is not sufficient financing for overall property construction. Table 1How Large Are Property Developers Bailout Funds? Table 1 illustrates that these amounts are equal to just 3-4% of annual fixed-asset investment in real estate excluding land purchases, 1.5-2% of total financing of developers, and 3-4% of the advance payments that property developers received for pre-sold housing in 2021. Property developers will not be receiving any cash upon the completion and delivery of presold housing units because they were paid in advance. Hence, without liquidating their other assets, homebuilders cannot repay the bailout financing. Consequently, only state financing can work here because, from the viewpoint of providers of this financing, this scheme de-facto means throwing good money after bad. The property industry in China is extremely fragmented. This makes bailouts difficult to organize and execute. There are officially about 100,000 property developers in China. The overwhelming majority of them are not state-owned companies. Plus, the two largest property developers, Evergrande (before defaulting) and Country Garden, had only 3.8% and 3.3% of market share respectively in 2020. The failure of homebuilders to complete and deliver pre-sold housing units could unleash a death spiral for them. In recent years, 90% of housing units have been pre-sold, i.e., buyers made advance payments/prepayments, often taking out mortgages (Chart 7, top panel). Witnessing the inability of developers to deliver on presold units, a rising number of people may decide to wait to buy. The largest source of developers’ financing – advance payments for pre-sold housing units – might very well dry up. This source has accounted for 50% of real estate developers’ total financing in recent years (Chart 7, bottom panel). In brief, a vicious cycle is possible. The lack of financing for homebuilders bodes ill for construction activity (Chart 8). Chart 7China: Housing Presales And Pre-Payments Are Critical To Developers Chart 8Lack Of Homebuilder Financing = Shrinking Construction Activity Chart 9Chinese Property Developers Are Extremely Leveraged Besides, property developers are very leveraged with an assets-to-equity ratio close to nine (Chart 9). They have grown accustomed to borrowing heavily to accumulate real estate assets. They have been starting but not completing construction (Chart 10, top panel). We have been referring to this phenomenon as the biggest carry trade in the world. The bottom panel of Chart 10 shows two different measures of residential floor space inventories held by property developers. One measure subtracts completed floor space from started floor space, and another one deducts sold floor space from started floor space. On both measures, residential inventories are enormous. In theory, they could raise funds by selling their real estate assets. However, if they all try to sell simultaneously, there will not be enough buyers, and asset prices will plunge, which could lead to a full-blown debt deflation spiral. The last time the real estate market was similarly distressed in 2014-15, the central bank launched the Pledged Supplementary Lending (PSL) facility. This was effectively a QE program to monetize housing. This was the reason why housing recovered strongly in 2016-2017. There is currently no such program up for discussion. On the whole, odds are that the current property market breakdown is structural, not cyclical. Financial markets – the prices of stocks and USD bonds of property developers – convey a similar message and continue to plunge (Chart 11). Chart 10Excessive Property Inventories Chart 11No Green Light From Property Stocks And Corporate Bond Prices Chart 12There Has Been No Recovery In China Without A Revival in Real Estate Without an improvement in the housing market, a meaningful business cycle recovery is unlikely in China. Chart 12 illustrates that all recoveries in the Chinese broader economy since 2009 occurred alongside a revival in property sales. The importance of the property market goes beyond its size. Rising property prices lift household and business confidence, boosting aggregate spending and investment. The sluggish housing market and falling house prices will impair consumer and business confidence. This, along with uncertainty related to the dynamic zero-COVID policy, will dent consumer spending and private investments. Finally, the upcoming contraction in Chinese exports will dampen national income growth. Taken together, the multiplier effect of stimulus in the upcoming months will be lower than it has been in previous periods of stimulus. There are two areas that will see meaningful improvement in the coming months: infrastructure spending and autos. BCA’s China Investment Strategy service discussed the outlook for auto sales in a recent report. Chart 13Green Shoots In China's Infrastructure Investment On the infrastructure front, there has been mixed evidence of an improvement in activity. The top and middle panels of Chart 13 demonstrate that Komatsu machinery’s operational hours and the number of approved infrastructure projects might be bottoming. However, the installation of high-power electricity lines has fallen to a 15-year low (Chart 13, bottom panel).   As we elaborated in last month’s report, the new financing/stimulus for infrastructure development will not result in new investments. Rather, it will by and large offset the drop in local government (LG) revenues from land sales this year. In short, there is little new stimulus for infrastructure beyond what was approved in the budget plan earlier this year. Bottom Line: The recovery in China will be U- rather than V-shaped, with risks tilted to the downside. Investment Recommendations Our bias is that the rebound in global risk assets could last for a few more weeks. The basis is that investor positioning in risk assets was very light when this rebound began. Plus, falling oil prices could reinforce the idea among investors that US inflation is no longer a problem. Looking beyond the next several weeks, the outlook for global and EM risk assets is dismal. Markets will realize that the Fed cannot halt its tightening with core inflation well above 4-5%. Hawkish Fed policy and contracting global trade will boost the US dollar and weigh on cyclical assets. We continue to recommend an underweight allocation to EM in global equity and credit portfolios. Consistently, we are also reluctant to chase EM currencies higher. EM local bonds offer value, as we have argued over the past couple of months, but for now we prefer to focus on yield curve flattening trades. We continue betting on yield curve flattening/inversion in Mexico and Colombia and are long Brazilian 10-year domestic bonds while hedging the currency risk. In addition, we recommend investors continue receiving 10-year swap rates in China and Malaysia.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Listen to a short summary of this report.     Executive Summary The Dollar Rises During Recessions At 106.5, the dollar DXY index is certainly pricing in a recession deeper than during the Covid-19 crisis. The dollar tends to rise during recessions and only peaks when a global economic recovery is in sight (Feature Chart). One caveat: contrary to conventional wisdom, US economic data is deteriorating relative to the rest of the world. Historically, that has been a negative for the greenback. The key question facing investors is if markets are entering a riot point. That is a high probability. Historically, high volatility supports the dollar. As such, our recommended stance on the dollar is neutral over the next few months. Our highest conviction bets are short EUR/JPY and long Swiss franc trades. Valuations tend to matter when most investors least expect them to. On this basis, we are negative the dollar on a 12-to-18 month time horizon. Place a limit sell on CHF/SEK at 10.76.   TRADES* INITIATION DATE PERCENT RETURNS Short EUR/JPY 2022-07-21 2.73% Bottom Line: Stand aside on the dollar for now. Continue to opportunistically play trades at the crosses. Short EUR/JPY bets make sense as a volatility hedge.   Chart 1Any Dollar Bears Left? In our conversations with clients, it is rare to find a dollar bear these days. One barometer is price action – the dollar DXY index is up 18% from its 2021 lows. More instructively, net long speculative positions are near a multi-decade high (Chart 1). In our meetings, we sense a specter of capitulation among fundamental dollar bears, as the macroeconomic environment becomes more uncertain. For chart enthusiasts, the DXY index staged a classic breakout, and the next technical level is closer to the 2002 highs near 120. We doubt the DXY index will hit this level, as significant headwinds are building. It is true that as markets increasingly price in the probability of a recession, especially in Europe, the dollar will be bought. But as we argue below, the dollar has already priced in a recession, deeper than was the case in 2020 (or admittedly, at any time since the end of the Bretton Woods system). This suggests that investors with a relatively benign economic backdrop should be fading any strength in the dollar. In other words, if your bet on a recession is low odds, fade dollar strength relatively to your colleagues. As such, our recommended stance on the dollar is neutral over the next few months, but bearish for investors with a longer-term horizon. For today, our highest conviction bets are short EUR/JPY and long Swiss franc trades. The US Dollar And Global Growth Chart 2The Dollar Tracks Global Growth There are many important drivers of the US dollar. One is the path for global growth. If global activity is going to slow meaningfully, then as a countercyclical currency, the dollar tends to rise in that environment. The dollar has been closely correlated (inversely) to the trend in global PMIs, industrial production, and other measures of global growth (Chart 2). Across the world, global growth is slowing (Chart 3). Most manufacturing PMIs in the developed world peaked in the middle of last year. In the developing world, China’s zero Covid-19 policy has nudged many PMIs close to the 50 boom/bust level. As a rule of thumb, you do not want to be short the greenback when global industrial activity is slowing. That is the bull case. Chart 3AGlobal Growth Is Slowing In Developed Markets Chart 3BGrowth Is Also Soft In Emerging Markets The good news for dollar bears is that most of this information is already priced in. Looking back at recessions since the 1970s, the dollar is pricing in one of the most anticipated slowdowns in history (Chart 4). This alone is not a reason to turn bearish on the greenback, but it is a red flag towards the consensus view. In general, currencies are a relative game. The dollar tends to rise 10%-to-15% during recessions. We are already there, with the DXY index up 18% since the 2021 lows. It is also important to gauge how the US is faring relative to the rest of the world. Quite simply, US economy economic activity is deteriorating vis-à-vis its trading partners. This is visible in the Citigroup economic surprise indices, but also via a simple chart of relative PMIs (Chart 5). Historically, that has been a negative for the greenback outside of recessions. Chart 4The Dollar Overshoots During Recessions Chart 5US Economic Momentum Is Deteriorating The US Dollar And Interest Rates The Fed hiked interest rates by 75bps this week. This was as expected but given what the Bank of Canada delivered on July 13th, a 100bps hike was a whisper number in our books. More importantly, interest rate differentials (real and nominal) are increasingly moving against the US. As we go to press, 10-year bond yields are 2.67% in the US, but 2.62% in Canada, 3.41% in New Zealand, and even 3.1% in Australia. Chart 6The Euro And Relative Interest Rates The key point is that the market consensus is centered around the Fed being the most hawkish central bank. That will face a critical test in the next few months, if the world enters a recession. This is especially true in the euro area. The market is pricing that interest rates in the eurozone will be 200bps lower next year, relative to the US (Chart 6). The historical spread between US and German 2-year yields has been 83 bps. If Europe indeed enters a deep recession, then that is already priced in the euro. If we get any green shoots in economic growth, then the euro is poised for a coiled-spring rebound. The market is also pricing in that US interest rates will peak next year, relative to other G10 economies (Chart 7). This could happen in one of two ways: The Fed turns more dovish and/or non-US growth loses steam, leading to lower interest rates outside the US. It is difficult to forecast how the economic scenario will evolve, but from an investor’s standpoint, the dollar has already overshot the level implied by relative interest rates (Chart 8). Chart 7US Short Real Yields Are Attractive Chart 8The Dollar Has Overshot Rate Fundamentals A Short Note On USD Valuations Valuations usually get little respect, especially over the last few years. The bull market in the dollar from 2011 to 2022 coincided with higher real interest rates in the US relative to the rest of the developed world. That said, a rising trade deficit (imports > exports) requires a lower exchange rate to boost competitiveness in the manufacturing sector, or less spending to reduce the trade deficit. Therefore, the natural adjustment mechanism for countries running wide trade deficits will have to be the exchange rate. Quite simply, rising deficits are a symptom of an overvalued exchange rate. Within a broad spectrum of developed and emerging market currencies, the US dollar is overvalued on a real effective exchange rate basis (Chart 9 and 10). While valuations tend to matter less until they trigger a tipping point, such inflections usually occur with a shift in animal spirits, especially when investors start to worry about huge external imbalances. Chart 9The Dollar Is Overvalued Chart 10The Dollar Is One Of The Most Expensive Currencies In the US, these imbalances are already starting to spark a shift. The US trade deficit has deteriorated. The basic balance in the US (the sum of the current account and foreign direct investment) is deteriorating. The dollar tends to decline on a multi-year basis when the basic balance peaks and starts deteriorating. It is remarkable that at a time when real rates are quite negative in the US, the dollar is the most overvalued in decades on a simple PPP model basis. This is a perfect mirror image of the dollar configuration at the start of the bull market in 2010, where the dollar was cheap and real rates were more supportive. According to economic theory, a currency should adjust to equalize returns across countries. In the early 80s, an expensive dollar was supported by very positive real rates. The subsequent dollar declines thereafter also coincided with falling real interest rates. If global growth shifts from relative strength in the US to overseas, interest rate differentials will tilt in favor of non-US markets. That will be solace for dollar bears. Conclusions In financial markets, it pays to be humble but also to be bold. Our recommended stance on the DXY (and by association, the euro and cable) is to stay on the sidelines. Our highest conviction trade is to short EUR/JPY. With the drop in commodity prices, resource-related currencies are becoming interesting, a topic we will discuss in upcoming bulletins. But momentum is your friend for now, which suggests prudence.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary   More Tightening To Come In the following report we answer the most asked questions from our recent “Bear Market 2.0” webcast. Macroeconomic backdrop and inflation: While commodity prices falling, the wage-price spiral is in full force, implying that it will take many months to reach the level of PCE inflation palatable to the Fed. The Fed will continue to tighten monetary conditions until entrenched inflation reaches its target, which may take longer than the market expects. Earnings outlook: Q2-2022 results show that an earnings slowdown has already commenced and is bound to get worse over the next couple of quarters. However, earnings forecasts are still too optimistic and a slowdown in earnings growth is not yet priced in. Investment themes: We recommend topping up allocation to Tech as it benefits from rate stabilization.  However, be judicious in your choices, staying away from the more cyclical areas, such as Hardware and Equipment, and Semiconductors.  We are overweight Software and Services, which is dominated by profitable and stable growth companies. Bottom Line: We continue to recommend that investors remain patient and prudent in range-bound markets. Earnings growth is likely to deteriorate into the year end. Feature Last Monday, July 18, I hosted a webcast called “Bear Market 2.0.” A total of 675 people dialed in, and I was honored. The webcast generated a significant number of client questions which I aim to address in this weekly publication. Broadly speaking, questions fell under each of the three rubrics of the webcast: Macroeconomic backdrop, earnings outlook, and investment themes, with the latter generating the lion’s share of questions. In today’s report, we will discuss inflation and rates, earnings season results, potential S&P 500 targets, whether the S&P 500 rally is sustainable, and if it is a good idea to top up Tech. We will address remaining questions on Energy and Materials, and Semiconductor in the near future. And as always, we are looking forward to more questions! Macroeconomic Backdrop How do you reconcile your inflation outlook with an assumption that long yields may have peaked? In the “Fat and Flat” and “Adaptive Expectations” reports, we outline our view that the market’s focus is shifting away from concerns about inflation and the hawkish Fed toward worries about growth. Indeed, the 10-year rate has stabilized at 2.78% on fears of impending slowdown (Chart 1). How does this reconcile with our view that inflation is entrenched and broadening (Chart 2), especially in light of the recent pullback in energy and commodities prices? Chart 1Yields Are Stabilizing Chart 2Inflation Is Entrenched Even if energy and commodities prices are falling, the latest wage survey from the Atlanta Fed demonstrates wage growth is not letting up, and labor costs, at over 50% of sales as per NIPA accounts, are a more important component of the US corporate cost structure than the cost of energy. Inflation is embedded as, companies pass on wage increases to customers by increasing prices – and, voilà, the wage-price spiral is becoming pervasive. This dynamic implies the following: Even if inflation peaks over the next several months, it will take many months to reach the level of PCE inflation palatable to the Fed. After having mismanaged inflation over the past 18 months, the Fed will err on the side of tighter policy. In fact, in its official statement, the Fed has asserted that its commitment to bringing inflation to its 2% target is unconditional. Therefore, we are still in the early innings of the monetary tightening cycle (Chart 3), where elevated inflation coexists with slowing growth and range-bound long rates. Bottom Line: The Fed will continue to tighten monetary conditions until entrenched inflation reaches its target, which may take longer than the market expects. Chart 3More Tightening To Come Earnings Outlook What are your takeaways from the earnings seasons so far? In the Daily Insight, which we published on July 21, we offer our initial reaction to the results. In short, so far earnings have been good, but margins are under pressure (Chart 4) from rising wages and fading pricing power (Chart 5). We have also heard quite a few negative comments from companies concerning the effects of inflation and rising costs, a strong dollar, and withdrawal from Russia. Some of the largest Technology companies announced slowdowns in hiring as they anticipate falls in demand. Forward guidance has also been concerning. Most companies talk about deteriorating economic conditions. Chart 4Margins Are Expected To Contract Chart 5Pricing Power Turning We are still convinced that street forecasts of earnings growing at about a 10% rate over the next 12 months and 11% into year-end (Table 1), despite ubiquitous negative corporate guidance, are unrealistically high. Even in this reporting season for Q2-22, earnings growth is -3%, excluding Energy. Table 1S&P 500 EPS: Actual And Expected It is unlikely that, over the next several months, macro headwinds, such as slowing growth, the hawkish Fed, stubborn inflation, and rising wages will dissipate. There is little consensus among analysts on forecasts (Chart 6) and downgrades are likely. We take it a step further, and call an earnings recession in three to six months. Chart 6Analysts Have Little Confidence In Their Forecasts Bottom Line: Q2-2022 results show that an earnings slowdown has most likely already commenced and is bound to get worse over the next couple of quarters. However, earnings forecasts are still too optimistic and a slowdown in earnings growth is not yet priced in. Do you think that the slowdown in earnings might trigger multiple expansion? Earnings contraction, everything else equal, translates into multiple expansion, as the denominator of the fraction gets smaller. For example, according to our back-of-the-envelope estimates, earnings contracting by 10% will increase the forward multiple from the current 16x to 19x. Therefore, the key question here is how likely is it that everything else will indeed stay equal, as opposed to the market selling off in line with earnings? Multiples will expand if the market is able to see past negative earnings growth, identifying a catalyst for an imminent rebound. That was the case in 2020 as investors anticipated earnings bouncing back helped by easy monetary and fiscal policy, and COVID receding. What will be a catalyst for earnings rebound in, say, 2023? We can only speculate but one of the potential reasons for faster earnings growth is perhaps normalization of growth outside of the US: A weaker dollar, peace in Ukraine, resolution of the energy crisis, or ultra-loose monetary and fiscal policy in China. At home, the anticipation of a soft landing and a more dovish monetary policy coupled with a positive real wage growth boosting consumers’ spending power may be sufficient to reassure investors that earnings growth turning positive is imminent. However, all of these developments are probably months away. And we expect the market to sell off if earnings growth disappoints. Where do you see the S&P 500 by the end of the year? Broadly speaking, BCA Research does not provide targets but rather aims to offer insights into market trends. However, in the “Is Earnings Recession In The Cards?” report, we presented a matrix outlining different scenarios of earnings growth vs. forward multiples to arrive at a potential range of the outcomes for the index. We assume that the forward multiple stays at 16x, as the multiple contraction stage of the bear market is likely completed, but there is still no clear catalyst for earnings rebound. We will approximate CY 2022 results using the Next Twelve Months Matrix (Table 2). Table 2The S&P 500 Price Target Scenarios We can distill the matrix into three likely scenarios: Earnings growth delivered by companies in line with analyst expectations of 11% over the six months; flat earnings (0% growth) broadly in line with the forecast based on our earnings model; and the worst-case scenario of a severe earnings contraction of -10% into year-end. We assign 25% to both extreme cases and about 50% to earnings staying flat for the next six months (earnings recession commencing in 2023). Best-case scenario: Earnings grow into year-end by 11%, and by 9.7% over the next 12 months. In that case, the S&P 500 will end the year at 3,837 or 3% off the current level. This is what is being priced in. Most likely scenario: Earnings growth trends to zero by the end of the year with the S&P 500 hitting 3500 or downshifting roughly 10% from here. Worst-case scenario: Earnings contract by 10%, and with the multiple staying at 16x, the S&P 500 price target will be 3287 or about 17% lower than today. With “E” falling so much, perhaps the multiple expands to 17x, in which case the market will fall “only” 11% from here. Bottom Line: We expect flagging earnings to cause another leg of the bear market, which is likely to be 5-10% into year-end, and perhaps another 5-10% in 2023. Equity Market Outlook And Key Investment Themes Are investors capitulating? Are we near or even past the bottom? The decline in oil and food prices and the easing of supply-side bottlenecks have alleviated market worries about US inflation. This, coupled with oversold risk assets, and apparent extreme pessimism in investor sentiment, has resulted in the S&P 500 rebounding 8% from its June lows. Sectors that have sold off the most over the past six months have bounced back the hardest (Chart 7). Naturally, the question that is top of mind for investors is whether this rebound is sustainable. Should they add beaten-down cyclicals to their portfolios to partake in the rally? Of course, no one can predict what Mr. Market will do with 100% certainty but here are some thoughts: Chart 7Sector Performance Overview Positives Many risk assets are severely oversold, and for long-term investors, an entry point is attractive valuation-wise. So far, many investors find earnings season results somewhat encouraging: Netflix soared on what its CEO Hawkins called “less bad results.” Multiples have contracted and priced in most of the primary effects of high inflation and rising rates. Negatives The Fed is determined to extinguish inflation, and this hiking cycle may end up much longer and steeper than the market is pricing in. We do not anticipate monetary easing in the first half of 2023. Financial markets are currently underrating the risk of a seriously hawkish Fed. Economic growth is slowing, and consensus forecasts of earnings growth are still overly optimistic. Earnings contraction over the next several quarters is likely but is certainly not priced in, and disappointment may rock markets. The catalyst for this summer’s rebound is two-fold: The market is celebrating the end of inflation worries and is rebounding from severely oversold conditions. Black swan “generators” such as China and Russia, may have more surprises in stock (Table 3). We continue to stick to “fat and down” expectations for the equities outlined in the “Adaptive Expectations” report and anticipate a range-bound market where relief rallies are alternated with pullbacks, mostly triggered by growth disappointments and realizations that the Fed has dug in its heels and is unlikely to let up anytime soon. The “down” leg will ensue if earnings contract. Yet we recommend investors take a granular approach to industry selection and start tilting portfolios away from assets that benefit from rising inflation, such as Energy and Materials, towards the “growthy” assets that benefit from rate stabilization and falling growth. We picked up on the turning point and upgraded Growth to overweight in early July, funding it from Value.   Table 3Scorecard   Bottom Line: We consider the recent rebound in US equities a bear market rally, and don’t believe that it is sustainable. The Fed and the stock market are on a collision course – easier financial conditions will make the Fed even more aggressive. Is it time to buy Tech? As we have highlighted in the “Are We There Yet?!” report back in January, Tech’s worst performance is two to three months prior to the first rate hike, and the rebound is two to three months after the beginning of the monetary cycle. The slump and a recent rally are perfectly in line with history (Chart 8). Rates have stabilized and “growthy” Tech has pounced (Chart 9). Another issue that was holding the sector back earlier in the year was a slowdown in demand for Tech investment (Chart 10). Recently, business demand for Tech has picked up. However, US consumer spending on Tech is falling, as demand for consumer goods, pulled forward by the pandemic, is fading (Chart 11). Therefore, we need to be judicious in our selection of technology stocks. Chart 8Tech Performance During A Hiking Cycle Chart 9Technology Rebounded On The Back Of Yields Peaking Chart 10Corporate Demand For Tech Has Picked Up… We reiterate our overweight in Software and Services, which is least exposed to consumer demand. Our thesis is that this industry group represents “defensive growth” thanks to the key trends of digitization of the US economy and migration to cloud. Spending on digitization and the cloud are pervasive across non-tech companies and capture a large swath of corporate America by both size and industry. Also, software and services companies tend to have stable earnings growth throughout the cycle, as software improves productivity and cuts costs (Chart 12). Chart 11...But Consumer Spending Slowed Chart 12Software Is Defensive Growth We are underweight more cyclical Hardware and Equipment, and Semiconductors industry groups as they are more exposed to the slowing economy and the flagging demand for hardware and chips. We will take a close look at the Semiconductor Industry Group in the near future. Bottom Line: We recommend topping up allocation to tech as it benefits from rate stabilization. However, be judicious in your choices, staying away from the more cyclical areas, such as Hardware and Equipment, and Semiconductors. We are overweight Software and Services, which is dominated by profitable and stable growth companies.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation Recommended Allocation: Addendum 

Executive Summary Investors Should Mind Surging US Wages Despite Western sanctions on Russia, the country’s oil exports have not collapsed. According to the International Energy Agency’s (IEA) estimates, Russia’s shipments of crude and oil products have declined by only 5% since January. The combination of relatively stable supply and downshifting global oil demand constitutes a bearish cocktail for oil prices. Odds are that oil prices will decline further and recouple with industrial and precious metal prices. Labor costs are more important than oil prices for the US core inflation outlook and, hence, for Fed policy. In the US, surging wages and easing financial conditions would make the Fed even more committed to tightening monetary policy substantially. The Fed and the stock market remain on a collision course. EM/China exports will contract, and their domestic demand will also struggle. Bottom Line: As the US dollar continues to overshoot, EM stocks will underperform DM equities, and EM credit markets will underperform US credit markets on a quality-adjusted basis. An underweight position in EM in global equity and credit portfolios is warranted. Feature The decline in oil and food prices and the easing of supply-side bottlenecks have alleviated market worries about US inflation. As a result, the S&P500 has rebounded, despite the grim inflation report last week. BCA’s Emerging Markets Strategy team expects oil and industrial metal prices to drop further. Does this mean that the worst of both US inflation and the Fed’s tightening is behind us and that it is time to buy risk assets? Not really. In this report, we discuss (1) why oil prices will drop further, (2) why the worst of US monetary tightening is not over, and (3) why emerging markets are not out of the woods. In fact, EM asset prices have so far failed to advance, despite the rebound in the S&P500. This is true for EM stocks, currencies, EM credit spreads, and domestic bonds (Charts 1 and 2). Overall, our macro themes of Fed tightening amid slowing global growth, the US dollar overshooting, and China’s disappointing recovery remain intact. These factors still warrant a defensive investment strategy, despite a possible near-term rebound in the S&P 500. EMs will lag and underperform in this rebound. Chart 1No Rebound In EM Stocks And Currencies… Chart 2…Nor In EM Credit Space And Local Bonds Oil Prices Will Drop But… Chart 3Russian Oil Export Volumes Have Dropped Only By 5% Since January Odds are that crude prices have peaked and face material downside: Despite the sanctions and logistical challenges that Western governments have enforced on Russia, the country’s oil exports have not collapsed. According to the International Energy Agency’s (IEA) estimates, Russia’s shipments of crude and oil products have declined by only 5% since January (Chart 3). Even though Saudi Arabia appears to be committed to its production management policy, it cannot completely ignore US demands to raise its oil output. Odds are that Saudi Arabia and the United Arab Emirates will boost their oil output in the coming months. Chart 4US And Chinese Oil Consumption Is Weak In the meantime, global oil demand is shrinking, in part due to high prices. US consumption of gasoline and other motor fuel has marginally contracted (Chart 4, top panel). In China, rolling lockdowns and weak income growth will continue to suppress the nation’s crude oil imports, which have already been depressed over the past 12 months (Chart 4, bottom panel). In the rest of EM (excluding China), high oil prices in their local currency terms are leading to demand destruction. Chart 5 illustrates that oil and food prices in local currency terms are still very elevated for EM. When various commodity prices – ranging from industrial and precious metals, to soft commodities, and oil – all drop simultaneously and precipitously, it suggests that supply is not what is dominating the price action (Chart 6). Their supply is idiosyncratic, so the concurrent fall in their prices cannot be explained by their production. Chart 5Oil And Food Prices In EM Currencies Chart 6The Simultaneous Drop In Various Commodity Prices Cannot Be Explained By Supply   Our interpretation for the synchronized decline in various commodity prices is as follows: the sanctions imposed on Russia initially led buyers to increase their precautionary and speculative purchases of various commodities, which was a tailwind for prices. However, these precautionary and speculative purchases have since been halted or reversed, causing commodity prices to plunge. From the perspective of business and financial cycles, oil prices are a lagging variable. Their turning points often occur after the peaks or bottoms in global cyclical stock prices (Chart 7). Chart 7Oil Prices Often Lag Global Cyclical Stocks In contrast with the downbeat investor sentiment on risk assets, investor sentiment on oil prices remains very elevated (Chart 8). In terms of market technicals, the outlook for oil prices and energy stocks is troublesome. Crude prices have lately formed a double top (see Chart 6 above). From a long-term perspective, oil prices and global energy share prices in SDR1 terms might have formed a triple top (Chart 9). Chances are that the recent top in crude prices and energy stocks is a major one and a protracted selloff is in the cards. Chart 8Investors Are Still Bullish On Oil Chart 9A Triple Top In Oil Prices And Global Energy Stocks   Bottom Line: Fears that sanctions on Russia would considerably reduce global oil supply have not yet materialized. Meanwhile, global oil demand is downshifting in response to both high fuel prices and weakening global growth. In addition, the US is leveraging its geopolitical power to push Gulf countries to boost oil production. These forces all constitute a bearish cocktail for oil prices. That said, a flare-up in geopolitical tensions in the Middle East around Iran is a potential risk to our view on oil, as it would push crude prices up again. …Surging Wages Will Keep US Core Inflation Elevated Chart 10Investors Should Mind Surging US Wages A drop in oil prices has brought some relief to US financial markets as US inflation expectations have dropped materially. Yet, we do not think the drop in oil or food prices – and hence in US headline inflation – will lead to a less hawkish stance from the Fed. The basis for this belief is that US inflationary pressures are genuine and have been broadening. In fact, as we have argued since late last year, the US has entered a wage-price spiral. Recent wage data from the Atlanta Fed validates this thesis – US wage growth has surged to around 7% (Chart 10). To be technically correct, unit labor costs, not wages, are key to inflation dynamics (Chart 11). Unit labor cost = (wage per hour) / (productivity). Productivity is output per hour. Chart 11Unit Labor Costs, Not Oil, Drive US Core Inflation Given that labor, not oil, is the largest cost component of US businesses, unit labor costs swell and profit margins shrink when salaries rise faster than productivity. CEOs and business owners always do their best to protect their profit margins. Thus, accelerating unit labor costs will lead them to raise their selling prices. A wage-price spiral will be unleashed if consumers accept these higher prices and go on to demand even higher wages. Chart 12US Core Inflation Is Broadening And Is Well Above The Fed's Target This is why wage costs, and more specifically unit labor costs, are the most important variable to monitor for the inflation outlook. If consumers facing high energy and food prices are able to successfully negotiate greater wage gains that surpass their productivity growth, then inflation will become more broad-based and genuine. This is what is presently occurring in the US, and a decline in oil prices will not halt this dynamic for now. Only higher US unemployment will lead to a meaningful deceleration in wage growth. Consistent with broadening US inflation, trimmed-mean and median CPIs have accelerated and reached 6-7%, even though core CPI has recently moderated (Chart 12). After having mismanaged inflation in the past 18 months, the Fed will err on the side of tighter policy. The rationale is that the US is already facing surging wages and a very tight labor market. Financial markets are currently underrating this risk. In fact, in its official statement the Fed has asserted that its commitment to bring inflation to its 2% target is unconditional. As we have written extensively, wages and inflation are lagging business cycle variables. Despite the ongoing slowdown in the US economy, it will take many months before the underlying core inflation rate drops below 3.5%. Bottom Line: We maintain that the Fed and the stock market remain on a collision course. In the US, surging wages and easing financial conditions would make the Fed even more committed to tightening policy substantially. The basis for this perspective is that, even if core inflation falls in the coming months, it will still be well above the Fed’s target of 2%. EM/China Growth Outlook Chart 13Global Trade Will Shrink In H2 2022 EM currencies will continue depreciating versus the US dollar as the Fed reinforces its hawkish stance and global growth/EM exports contract. Indicators from Korea and Taiwan that lead global trade suggest that global export volumes are heading into contraction (Chart 13). While lower oil prices are marginally positive for EM energy importers, share prices and currencies of these countries are often driven by their exports. The latter are set to shrink. EM ex-China domestic demand will decelerate because of (1) drastic monetary tightening by their central banks, (2) reduced household purchasing power due to the substantial rise in food and energy prices in their local currency earlier this year (see Chart 5 above), and (3) the unwinding of pandemic fiscal stimulus. Currency depreciation and slumping global and domestic growth will weigh on both EM share prices and credit markets. Chart 14 illustrates that EM sovereign bond yields have continued rising (shown inverted on the chart), which is consistent with lower EM non-TMT equity prices. Chart 14Rising EM USD Bond Yields (Shown Inverted) Point To Lower Share Prices With respect to China, we discussed the country’s new infrastructure stimulus in depth in last week’s report. Our assessment is that this new infrastructure funding will not result in new investments. Rather, it will largely offset the drop in local government (LG) revenues from land sales this year. As for the latest events regarding mortgage boycotts and authorities’ decision to introduce a moratorium on mortgages linked to delayed housing completions, the damage to homebuyers’ confidence has already been done. Given the ongoing turmoil in China’s property market, potential homebuyers will drag their feet. As a result, home sales will be underwhelming, real estate developers will struggle, and construction activity will contract. The top panel of Chart 15 illustrates that home sales have relapsed anew in the first two weeks of July after stabilizing in June. This implies that June’s bounce was a one-off move driven by pent-up demand after lockdowns were eased. Moreover, house prices are deflating (Chart 15, bottom panel). Consistently, Chinese property stocks and offshore corporate bond prices continue to plunge (Chart 16). Chart 15Chinese Housing: Sales And Prices Are Falling Chart 16Chinese Property Developers: Stock And Bond Prices Continue Plunging All of the above corroborates our thesis that housing construction in China will continue to contract, weighing on raw material demand and prices and, thereby, EM exports. Finally, rolling lockdowns in China will persist as long as the mainland’s stringent dynamic zero-COVID policy remains in place. The number of cities under mobility restrictions or some form of lockdown climbed during the second week of July. Putting it all together, China’s private sector sentiment remains in the doldrums. The willingness to spend or invest among households and enterprises will remain depressed. This will ensure that the multiplier effect of the fiscal and credit stimulus will be small. Bottom Line: Not only will EM/China exports contract but their domestic demand will also struggle. These dynamics, in combination with a hawkish Fed, are bearish for EM currencies, credit markets and equities. Investment Conclusions Chart 17EM Domestic Bonds: Do Not A Catch Falling Knife Global risk assets are oversold, and investor sentiment is pessimistic. In this context, a technical equity rebound cannot be ruled out. However, we do not think it will be the beginning of a major cyclical rally. As the US dollar continues to overshoot, EM will underperform DM equities, and EM credit markets will underperform US credit markets on a quality-adjusted basis. An underweight position in EM in global equity and credit portfolios is warranted. With respect to EM local currency bonds, we remain on the sidelines as near-term risks are still elevated (Chart 17). For now, we prefer to bet on yield curve flattening. Our favorite markets for flatteners are currently Mexico and Colombia. We continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN, PHP, and IDR. In addition, we recommend shorting HUF vs. CZK, and KRW vs. JPY. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     Special Drawing Rights are the IMF’s synthetic currency – we use it as a proxy for the global average currency.   Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Executive Summary China's Unemployment Over the past week we have been visiting clients along the US west coast. In this report we hit some of the highlights from the most important and frequently asked questions. Xi Jinping is seizing absolute power just as the country’s decades-long property boom turns to bust. He will stimulate the economy but Chinese stimulus is less effective than it used to be. The US and Israel are underscoring their red line against Iranian nuclear weaponization. If Iran does not freeze its nuclear program, the Middle East will begin to unravel again. The UK’s domestic instability is returning, with Scotland threatening to leave the union. Brexit, the pandemic, and inflation make a Scottish referendum a more serious risk than in the past. Shinzo Abe’s assassination makes him a martyr for a vision of Japan as a “normal country” – i.e. one that is not pacifist but capable of defending itself. Japan’s rearmament, like Germany’s, points to the decline of the WWII peace settlement and the return of great power competition. Bottom Line: Investors need a new global balance to be achieved through US diplomacy with Russia, China, and Iran. That is not forthcoming, as the chief nations face instability at home and a stagflationary global economy. Feature The world is becoming less stable as stagflation combines with great power competition. Global uncertainty is through the roof. From a macroeconomic perspective, investors need to know whether central banks can whip inflation without triggering a recession. From a geopolitical perspective, investors need to know whether Russia’s conflict with the West will expand, whether US-China and US-Iran tensions will escalate in a damaging way, and whether domestic political rotations in the US and China this fall will lead to more stable and productive economies. China: What Will Happen At The Communist Party Reshuffle? General Secretary Xi Jinping will cement another five-to-10 years in power while promoting members of his faction into key positions on the Politburo and Politburo Standing Committee. By December Xi will roll out a pro-growth strategy for 2023 and the government will signal that it will start relaxing Covid-19 restrictions. But China’s structural problems ensure that this good news for global growth will only have a fleeting effect. China’s governance is shifting from single-party rule to single-person rule. It is also shifting from commercially focused decentralization to national security focused centralization. Xi has concentrated power in himself, in the party, and in Beijing at the expense of political opponents, the private economy, and outlying regions like Hong Kong, the South China Sea, and Xinjiang. The subordination of Taiwan is the next major project, ensuring that China will ally with Russia and that the US and China cannot repair or deepen their economic partnership. Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Xi and the Communist Party began centralizing political power and economic control shortly after the Great Recession. At that time it became clear that a painful transition away from export manufacturing and close relations with the United States was necessary. The transition would jeopardize China’s long-term economic, social, political, and geopolitical stability. The Communist Party believed it needed to revive strongman leadership (autocracy) rather than pursuing greater liberalization that would ultimately increase the odds of political revolution (democratization). The Xi administration has struggled to manage the country’s vast debt bubble, given that total debt standing has surged to 287% of GDP. The global pandemic forced the government to launch another large stimulus package, which it then attempted to contain. Corporate and household deleveraging ensued. The property and infrastructure boom of the past three decades has stalled, as the regime has imposed liquidity and capital requirements on banks and property developers to try to avoid a financial crisis. Regulatory tightening occurred in other sectors to try to steer investment into government-approved sectors and reduce the odds of technological advancement fanning social dissent. China’s draconian “zero Covid” policy sought to limit the disease’s toll, improve China’s economic self-reliance, and eliminate the threat of social protest during the year of the twentieth party congress. But it also slammed the brakes on growth. China is highly vulnerable to social instability for both structural and cyclical reasons. Chinese social unrest was our number one “Black Swan” for this year and it is now starting to take shape in the form of angry mortgage owners across the country refusing to make mortgage payments on houses that were pre-purchased but not yet built and delivered (Chart 1). Chart 1China: Mortgage Payment Boycott The mortgage payment boycott is important because it is stemming from the outstanding economic and financial imbalance – the property sector – and because it is a form of cross-regional social organization, which the Communist Party will disapprove. There are other social protests emerging, including low-level bank runs, which must be monitored very closely. Local authorities will act quickly to stop the spread of the mortgage boycott. But unhappy homeowners will be a persistent problem due to the decline of the property sector and industry. China’s property sector looks uncomfortably like the American property sector ahead of the 2006-08 bust. Prices for existing homes are falling while new house prices are on the verge of falling (Chart 2). While mortgages only make up 15% of bank assets, and household debt is only 62% of GDP, households are no longer taking on new debt (Chart 3). Chart 2China's Falling Property Prices​​​​​​ Chart 3China's Property Crisis​​​​​​ Chart 4China's Unemployment Most likely China’s property sector is entering the bust phase that we have long expected – if not, then the reason will be a rapid and aggressive move by authorities to expand monetary and fiscal stimulus and loosen economic restrictions. That process of broad-based easing – “letting 100 flowers bloom” – will not fully get under way until after the party congress, say in December. Unemployment is rising across China as the economy slows, another point of comparison with the United States ahead of the 2008 property collapse (Chart 4). Unemployment is a manipulated statistic so real conditions are likely worse. There is no more important indicator. China’s government will be forced to ease policy, creating a positive impact on global growth in 2023, but the impact will be fleeting. Bottom Line: The underlying debt-deflationary context will prevail before long in China, weighing on global growth and inflation expectations on a cyclical basis. Middle East: Why Did Biden Go And What Will He Get? President Biden traveled to Israel and now Saudi Arabia because he wants Saudi Arabia and the Gulf Arab members of OPEC to increase oil production to reduce gasoline prices at the pump for Americans ahead of the midterm elections (Chart 5). Chart 5Biden Goes To Israel And Saudi Arabia True, fears of recession are already weighing on prices, but Biden embarked on this mission before the growth slowdown was fully appreciated and he is not going to lightly abandon the anti-inflation fight before the midterm election. Biden also went because one of his top foreign policy priorities – the renegotiation of the 2015 nuclear deal with Iran – is falling apart. The Iranians do not want to freeze their nuclear program because they want regime survival and security. While Biden is offering a return to the 2015 deal, the conditions that produced the deal are no longer applicable: Russia and China are not cooperating with the US and EU to isolate Iran. Russia is courting Iran, oil prices are high and sanction enforcement is weak (unlike 2015). The Iranians now know, after the Trump administration, that they cannot trust the Americans to give credible security guarantees that will last across parties and administrations. The war in Ukraine also underscores the weakness of diplomatic security guarantees as opposed to a nuclear deterrent. Hence the joint US and Israeli declaration that Iran will never be allowed to obtain nuclear weapons. The good news is that this kind of joint statement is precisely what needed to occur – the underscoring of the red line – to try to change Ayatollah Ali Khamenei’s calculus regarding his drive to achieve nuclear breakout. In 2015 Khamenei gave diplomacy a chance to try to improve the economy, stave off social unrest, prepare the way for his eventual leadership succession process, and secure the Islamic Republic. The bad news is that Khamenei probably cannot make the same decision this time, as the hawkish faction now runs his government, the Americans are unreliable, and Russia and China are offering an alternative strategic orientation. The Saudis will pump more oil if necessary to save the global business cycle but not at the beck and call of a US president. The drop in oil prices reduces their urgency. The Americans can reassure the Saudis and Israel as long as the deal with Iran is not going forward. That looks to be the case. But then the US and Israel will have to undertake joint actions to underline their threat to Iran – and Iran will have to threaten to stage attacks across the region so as to deter any attack. Bottom Line: If a US-Iran deal does not materialize at the last minute, Middle Eastern instability will revive and a new source of oil supply constraint will plague the global economy. We continue to believe a US-Iran deal is unlikely, with only 40% odds of happening. Europe: Will Russia Turn Back On The Natural Gas? Russia’s objective in cutting off European natural gas is to inflict a recession on Europe. It wants a better bargaining position on strategic matters. Therefore we assume Russia will continue to squeeze supplies from now through the winter, when European demand rises and Russian leverage will peak. If Russia allows some flow to return, then it will be part of the negotiating process and will not preclude another cutoff before winter. It is possible that Russia is merely giving Europe a warning and will revert back to supplying natural gas. The problem is that Russia’s purpose is to achieve a strategic victory in Ukraine and in negotiations over NATO’s role in the Nordic countries. Russia has not achieved these goals, so natural gas cutoff will likely continue. Russia also hopes that by utilizing its energy leverage – while it still has it – it will bring forward the economic pain of Europe’s transition away from reliance on Russian energy. In that case European countries will experience recession and households will begin to change their view of the situation. European governments will be more likely to change their policies, to become more pragmatic and less confrontational toward Russia. Or European governments will be voted out of power and do the same thing. Other states could join Hungary in saying that Europe should never impose a full natural gas embargo on Russia. Russia would be able to salvage some of its energy trade with Europe over the long run, despite the war in Ukraine and the inevitable European energy diversification. In recent months we highlighted Italy as the weakest link in the European chain and the country most likely to see such a shift in policy occur. Italy’s national unity coalition had lost its reason for being, while the combination of rising bond yields and natural gas prices weighed on the economy. The Italian bond spread over German bunds has long served as our indicator of European political stress – and it is spiking now, forcing the European Central Bank to rush to plan an anti-fragmentation strategy that would theoretically enable it to tighten monetary policy while preventing an Italian debt crisis (Chart 6). The European Union remains unlikely to break up – Russian aggression was always one of our chief arguments for why the EU would stick together. But Italy will undergo a recession and an election (due by June 2023 but that could easily happen this fall), likely producing a new government that is more pragmatic with regard to Russia so as to reduce the energy strain. Chart 6Italy's Crisis Points To EU Divisions On Russia Italy’s political turmoil shows that European states are feeling the energy crisis and will begin to shift policies to reduce the burden on households. Households will lose their appetite for conflict with Russia on behalf of Ukrainians, especially if Russia begins offering a ceasefire after completing its conquest of the Donetsk area. If Russia expands its invasion, then Europe will expand sanctions and the risk of further strategic instability will go up. But most likely Russia will seek to quit while it is ahead and twist Europe’s arm into foisting a ceasefire onto Ukraine. Bottom Line: A change of government in Italy will increase the odds that the EU will engage in diplomacy with Russia in the coming year, if Russia offers, so as to reach a new understanding, restore natural gas flows, and salvage the economy. This would leave NATO enlargement unresolved but a shift in favor of a ceasefire in Ukraine in 2023 would be less negative for European assets and the euro. UK: Who Will Replace Boris Johnson? Last week UK Prime Minister Boris Johnson fell from power and now the Conservative Party is engaging in a leadership competition to replace him. We gave up on Johnson after he survived his no-confidence vote and yet it became clear that he could not recover in popular opinion. The inflation outburst destroyed his premiership and wiped away whatever support he had gained from executing Brexit. In fact it reinforced the faction that believed Brexit was the wrong decision. Going forward the UK will be consumed with domestic political turmoil as the cost of stagflation mounts, and geopolitical turmoil as Scotland attempts to hold a second independence referendum, possibly by October 2023. Global investors should focus primarily on Scotland’s attempt to secede, since the breakup of the United Kingdom would be a momentous historical event and a huge negative shock for pound sterling. While only 44.7% of Scots voted for independence in 2014, now they have witnessed Brexit, Covid-19, and stagflation, producing tailwinds for the Scots nationalist vote (Chart 7). Chart 7Forget Bojo's Exit, Watch Scotland There are still major limitations on Scotland exiting, since its national capabilities are limited, it would need to join the European Union, and Spain and possibly others will threaten to veto its membership in the European Union for fear of feeding their own secessionist movements. But any new referendum – including one done without the approval of Westminster – should be taken very seriously by investors. Bottom Line: Johnson’s removal will only marginally improve the Tories’ ability to manage the rebellion brewing in the north. A snap election that brings the Labour Party back into power would have a greater chance of keeping Scotland in the union, although it is not clear that such a snap election will happen in time to affect any Scottish decision. The UK faces economic and political turmoil between now and any referendum and investors should steer clear of the pound. (Though we still favor GBP over eastern European currencies). Britain will remain aggressive toward Russia but its ability to affect the Russian dynamic will fall, leaving the US and EU to decide the fate of Russian relations. Japan: What Is The Significance Of Shinzo Abe’s Assassination? Former Japanese Prime Minister Shinzo Abe was assassinated by a lone fanatic with a handmade gun. The significance of the incident is that Abe will become a martyr for a certain vision of Japan – his vision of Japan, which is that Japan can become a “normal country” that moves beyond the shackles of the guilt of its imperial aggression in World War II. A normal country is one that is economically stable and militarily capable of defending itself – not a pacifist country mired in debt-deflation. Abe stood for domestic reflation and a proactive foreign policy, along with the normalization of the Japanese Self-Defense Forces (JSDF). True, economic policy can become less dovish if necessary to deal with inflation. Some changes at the Bank of Japan may usher in a less dovish shift in monetary policy in particular. But monetary policy cannot become outright hawkish like it was before Abe. And Abe’s fiscal policy was never as loose as it was made out to be, given that he executed several hikes to the consumption tax. Japan’s structural demographic decline and large debt burden will continue to weigh on economic activity whenever real rates and the yen rise. The government will be forced to reflate using monetary and fiscal policy whenever deflation threatens to return. Debt monetization will remain an option for future Japanese governments, even if it is restrained during times of high inflation. Chart 8Shinzo Abe's Legacy ​​​​​​​ This is not only because Japanese households will become depressed if deflation is left unchecked but also because economic growth must be maintained in order to sustain the nation’s new and growing national defense budgets. Japan’s growing need for self defense stems from China’s strategic rise, Russia’s aggression, and North Korea’s nuclearization, plus uncertainty about the future of American foreign policy. These trends will not change anytime soon. Indeed the Liberal Democratic Party’s popularity has increased under Abe’s successor, Prime Minister Fumio Kishida, who will largely sustain Abe’s vision. The Diet still has a supermajority in favor of constitutional revision so as to enshrine the self-defense forces (Chart 8). And the de facto policy of rearmament continues even without formal revision. Bottom Line: Any Japanese leader who attempts to promote a hawkish BoJ, and a dovish JSDF, will fail sooner rather than later. The revolving door of prime ministers will accelerate. As Japan’s longest-serving prime minister, Shinzo Abe opened up the reliable pathway, which is that of a dovish BoJ and a hawkish foreign policy. This is important for the world, as well as Japan, because a more hawkish Japan will increase China’s fears of strategic containment. The frozen conflicts in Asia will continue to thaw, perpetuating the secular rise in geopolitical risk. We remain long JPY-KRW, since the BoJ may adjust in the short term and Chinese stimulus is still compromised, but that trade is on downgrade watch. Investment Takeaways Russia’s energy cutoff is aimed at pushing Europe into recession so as to force policy changes or government changes in Europe that will improve Russia’s position at the negotiating table over Ukraine, NATO, and other strategic disputes. Hence Russia is unlikely to increase the natural gas flow until it believes it has achieved its strategic aims and multiple veto players in the EU will prevent the EU from ever implementing a full-blown natural gas embargo. Chinese stimulus cannot be fully effective until it relaxes Covid-19 restrictions, likely beginning in December or next year when Xi Jinping uses his renewed political capital to try to stabilize the economy. However, China’s government powers alone are insufficient to prevent the debt-deflationary tendency of the property bust. The Middle East faces rising geopolitical tensions that will take markets by surprise with additional energy supply constraints. The implication is continued oil volatility given that global growth is faltering. Once global demand stabilizes, the Middle East’s turmoil will add to existing oil supply constraints to create new price pressures. The odds are not very high of the Federal Reserve achieving a “soft landing” in the context of a global energy shock and a stagflationary Europe and China.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com ​​​​​​​ Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades () Section II: Special (EDIT this Header) Section III: Geopolitical Calendar

In lieu of next week’s report, I will host the monthly Counterpoint Webcast on Monday, July 25. Please mark the date in your calendar, and I do hope you can join. Executive Summary Central banks face a ‘Sophie’s choice’. Inflation at 2 percent, or full employment? If they choose inflation at 2 percent, they will have to take the economy into recession. To take the economy into recession, bond yields and energy prices do not need to move any higher. They just need to stay where they are. The stock market has not yet discounted a recession. With stocks and bonds having become equally ‘cheaper’ this year, but stocks now vulnerable to substantial downgrades to their profits, stocks are likely to underperform bonds over the coming 6-12 months. In the event of recession followed by plunging inflation, a valuation uplift for bonds will also underpin stock prices and limit further downside in absolute terms. The biggest loser will be commodities. On a 6-12 month horizon, the optimal asset allocation is: overweight bonds, neutral stocks, underweight commodities. Fractal trading watchlist: Ethereum. The Bear Market Is A Valuation Bear Market. Profits Are Not Discounting A Recession… Yet Bottom Line: On a 6-12 month horizon, overweight bonds, neutral stocks, underweight commodities. Feature The Greek mythological sea monsters, Scylla and Charybdis, sat on opposite sides of the narrow Strait of Messina, with one monster likened to a shoal of rocks, the other to a vortex. Avoiding the rocks meant getting too close to the vortex, and avoiding the vortex meant getting too close to the rocks. In today’s stock market, if Scylla is the monster of high bond yields, then Charybdis is the monster of falling profits. Whether the stock market can safely navigate these twin monsters without further damage depends on a sequence of questions. In today’s stock market, if Scylla is the monster of high bond yields, then Charybdis is the monster of falling profits. If the market can escape high bond yields, can it also escape falling profits? The answer to this depends on a second question. Can central banks guide inflation back to 2 percent without taking the economy into recession? The answer to this depends on a third question. Is 2 percent inflation still consistent with full employment? Central Banks Face A ‘Sophie’s Choice’ – Low Inflation, Or Full Employment? In the US, the main transmission mechanism from employment to inflation is through so-called ‘rent of shelter’. Because, to put it bluntly, you need a steady job to pay the rent. And rent comprises 41 percent of the core inflation basket. For the past couple of decades, the Fed could have its cake and eat it: full employment and inflation running close to 2 percent. This was because full employment was consistent with rent of shelter inflation running at 3.5 percent, which itself was consistent with core inflation running at 2 percent. The Fed faces a ‘Sophie’s choice’. Inflation at 2 percent, or full employment? If it chooses inflation at 2 percent, then the Fed will have to take the economy into recession. But recently, there has been a phase-shift between the employment market and rent of shelter inflation. The current state of full employment equates to rent of shelter inflation running not at 3.5 percent, but at 5.5 percent (Chart I-1). Chart I-1Central Banks Face A 'Sophie's Choice' - Low Inflation, Or Full Employment? Hence, the Fed faces a ‘Sophie’s choice’. Inflation at 2 percent, or full employment? If it chooses inflation at 2 percent, the unemployment rate will have to rise by 2 percent. Meaning, the Fed will have to take the economy into recession. The Economy Tries The ‘Cold Pressor Test’ To take the economy into recession, bond yields and energy prices do not need to move any higher – they just need to stay where they are. This is because the damage from elevated bond yields and energy prices doesn’t come just from their level. It comes from their level multiplied by the length of time that they stay elevated. Try putting your hand in a bucket of ice water. For the first few seconds, or even tens of seconds, you will not feel any discomfort. After a few minutes though, the pain becomes excruciating. This so-called ‘cold pressor test’ tells us that your discomfort results not just from the temperature level of the ice water, but equally from the length of time that you keep your hand in it. Likewise, a short-lived spike in the mortgage rate or in the price of natural gas, or a short-lived collapse in your stock market wealth will not cause any discomfort. But the longer the mortgage rate stays elevated, and more and more people are buying or refinancing a home at a much higher rate, the greater becomes the economic pain. In the same vein, most Europeans will not notice the sky-high prices of natural gas in the summer when the heating is off. But come the cold of October and November, many people will have to choose literally between physical or economic pain. Some commentators counter that the “war chest of savings” accumulated during the pandemic will buffer households against higher mortgage rates and energy prices. We strongly disagree. The savings accumulated during the pandemic just added to, and became indistinguishable from, other wealth. Yet now, in case you hadn’t noticed, wealth has been pummelled. In case you hadn’t noticed, wealth has been pummelled. The impact of wealth on spending is a huge topic which we will expand upon in a future report. In a nutshell, most spending comes from income and income proxies. Wealth generates income, but it also generates an income proxy via capital gain. So, to the extent that wealth can drive spending growth, the biggest contributor comes from the change in capital gain, also known as the ‘wealth impulse’. Unfortunately, the wealth impulse is now in deeply negative territory (Chart I-2). Chart I-2The Wealth Impulse Is In Deeply Negative Territory The Stock Market Has Not Yet Discounted A Recession Coming back to the stock market, does the 2022 bear market mean that it has already discounted a recession? No, this year’s bear market is entirely due to a collapse in valuations. Since the start of the year, US profit expectations have held up. If the bear market were front running profit downgrades, then it would be underperforming its valuation component, but it is not. The counterargument is that analysts are notoriously slow to downgrade their profit estimates. Isn’t the bear market the ‘real-time’ stock market ‘front running’ big downgrades to these profit estimates? Again, no. If the market were front running profit downgrades, then it would be underperforming its valuation component, but it is not (Chart I-3). Chart I-3The Bear Market Is A Valuation Bear Market. Profits Are Not Discounting A Recession...Yet The bear market in the S&P 500 has near-perfectly tracked the bear market in its valuation component, the 30-year T-bond price. The valuation component of the S&P 500 is the 30-year T-bond price because the duration of the S&P 500 equals the duration of the 30-year T-bond. Several clients have asked how to prove that the duration of the S&P 500 equals that of the 30-year T-bond. We can do it either a difficult theoretical way, or an easy empirical way. The difficult theoretical way is to take the projected cashflows, and calculate the weighted average time to those cashflows, where the weights are the discounted values of those cashflows. The much easier empirical way is to show that the S&P 500 tracks its profits multiplied by the 30-year T-bond price more faithfully than if we use a shorter maturity bond, such as the 10-year T-bond (Chart I-4 and Chart I-5) Chart I-4The S&P 500 Tracks Profits Multiplied By The 30-Year T-Bond Price More Faithfully... Chart I-5...Than Profits Multiplied By The 10-Year T-Bond Price One important upshot is that any valuation comparison of the S&P 500 with a bond other than the 30-year T-bond is a fundamental error of duration mismatch. Most strategists compare the S&P 500 with the 10-year T-bond because it is convenient. But the duration mismatch makes this ‘apples versus oranges’ valuation comparison one of the most common mistakes in finance. Overweight Bonds, Neutral Stocks, Underweight Commodities All of this is important to answer a crucial question about stock market valuations. With the stock market 20 percent down this year when expected profits have held up, it might appear that stocks have become much cheaper. The truth is more nuanced. Relative to expected profits over the next 12 months the US stock market is indeed much cheaper (Chart I-6). The caveat is that these expected profits are vulnerable to substantial downgrades in the event of a recession. Chart I-6The US Stock Market Is Cheaper Versus Expected Profits, But These Profits Are Too Optimistic Chart I-7The US Stock Market Is Not Cheaper Versus The 30-Year T-Bond But relative to the equal duration 30-year T-bond, the US stock market is not cheaper. Since, the start of the year, the uplift in the stock market’s (forward earnings) yield is precisely the same as the that on the 30-year T-bond yield (Chart I-7).  Relative to the equal duration 30-year T-bond, the US stock market has not become cheaper. With stocks and bonds having become equally ‘cheaper’ this year, but stocks now vulnerable to substantial downgrades to their profits, stocks are likely to underperform bonds over the coming 6-12 months. The good news is that a valuation uplift for bonds will also underpin stock prices, and limit further downside in absolute terms. Unfortunately, the same cannot be said for commodities, whose real prices are still close to the upper end of their 40-year trading range (Chart I-8) Chart I-8The Real Price Of Metals Is Still At The Upper End Of Its 40-Year Trading Range In the event of recession followed by plunging inflation, the biggest winner will be bonds and the biggest loser will be commodities. Therefore, on a 6-12 horizon, the optimal asset allocation is: Overweight bonds. Neutral stocks. Underweight commodities. Fractal Trading Watchlist This week we are adding Ethereum to our watchlist, as its 130-day fractal structure is approaching the capitulation point that signalled previous major trend reversals in 2018 (a bottom) and 2021 (a top). The full watchlist of 27 investments that are approaching, or at, potential trend reversals is available on our website: cpt.bcaresearch.com Fractal Trading Watchlist: New Additions Chart I-9Fractal Trading Watch List Chart 1CNY/USD At A Potential Turning Point   Chart 2US REITS Are Oversold Versus Utilities Chart 3CAD/SEK Is Vulnerable To Reversal Chart 4Financials Versus Industrials Has Reversed Chart 5The Outperformance Of Resources Versus Biotech Has Ended Chart 6The Outperformance Of Resources Versus Healthcare Has Ended Chart 7FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 8Netherlands' Underperformance Vs. Switzerland Is Ending Chart 9The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 10The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 11Food And Beverage Outperformance Is Exhausted Chart 12German Telecom Outperformance Vulnerable To Reversal Chart 13Japanese Telecom Outperformance Vulnerable To Reversal Chart 14ETH Is Approaching A Possible Capitulation Chart 15The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 16The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 17A Potential Switching Point From Tobacco Into Cannabis Chart 18Biotech Is A Major Buy Chart 19Norway's Outperformance Has Ended Chart 20Cotton Versus Platinum Has Reversed Chart 21Switzerland's Outperformance Vs. Germany Has Ended Chart 22USD/EUR Is Vulnerable To Reversal Chart 23The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 24A Potential New Entry Point Into Petcare Chart 25GBP/USD At A Potential Turning Point Chart 26US Utilities Outperformance Vulnerable To Reversal Chart 27The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Executive Summary No Funding For Property Developers, No Land Sales Beijing’s plan to bring forward RMB 2.6 trillion of financing for infrastructure expenditures in H2 2022 is a considerable stimulus. However, this new funding will not result in new investments. Rather, it will, by and large, offset the drop in local government (LG) revenues from land sales this year. In short, there is little new stimulus for infrastructure beyond what has been approved in the budget plan earlier this year. Not only is the credit and fiscal impulse smaller in this cycle than in the previous ones, but also the multiplier effect will be lower. This will hinder the recovery in domestic demand. After the one-off rebound in economic activity following the lockdowns in April and May of this year, China’s business cycle recovery will be more U shaped rather than V shaped. Bottom Line: For absolute-return investors neither A-shares nor investable stocks offer an attractive risk-reward profile. Within a global equity portfolio, we continue to recommend a neutral allocation to China’s A-shares and an underweight allocation to Chinese investable stocks. Relative to the EM equity benchmark, investors should continue to overweight A-shares and remain neutral on investable stocks. Maintain the long A-shares / short offshore investable Chinese stocks position.   Alleged plans of an additional RMB 1.5 trillion local government (LG) special bond issuance in H2 2022 have prompted investors to speculate about whether this stimulus initiative is sufficient to produce a considerable acceleration in infrastructure investment.  This stimulus would be added to RMB 800 billion and 300 billion of policy bank funding for infrastructure that the government approved earlier in Q2 this year. Hence, the combined new infrastructure financing made available by Beijing is RMB 2.6 trillion. Below, we elaborate on how this RMB 2.6 trillion of additional infrastructure financing will be largely offset by a drop in LG revenues from land sales. In short, the stimulus will preclude downside in infrastructure investment rather than herald a major acceleration.  In addition, the economic recovery still faces substantial headwinds from other segments of the economy. We believe that, approached as a whole, China’s business cycle recovery will be more U shaped than V shaped. Quantifying Infrastructure Stimulus The degree of new financing for infrastructure is considerable. This RMB 2.6 trillion in new financing in H2 2022 is equal to 7% of planned 2022 LG aggregate expenditures, 6% of planned 2022 aggregate total central and local government spending including budgetary and managed funds, 14% of fixed-asset investment (FAI) in traditional infrastructure, and 2% of GDP.  The composition of general government spending is presented in Table 1. Table 1Structure And Composition Of Government Spending In China However, a caveat is in order: this new funding will not result in new investments. Rather, it will, by and large, offset the drop in LG revenues from land sales. The primary source of financing infrastructure investment is LG managed funds. LG managed funds budgets, however, are under severe stress because of the plunge in revenues from land sales. Notably, proceeds from land sales account for 23% of aggregate LG expenditures (Chart 1). Land sales have contracted by about 30% in the January-June period of this year, and there is little hope that they will pick up in H2 2022. The reason is that property developers’ financing is down by 30% and is unlikely to recover soon (Chart 2). Chart 1Land Sales Are Critical For LG Expenditures Chart 2No Funding For Property Developers, No Land Sales Chart 3Property Developers Are Facing Debt Deflation As we have argued in our past reports, property developers carry a substantial inventory of real estate assets funded by a massive debt build-up (Chart 3, top panel). With housing prices beginning to deflate, property developers are about to face debt deflation – falling asset prices and a high debt burden (Chart 3, bottom panel). Thereby, they have little appetite or capacity to expand their assets and leverage. Assuming land sales for the full year will decline by 30%, this drop would lead to an RMB 2.52 trillion reduction in LGs managed fund revenues in 2022 (Table 2). Hence, the new RMB 2.6 trillion infrastructure financing will be used to offset the RMB 2.5 trillion shortfall in LG managed funds budgets because of the plunge in land transfer proceeds. Table 2China: New Stimulus For Infrastructure in H2 2022 On the whole, there will be very little new funding available to boost infrastructure spending beyond what has been approved by the 2022 National People’s Congress (NPC) earlier this year. Chart 4The Credit And Fiscal Impulse Will Be Moderate Hence, for this full year, there is no change to the aggregate fiscal spending impulse that incorporates central and local government budgetary spending as well as managed funds’ expenditures (Chart 4, top panel). The two scenarios for the non-government credit impulse are shown in the middle panel of Chart 4. The optimistic scenario assumes non-government credit will accelerate to 9.5% from 8.7%, and the pessimistic scenario is based on no acceleration in non-government credit growth. Finally, the bottom panel of Chart 4 illustrates the projections for the combined credit and fiscal spending impulse for the remainder of this year. Although the aggregate fiscal and credit impulse is non-trivial, it is smaller than those in 2020, 2016, 2013, and 2009. Bottom Line: The government has announced RMB 1.1 trillion in infrastructure funding and will likely raise the LG special bond quota by RMB 1.5 trillion. Yet, this RMB 2.6 trillion financing will only offset the shortfall in infrastructure financing from plunging land transfer revenue.  In brief, there is little new stimulus for infrastructure beyond what has been approved in the budget plan from early this year.   Economic Headwinds Chart 5China's Reopening Rebound Economic activity in China has rebounded following the reopening of the economy. Chart 5 illustrates that high-frequency data, such as car sales, house sales, commercial truck cargo, and steel production have all recently improved. We expect the one-off renormalization of economic activity following the lockdowns in April and May to give way to more subdued growth. The reason is that the mainland economy is facing several major headwinds: The real estate market is unlikely to recover meaningfully given the “three red lines” policy has not been eased, and many of property market excesses have not been purged. Hence, the question remains whether the Chinese economy can stage a robust recovery without the participation of the property market. We doubt it can because of the vital role that real estate has played in the economy in the past 20 years as the result of its large share in GDP and its impact on consumer and business sentiment. Since 2008, there has been no business cycle recovery in China without the property market firing on all cylinders (Chart 6). Chart 6All Economic Recoveries Were Accompanied By A Revival In The Property Market Chart 7China: The Willingness To Spend And Invest Is Very Low Rolling lockdowns will likely persist. This will weigh on household and private business confidence. Diminishing confidence will undermine the willingness to spend, invest, and hire. Our marginal propensity to spend indicators for households & enterprises remain very depressed (Chart 7). Low propensity to spend entails that the multiplier effect of fiscal and credit stimulus will be lower in this cycle than in the previous ones. Not only is the credit and fiscal impulse smaller than in the previous cycles but also the multiplier will be lower. This will hinder the recovery in domestic demand. Finally, Chinese exports are set to contract in H2 2022 because of shrinking demand for consumer goods (ex-autos) in the US and Europe as well as mainstream EM. Bottom Line: After the one-off rebound in economic activity following the lockdowns in April and May, the business cycle recovery will be more U shaped rather than V shaped. Investment Conclusions For absolute-return investors, neither A-shares nor investable stocks offer an attractive risk-reward profile.   Within the A-share market, our strongest conviction is to overweight interest rate-sensitive sectors like consumer staples, utilities, and healthcare. Consumer discretionary stocks should also be a slight overweight now.   We continue to recommend a neutral allocation to Chinese A-shares and an underweight allocation to investable stocks within a global equity portfolio. Relative to the EM equity benchmark, investors should continue to overweight A-shares and remain neutral on investable Chinese stocks.   Maintain the long A-shares / short offshore investable stocks position.   The yuan, like all other emerging Asian currencies, is still facing near-term downside risk versus the US dollar. Chinese onshore government bond yields will likely drop further.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes Cyclical Recommendations

Executive Summary Global risk assets are oversold, and investor sentiment is downbeat. In this context, a technical equity rebound cannot be ruled out. However, we do not think it will be the beginning of a major cyclical rally. The Fed and the stock market remain on a collision course. An equity rally and easing financial conditions would make the Fed even more resolute to continue hiking interest rates. There are many similarities between dynamics that prevailed in US tech stocks and in previous bubbles. While it is not our baseline view, the odds of a protracted bear market are nontrivial. Resource prices and commodity plays have more downside. The History Of Financial Bubbles: Is This Time Different? Bottom Line: The decline in commodity prices and the relentless US dollar rally will ensure that EM currencies, bonds and stocks continue to sell off even if the US equity market rebounds in the near term. Feature Among the most frequently discussed topics in recent client calls are the upside and downside risks to our baseline view. We elaborate on these risks in this report. To recap, our baseline view is as follows: EM and DM stocks have another 15% downside in USD terms, the US dollar will continue overshooting and commodity prices will fall. Global yields are topping out, and the US yield curve will soon invert. Hence, defensive positioning for absolute-return investors is still warranted, and global equity and fixed-income portfolios should continue to underweight EM. The rationale is that US and EU demand for goods ex-autos, and hence global trade, is about to contract while the Fed is straightjacketed by high and broad-based inflation. China’s economy will be struggling to recover. In EM ex-China, domestic demand will relapse. Chart 1Will The S&P 500's Technical Support Hold? If one believes that the US equity bull market that began in 2009 is still alive (i.e. the March 2020 selloff is a short-lived red herring), odds are that the S&P 500 drawdown is over. The reasoning is that the S&P 500 is already down 23% from its 2021 peak, on par with the selloffs that occurred in 2011, 2015-16 and 2018 (Chart 1). However, if one believes that the structural bull market is over, the magnitude of the current equity selloff is likely to exceed the ones in 2011, 2015-16 and 2018. Hence, a bearish stance is still warranted. As we argue below, after a 12-year bull run, the excesses in the US equity market in general, and US tech stocks in particular, have become extreme. There are many signs of a bubble, or at least of a major top. Even though we risk overstaying in our negative view, our bias is that the global equity market rout is not yet over. A Bullish Scenario A (hypothetical) bullish case would look something like this: Weakening global and US growth and falling commodity prices bring down US inflation and Treasury yields. As US bond yields drop further, the S&P 500 rallies given their negative correlation of the past 18 months or so. As US inflation declines rapidly, the Fed makes a dovish pivot, reinforcing the risk asset rally and reversing the US dollar’s uptrend. Finally, Chinese stimulus produces a robust business cycle recovery in China that propels commodity prices higher and lifts the rest of EM out of the abyss. Chart 2Keep An Eye On Rising US Trimmed-Mean Inflation In our opinion, this scenario has no more than a 25% chance of playing out. Even if there are apparent signs of a US/global slowdown, elevated US core inflation and accelerating wages and unit labor costs would keep the Fed from dialing down its hawkishness Critically, even though US core PCE inflation has rolled over and will likely decline further, its trimmed-mean PCE inflation is rising (Chart 2). The latter means that inflation is broadening even as some volatile items like food, energy and used-auto prices deflate. As we have written extensively, wages and inflation are lagging variables. Despite the ongoing slowdown in the US economy, it will take many months before the underlying core inflation rate drops below 3%. We maintain that the Fed and the stock market remain on a collision course. An equity rally and easing financial conditions would make the Fed even more resolute to hike interest rates. The basis is that even if core inflation falls in the coming months, it would still be well above the Fed’s target of 2%. Notably, the Fed has recently communicated that its commitment to bring down inflation to 2% is unconditional. Chart 3The Anatomy Of The US Equity Bear Market In 2000-2002 This policy stance represents a major departure from the past several decades when the Fed was very sensitive to any tightening in financial conditions and often eased preemptively. In short, with inflation still well above its target, the Fed will, for now, err on the side of hawkishness if financial conditions ease. Importantly, US corporate profits will likely contract even if US real GDP does not shrink. As US corporate top-line growth slows and unit labor costs accelerate, profit margins will shrink. For example, the 2001-2002 recession was very mild – consumer spending did not contract at all, and housing boomed (Chart 3, top two panels). Yet, the S&P 500 operating earnings dropped by 30%, and the S&P 500 fell by 50% (Chart 3, bottom two panels). In brief, a devastating bear market does not necessarily require a hard landing. Concerning China, the recovery will likely be U-shaped rather than V-shaped with risks skewed to the downside. Finally, contracting global trade and falling commodity prices will continue, which are negative for EM currencies and assets. Notably, industry data from Taiwan’s manufacturing PMI suggest that the slowdown in the Asian and global economies is widespread. Taiwan’s substantial trade linkages with mainland China signify that the slowdown is not limited to the US and the EU but includes China too. Taiwanese PMI export orders of both semiconductor and basic material producers have plunged to 40 and 30, respectively (Chart 4). Barring a quick turnaround, global semiconductor and basic materials stocks have more downside. Even as US Treasury yields drop, the dollar will continue firming versus EM currencies, including those of Emerging Asian countries. In such a scenario, EM stocks and bonds will weaken further (Chart 5).  Chart 4A Broad-Based Contraction In Global Trade Is In The Cards Chart 5A Free Fall In EM Ex-China Stocks And Currencies   Bottom Line: The S&P 500 is oversold, and investor sentiment is downbeat. In this context, a technical equity rebound can occur at any moment. However, we do not think it will be the beginning of a major cyclical rally. A Bearish Case: Are US TMT Stocks A Bubble? What is a more bearish scenario than our baseline case? The bursting of bubbles or the unwinding of excesses would entail a more protracted and devastating bear market than the 15% drop in global share prices we currently expect. We can identify two major excesses in the global economy and financial system: In US TMT (Technology, Media & Entertainment and Internet & Catalog Retail) stocks and private equity In Chinese real estate. We have written extensively about property market excesses in China. Below we discuss the recent sharp selloff in commodities, which is partially linked to Chinese property construction. We also present the case for major excesses in US stocks. Chart 6 illustrates the history of bubbles of the past several decades: The Nifty-fifty (involving the 50 US large-cap stocks) bubble occurred in the 1960s and burst in the 1970s (not shown in the chart). The commodity bubble took place in the 1970s and burst in the 1980s. Japanese equity and property prices rose exponentially in the 1980s and deflated in the 1990s. The Nasdaq bubble occurred in the 1990s and was shattered in the early 2000s. Commodities/EM/China were the leaders of the 2000s, and they were devastated in the 2010s. We use iron ore in this chart because its price surged the most in the 2000s. FAANGM stocks, the Nasdaq 100 index and private equity were by far the biggest beneficiaries of the 2010s. No one can be certain about bubbles in real time because there are always superior fundamentals or persuasive stories that justify exponential price appreciation. That said, there are a lot of similarities between dynamics prevailing in US tech and private equity and in previous bubbles: In the past decade, FAANGM stocks, the Nasdaq 100 index and private equity companies registered gains comparable to the bubbles of the previous 60 years. Furthermore, as Chart 6 illustrates, the equal-weighted FAANGM index in inflation-adjusted terms rose 30-fold, much more than the bubbles of the previous decades. The Nasdaq 100 index and share prices of Blackstone, the largest private equity company, have risen by nearly 10-fold in real (inflation-adjusted terms) between 2010 and the end of 2021. Chart 6The History Of Financial Bubbles: Is This Time Different? The final phase of bubbles is often characterized by growing retail investor participation. This is exactly what happened with US tech/new economy stocks. Chart 7US TMT Stocks: Exponential Growth Rarely Ends Well Toward the end of the decade, not only retail but also institutional capital stampedes into the winners of the decade. This played out with US large-cap tech stocks as well as in private equity and private debt spaces. Inflows into private equity and private debt have been enormous. As a result of these inflows into US large-cap stocks, the market cap share of US TMT stocks as a percentage of total US market cap has surpassed 40%, its peak in 2000 (Chart 7). Bubbles often thrive during periods of low interest rates and crash when the cost of capital rises. This is exactly what has been happening in global financial markets since early 2019. The parameters of the overall US equity market were also excessive prior to this bear market. As of last year, the S&P 500 stock prices in real (inflation-adjusted) terms became as elevated relative to their long-term time trend as they were in the late 1960s and the late 1990s − the peaks of previous secular bull markets (Chart 8, top panel).   Chart 8The S&P 500 and Operating Profits: A Long-Term Perspective Chart 9Equity Issuance Marks Market Tops The S&P 500’s operating earnings in real terms have surpassed two standard deviations above its time trend (Chart 8, bottom panel). Some sort of mean reversion to its long-term trend is in the cards. US corporate profits have benefited from fiscal/monetary stimulus, low labor costs and pricing power. All of these are now working against profits.   Finally, new share issuance in the US mushroomed in 2021, another sign of a major top (Chart 9). Bottom Line: We are not entirely convinced that US TMT stocks are a bubble waiting to burst. Yet, the odds of this happening are nontrivial. This time might not be different. A Word On Commodities The selloff in the commodity space has been broad-based. Odds are that it will continue for the following reasons: A global business cycle downtrend is always bearish for commodity prices. In fact, oil prices are often lagging and are typically the last shoe to drop during global slowdowns. US sales of gasoline have started to contract. Besides, Saudi Arabia will likely increase its oil output and shipments following President Biden’s visit to the Kingdom next week. Chart 10Investors Have Been Long Commodity Futures As we have argued in recent months, China’s demand for commodities was contracting and, in our opinion, the rally in resource prices over the past 12 months was supported by investment demand for commodities, i.e., financial inflows into the commodity space. Many portfolios have bought commodities as an inflation hedge. When a hedge becomes a consensus trade and crowded, it stops being a hedge. Chart 10 demonstrates that net long positions in 17 commodities have been very elevated. The speed at which liquidation is taking place corroborates our thesis that it is investors not producers or consumers who have been caught being long commodities. China’s business cycle recovery will be U-shaped at best. Domestic orders point to weaker import volumes in the months ahead (Chart 11, top panel). ​​​​​​​Corporate loan demand has plunged suggesting that liquidity provisions by the PBoC might fail to produce a meaningful recovery in credit growth (Chart 11, bottom panel). Finally, technicals bode ill for commodity prices. As Chart 12 illustrates, copper prices and global material stocks have probably formed medium-term tops, and risks are skewed to the downside.  Chart 11China: The Economy Is Struggling To Gain Traction Chart 12A Major Top In Commodity Prices?   Bottom Line: Commodity prices and their plays have more downside. Investment Strategy The decline in commodity prices and the relentless US dollar rally will ensure that EM currencies, bonds and stocks continue to sell off even if the US equity market rebounds in the near term driven by lower Treasury yields. Global equity and fixed-income portfolios should continue underweighting EM. We also continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN, PHP and IDR; as well as HUF vs. CZK, and KRW vs. JPY. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Special Report

Executive Summary Rebounding Chinese Auto Sales China’s stimulus for auto purchases and an easing global auto chip shortage will lead to about a 10% recovery in domestic auto sales in 2022H2 from a year ago. Next year, we expect Chinese auto sales to grow only modestly (under 5%).  The share of new energy vehicles (NEVs) in auto sales is rising rapidly in China, crowding out internal combustion engine vehicles (ICEVs) at a fast rate. China is becoming more competitive in global auto manufacturing given its edge in NEV battery technologies and autonomous driving. Production of NEVs and the installation of NEV charging poles will expand rapidly. Yet, given the still-high valuation of these stocks, we will look to buy into these sectors at a better price entry point. Bottom Line: Chinese onshore and offshore automobile stock prices have risen sharply in the past couple of months on the expectation of improving car sales. Our bias is that the rally has been too fast and gone too far. Investors should wait for a pullback before they buy. Feature Chinese total auto sales contracted by 12% year on year in the first five months of this year due to a deep 24% contraction in non-NEV sales. In stark contrast, Chinese NEV sales have more than doubled during the same period. However, the 1-million-unit increase in NEV sales failed to counteract the 2.4-million-unit loss in non-NEV demand. This raises two questions. Why have NEV sales skyrocketed at a time when non-NEV sales have tanked? Will Chinese auto sales recover in 2022H2 and 2023? If so, then how strongly will the recovery be? The answer to the first question lies in a major auto chip allocation strategy that many Chinese auto producers adopted last year. Under limited semiconductor supplies, auto producers in China prioritized the use of chips in their production of NEV models – which have higher profit margins –over traditional vehicles. The greater availability of NEVs than ICEVs has meant an increase in sales of the former and a deep contraction in the latter in 2022H1. Chart 1Chinese Auto Sales: A Recovery Ahead? For the second question, we believe that China’s stimulus package to boost auto sales and an easing global auto chip shortage will lead to about a 10% recovery in auto sales in 2022H2 from a year ago. On the other hand, growth in 2023 will be very modest (under 5%). Accordingly, the daily data of Chinese retail auto sales have already shown a strong rebound in the total sales of NEVs and ICEVs in the last three weeks of June (Chart 1). Auto Sales In China: A Gradual Recovery     China’s auto sales are set to have a gradual recovery in 2022H2. We expect auto sales to reach 26.2-26.8 million units by the end of this year, with NEV and non-NEVs rising to 5-5.3 million units and 21.2-21.5 million units, respectively1 (Chart 2). The reasons for our positive estimates include policy stimulus, improving technological advancement of NEVs, as well as an easing in the global auto chip shortage. First, the government has issued a flurry of policies since late May attempting to boost domestic auto demand. As Chart 1 shows, these policies have proved effective, at least for now. In previous episodes of stimulus aimed at boosting auto sales in 2009-2010, 2016-2017, and 2019-2021, authorities had implemented similar supportive measures. While the stimulus worked well in the first two episodes, it was not effective in 2019-2021 (Chart 3).   Chart 2Auto Demand In China: A Gradual And Moderate Rebound Chart 3Policy Stimulus Will Help Lift Chinese Auto Demand Box 1 shows our summary of those auto stimulus and a comparison of these episodes. Of all these policies, we believe that a sales tax reduction2 on certain vehicles has proved to be the most effective policy as it directly reduced the prices of these vehicles. In 2022H2, this policy will mainly benefit ICEVs sales as NEVs will continue to enjoy a full exemption from the 10% vehicle purchase tax. The government is also considering an extension of the exemption for NEVs to the end of next year.  Box 1China’s Stimulus Package For The Domestic Auto Industry​​​​​​​ This year’s stimulus is more comparable to the 2009 and 2016 episodes as they share the same reduction in the sales tax rate from 10% to 5%. The main difference is that this time the policy targets cars with 2-liter engines or smaller, while back in 2009 and 2016 this policy only applied to vehicles with capacity no bigger than 1.6-liters. This means a larger range of vehicles will benefit from the reduction. In short, the current policy will allow an additional 23% share of total vehicles sold to benefit from the stimulus. Please note that for the period of 2019-2021 there was no sales tax reduction. This may be one of the reasons for the lack of recovery in vehicle sales in this episode; Chinese auto sales contracted in both 2019 and 2020. Second, Chinese NEVs buyers have been enjoying government subsidies, albeit on a sliding scale since 2019. The amount of subsidy has been dropping by 10%, 20% and 30% in 2020, 2021 and 2022, respectively (Table 1). We expect NEV sales to rise as the subsidy is set to expire by the end of this year. This may induce some buyers to buy NEVs before the subsidy ends. Table 1Government Subsidy For NEV Purchase in China Chart 4NEVs Become More Appealing To Chinese Consumers In addition, NEVs are becoming increasingly appealing for auto buyers. This is due to longer travel mileage per battery charge, constant improvement in NEV related technologies, and an expanded charging/battery swap framework (Chart 4). Further, in comparison to traditional ICEVs, NEVs have become increasingly more equipped with functions such as autonomous driving, intelligent interconnection, and other software application-based services. NEVs will also become more integrated with intelligent and interactive networks. All these features will make NEVs more attractive to automobile buyers as well.  According to the McKinsey China Auto Consumer Insights 2021 report, Chinese consumers are more interested than ever in smart vehicle technologies, and they are willing to pay a premium for innovative features. 80% of consumers report that autonomous driving will be a key factor in their decision-making when they buy their next car. Meanwhile, 69% of consumers consider that over-the-air update technology (OTA) is an important feature, and 62% of those are willing to pay for it. Chart 5NEV Sales In China Are Not Very Sensitive To Gasoline Prices Rising oil and gasoline prices have also encouraged NEV sales in the past six-to-nine months. But we believe high fuel prices are relatively less important factors to NEV demand in China than in the US and EU. For example, in 2020H2, when oil prices were only around US$40-50 and domestic gasoline price were low, Chinese NEV sales still rose strongly during the same period (Chart 5). Third, the deep contraction in non-NEV sales in China in 2021 was partially caused by the global auto chip shortage. Global semiconductor chip shortages are likely to continue easing in 2022H2 as demand-supply gaps decrease across most components. Demand for consumer electronics is set to contract in the US and the EU in the next six-to-nine months. Hence, some capacity for PC and smartphone chips could be used to produce auto chips in the months ahead. Bottom Line: Government initiatives to boost auto sales, improving technological advancement of NEVs, and an easing of the global auto chip shortage will lift Chinese auto sales to some extent. Structural Auto Demand: A New Normal? Auto sales peaked in 2017 and are since down by 13%. Even if auto sales registered a modest recovery as we expect in 2022 and 2023, they will still be about 6% below their 2017 peak. The reasons why we do not expect a brisk auto sales recovery are as follows: Household (HH) income growth is very weak and the unemployment rate has been rising (Chart 6). HHs have considerable debt (Chart 7). With house prices not rising, and potentially deflating, HH willingness to take on more debt has declined. Chart 6Falling HH Income Growth And Rising Unemployment Chart 7HH Debt Burden Is Already High​​​​​​ Wage/income growth has downshifted and narrowed its gap with interest rates on consumer loans. The cost HH debt has therefore risen relative to their income growth, making consumers less willing to take on more debt.   Reflecting downbeat consumer sentiment, the HH marginal propensity to consume has fallen to very low levels and has not shown signs of improvement (Chart 8). With the mediocre structural auto demand outlook in China, NEV sales will rapidly gain market share from non-NEVs (Chart 9). NEVs currently account for about 18% of total auto sales in China, still much lower than the country’s goal of 40% in 2030. Chart 8HH Willingness To Spend Is Low Chinese Consumers: Falling Willingness To Consume Chart 9Accelerating NEV Penetration In China Last week the EU passed a plan of a 2035 phase-out of new fossil fuel car sales. This is also a trend for China. Chinese auto makers such as Changan, BAIC Motor and Haima have already announced that they will stop ICEV production in 2025. Chart 10Decelerating Growth In Chinese Oil Demand Declining ICEV sales will lead to lower growth of these vehicles on the road (Chart 10). Consequently, gasoline and diesel demand growth from passenger and commercial autos will be decelerating in China in the coming years. Bottom Line: Passenger car demand in China will be settled in low single digit growth rates. The market share of NEVs will rise very fast at the expense of ICEVs. In turn, falling ICEV sales will result in slower growth in domestic petroleum demand.  China: Increasing Competitiveness Chart 11Increasing Competitiveness Of Chinese Auto Manufacturers China has become increasingly competitive in global auto manufacturing. This is a strong tailwind for the country’s auto exports. In fact, the country’s net exports of autos have been rising (Chart 11). China is the world’s largest auto producer and consumer, accounting for 32.5% and 32% of global auto production and sales, respectively. The country is also the world’s largest NEV producer. Chart 12China: The World’s Leading And Largest EV Battery Producer ​​​​​​​​​​​​​​The battery is the most important component of an NEV, and its technological progress holds the key to the speed of NEV penetration. China is the world leader in this battery technology. China’s CATL is currently the world's largest battery manufacturer, with a market share of 32.5%. CATL ranked first in the world for five consecutive years from 2017 to 2021. In addition, four out of the top ten global EV battery players are Chinese companies, with a total market share of 44%, up from 41% last year (Chart 12). Moreover, in late June, CATL launched its cell-to-pack (CTP 3.0) battery. With a record-breaking volume utilization efficiency of 72% and an energy density of up to 255 Wh/kg, it achieves the highest integration level worldwide so far, capable of delivering a range of over 1,000 km on a single charge. The CTP 3.0 batteries are expected to be mass produced and come onto the market in 2023. The development of charging/battery-swapping infrastructure will continue to be faster in China than in other countries/regions due to the country’s competitive advantage in NEV production, including batteries, as well as related policy support. For example, the number of total public & private charging poles rose at a compound annual growth rate of 50% in the past five years. This allows China to collect more NEV charging-related data, which could be used to improve the country’s NEV manufacturing process, charging pole production, and the country’s charging infrastructure development. This will help reduce the charging anxiety of Chinese NEV users. In terms of autonomous driving, five Chinese companies have been included in the world’s 10 best autonomous driving companies based on their technological edge, according to the global autonomous driving report released by the California Department of Motor Vehicles (DMV). In addition to test drives in the US, major Chinese NEV makers have also carried out test drives in China with long distances and more complicated driving conditions. For example, as of mid-March, Baidu Apollo’s autonomous driving has already exceeded 25 million kilometers. In comparison, the total test distance of autonomous driving of all autonomous driving test cars in California were only 6.4 million kilometers. Chart 13China: Faster NEV Penetration Versus Other Countries At 13.4%, the share of NEVs in total auto sales in China was high last year compared with other countries (Chart 13). The ratio has already risen to 21% in the first five months of this year. Bottom Line: China will become more competitive in global auto manufacturing given its edge in NEV battery technologies and autonomous driving. Investment Implications Chinese onshore and offshore automobile stock prices have risen sharply in the past couple of months, expecting improving car sales in the short-to-medium term (Chart 14). Our bias is that the rally has been too fast and gone too far. Investors should wait for a pullback before they buy. A shakeout in broader Chinese offshore and onshore stocks is likely due to the following (Chart 15): Chart 14Chinese Automobile Stock Prices: A Lot Of Good News Already Priced In... Chart 15...A Pullback Is Due Chart 16Look To Buy Chinese NEV-related Stocks China’s economy is still facing downward pressure due to a faltering property market, sluggish household income growth and consumption, falling export demand, as well as heightened risks of further COVID-induced lockdowns. Global equities have probably not completed their downtrend. It will be hard for Chinese stocks to continue rallying if global share prices continue to fall. That said, we have a bullish bias towards Chinese NEV producers. China’s NEV sector enjoys tailwinds from structurally strong demand and its technological edge, especially in batteries. Hence, we will look to buy Chinese NEV and battery stocks at a better price entry point (Chart 16).   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Footnotes 1     China Association of Automobile Manufacturers (CAAM) predicted Chinese auto sales to rise to 27.5 million units for the full year. We are a little bit less optimistic on that front. 2     The State Council of China is enacting 60-billion-yuan (US$9 billion) worth of tax cuts between June and December. The purchase tax on certain passenger vehicles will be reduced by half to 5% of the sticker price. The tax cuts target cars with 2-liter engines or smaller, priced at 300,000 yuan (US$ 44,800) or less. Strategic Themes Cyclical Recommendations