Economy

Executive Summary Upside Oil Price Risk Dominates Despite global recession fears and uncertainty over Russia’s retaliation for the EU embargo against its exports, oil markets will continue to tighten. After breaching $15/bbl in June, the Dec22 vs Dec23 Brent backwardation – our preferred seasonal indicator for inventory tightness – is back above $10/bbl and rising.  There is an increasing risk Russia will cut crude output, if G7 states impose a price cap on its oil sales.  Our modeling indicates the loss of an additional 2mm b/d of Russian output vs our base case beginning in 4Q22 would lift prices above $220/bbl by 4Q23. On the downside, our modeling indicates the loss of 2mm b/d of demand vs our base case – i.e., essentially wiping out this year’s expected growth – would push average Brent prices toward $60/bbl next year. Our base case forecast for Brent crude oil is unchanged.  We expect 2022 Brent to average $110/bbl, and for 2023 prices to average $117/bbl.  WTI will trade $3-$4/bbl below Brent. Bottom Line: We expect markets to continue to tighten as the EU embargo of Russia oil progresses.  A price cap on Russian oil sales could lead to a production cut that takes prices above $220/bbl by 4Q23.  An economic collapse could push Brent toward $60/bbl.  Risks remain skewed to the upside.  Our base case Brent price forecast remains unchanged: $110/bbl on average this year and $117/bbl in 2023. Feature The global oil market is tightening even with China demand restrained by its zero-Covid-19 tolerance policy, and parts of Europe almost surely facing recession if Russian pipeline gas supplies are cut off or tighten significantly between now and the approach of winter. Upside price risk dominates, in our view. Our Brent price forecast remains unchanged, averaging $110/bbl this year and $117/bbl in 2023. Markets remain tight: Oil supply will remain below demand, which will force inventories to draw (Chart 1). Related Report  Commodity & Energy StrategyRecession Unlikely To Batter Oil Prices This will push Brent into a steeper backwardation going into year-end, forcing the Dec22 v Dec23 Brent spread higher (Chart 2). High levels of backwardation – i.e., prompt-delivery futures trading above deferred-delivery futures – is how inventory tightness manifests itself: Refiners are willing to pay more for prompt delivery than deferred delivery, because they need oil now to meet demand. This is occurring despite weaker demand coming out of China and EU states, as the latter begins to ration energy supplies ahead of the coming winter. Chart 1Inventories Will Tighten Chart 2Markets Will Backwardate Further Russia Risk Is Increasing The supply-side risks that we outlined in last week's report — chiefly the risk Russia will unilaterally cut oil supply if a price cap is imposed by G7 states led by the US – remain in place. We expect the EU to follow through on its commitment to phase out all Russian oil and refined product imports in 2H22 and 1Q23. The EU formally agreed to cut 90% of its Russian oil imports by the end of this year. The EU’s goal is to be completely out of ~ 2.3mm b/d of seaborne crude oil imports and 800k b/d of pipeline imports this year. In 1Q23, the EU will be reducing its refined product imports (e.g., diesel fuel) from Russia as well. Russia will lose more than 4mm b/d of crude and product exports to the EU as a result of these embargoes. We continue to expect the cutoffs in EU exports will result in Russia being forced to shut in 1.6mm b/d of production this year and another 500k b/d next year. In our base case, we expect this to take Russian crude production down from more than 10.5mm b/d prior to its invasion of Ukraine to something close to 8.0mm b/d by the end of next year. Spare capacity remains tight. Almost all of OPEC 2.0’s spare capacity is in the Kingdom of Saudi Arabia (KSA) and the United Arab Emirates (UAE). These are the only two OPEC 2.0 states that are able to increase production and maintain it at higher levels for an indefinite period of time. Despite repeated pleas from the US, these states continue to indicate they do not see the need to sharply increase oil production, even after US President Joe Biden made a trip to the region last week to ask them in person to do so. With ~ 2-3mm b/d of spare capacity available – the exact level is not public knowledge – digging into spare capacity now would leave nothing in the tank, so to speak, to meet another supply shock (e.g., a unilateral cut-off of Russian supplies in response to a G7 price cap on oil sales). KSA, as a matter of policy, maintains a minimal level of spare capacity (1.0 – 1.5mm b/d) to handle unforeseen supply shocks. In addition, the OPEC 2.0 agreement to return production removed from the market during the COVID-19 pandemic agreed last July, and the US release of 1mm b/d of inventories out of its Strategic Petroleum Reserve (SPR) both expire in September.1 The US SPR has not indicated it will extend its release of inventory beyond September. Markets will tighten. The return of barrels from OPEC 2.0 is largely moot, since only KSA and the UAE – which we dub Core OPEC 2.0 – have been able to consistently raise output since the July 2021 agreement to return barrels to the market. The other OPEC 2.0 member states – the “Other Guys” – have consistently missed their production quotas this past year (Chart 3). Lastly, the odds of the US and Iran reaching a rapprochement continue to fade, almost to the point of vanishing. Iran reportedly will supply Russia with drones for its war in Ukraine. This indicates the Iranian government has all but capitulated on reviving its nuclear deal with the US, which would have brought an additional 1mm b/d back on the market.2 Outside of OPEC 2.0, we expect US production in the Lower 48 states ex-US Gulf will increase 0.8mm b/d this year, and 0.75mm b/d next year, given price levels and the shape of the WTI forward curve (Chart 4). This is mostly unchanged from previous production expectations. Chart 3Lower OPEC 2.0 Production ex-KSA, UAE Chart 4Capital Discipline Drives US Shale Production Growth We continue to expect US shale-oil producers will maintain capital discipline, and will continue to prioritize shareholder interests by returning capital to investors via share buybacks and strong dividend distributions. Besides, boosting output over the balance of this year is becoming increasingly difficult, given oil-services equipment shortages and lack of capital.3 In our base case, we continue to anticipate demand will rise by 2.0mm b/d this year and 1.8mm b/d next year. This is lower than our estimates at the start of the year by close to 3mm b/d. This is all down to the sharp GDP growth slowdown forecast by the World Bank last month, which pushed our oil-demand estimates lower.4 Oil demand continues to grow, albeit it slowly, which, against a backdrop of tightening supplies, means the risk to prices remains to the upside. In our base case, the supply-demand fundamentals are largely balanced (Chart 5). These fundamentals (Table 1) are driving our forecast for $110/bbl Brent this year and $117/bbl next year (Chart 6). Chart 5Markets Remain Finely Balanced Chart 6Brent Backwardation Will Steepen Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Uncertain Evolutions: Between $60 And $220/bbl We have noted the heightened uncertainty surrounding our oil-price expectations, which makes forecasting more tentative than usual.5 This week, we consider larger supply and demand shocks via econometric simulations to at least define possible price paths consistent with our assumptions and modeling. To the upside, we estimate a 2mm b/d loss of output resulting from a cutoff of Russian crude oil production. Relative to the status quo ante – i.e., prior to Russia’s invasion of Ukraine in February – this would remove a total of ~ 4mm b/d of Russian production from the market (2mm in our base case plus an additional 2mm b/d). Our modeling indicates this could push prices above $220/bbl by 4Q23, depending on how the additional 2mm b/d production cut is implemented – i.e., suddenly or staged pro-rata (Chart 7).6 This high-price scenario would be difficult for markets to adjust to, given the short-term inelasticity of global oil demand. In its wake, we would expect demand destruction on a large scale. Chart 7Upside Oil Price Risk Dominates On the downside, we simulate a sharp contraction in oil consumption that removes an additional 2mm b/d of demand vs our base case – i.e., essentially wiping out this year’s expected growth. This would push average 2023 prices toward $60/bbl in our modeling. Losing this much demand would amount to a global economic collapse. A deep global recession cannot be ruled out, as markets have been reminding us over the past couple of weeks. However, the downside risks are not as pronounced as the upside risks in our estimation. There has not been an excessive accumulation of inventory in the OECD, as Chart 1 indicates. In the non-OECD economies, inventory accumulation in China appears to be intentional and policy driven. In addition, the supply response to sharply lower prices would be met by sharply lower production by KSA and the UAE, along with the US shale-oil producers over the course of a couple of months. This would arrest the down leg a demand shock produced in previous oil-price collapses when production was not as flexible, and inventories adjusted with longer lags. Economic growth in the EU could slow in some but not all of the member states, according to recent IMF estimates.7 The US may slow, and is at risk to a hard landing due to poorly calibrated Fed tightening. This could usher in a deep recession. However, the US also might even benefit from the EU going into recession, since it is not as resource constrained as the EU. Lastly, the EU’s been getting ready for this Russian energy cut-off and has lined up alternative energy sources (LNG and coal mostly). In addition, states already have begun asking their citizens to conserve energy, particularly natural gas. This forced conservation can achieve significant energy savings and is not new to the world: It was demonstrated by Japan after the Fukushima disaster in 2011 and the US in the late 1970s. Investment Implications Our base case oil-price forecast remains $110/bbl and $117/bbl on average for this year and next. Simulations of uncertain prices evolutions – i.e., evolutions we cannot attach a probability to at present – indicate upside price risk is dominant. This inclines us to remain long oil equities via the XOP ETF. We were tactically long 4Q22 and 1Q23 TTF futures until stop losses on both trades were elected on July 15th, generating returns of 89.6% and 83.1% respectively.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com     Commodities Round-Up Energy: Bullish Markets will await the conclusion of maintenance on the Nord Stream 1 (NS1) pipeline scheduled for this week. We continue to expect a cut-off of Russian natgas shipments to Europe, in addition to the 60% of volumes that already have been cut. In its latest GDP forecasts, the IMF expects EU GDP growth of 2.9% and 2.5% in 2022 and 2023, respectively. In and of itself, this would support our expectation for oil prices averaging $110/bbl and $117/bbl this year and next, as it is in line with the GDP forecast expected by the World Bank, which drives our forecasts. However, EU GDP still could contract in response to a complete shut-off of Russian gas imports in 2H22, particularly if it is sudden and prompts the EU to go to Phase 3 of its energy emergency plan and invoke gas rationing. EU gas inventories continue to build going into winter (Chart 8). Markets are critically dialed in to how the inventory builds ahead of winter proceed following NS1 maintenance: If it is delayed for technical reasons the storage fill rate will slow. Base Metals: Bullish China formally created a state-backed company to oversee all of its iron ore imports and overseas ore assets on Tuesday. The purpose of this company is to wrest pricing power away from iron ore suppliers – most of which are based in Australia – and reduce its reliance on Australian iron ore imports. A single buying entity will effectively create a monopsony, since China imports ~70% of global iron ore to supply its steel making industry, the largest in the world. Precious Metals: Bullish We have tactically downgraded our gold view on the back of continued USD strength. Reports of civil unrest in China – which was forecast by BCA’s Geopolitical Strategy - arising from the unfolding mortgage crisis likely will boost demand for gold, but it will boost demand for USD even more, in our view (Chart 9). We are closely monitoring this situation, along with possible increases in systemic financial risk in Chinese banks, which also would support USD demand. We remain strategically bullish gold. Chart 8 Chart 9       Footnotes 1     Please see OPEC+ agrees oil supply boost after UAE, Saudi reach compromise and U.S. to sell up to 45 mln bbls oil from reserve as part of historic release published by reuters.com on July 19, 2021 and June 14, 2022, respectively. OPEC 2.0 is our moniker for the producer coalition led by KSA and Russia; it also is referred to as OPEC+ in the media. 2     This could presage an unravelling of the status quo in the Middle East, as our colleagues at BCA Research’s Geopolitical Strategy highlight in their most recent report Questions From The Road published on July 15, 2022. 3    Please see Fracking Growth ‘Almost Impossible’ This Year, Halliburton Says, published by bloomberg.com on July 19, 2022. 4    Please see Recession Unlikely To Batter Oil Prices, which we published on June 16, 2022. It is available at ces.bcaresearch.com. 5    Running simulations is a good way to identify risks and at least have an intuition for where prices might go given difference evolutions of fundamentals. Please see Russia Pulls Oil, Gas Supply Strings for discussions and simulations of prices in response to different supply and shocks we ran last week. 6    The timing and depth of the shocks we simulate here are not assigned a probability to express our view of their likelihood. This reflects our belief that these are highly uncertain outcomes. That said, having an intuition for what to expect should the markets evolve in such a way as to create a probability one of these outcomes has become likely is useful. 7     The smaller EU economies are most at risk to sharp economic downturns from a cutoff in Russian gas exports, according to the IMF. The Fund estimates that in “Hungary, the Slovak Republic and the Czech Republic—there is a risk of shortages of as much as 40 percent of gas consumption and of gross domestic product shrinking by up to 6 percent.” Please see How a Russian Natural Gas Cutoff Could Weigh on Europe’s Economies published by the IMF on July 19, 2022. Investment Views and Themes Recommendations We were stopped out of our Long 4Q22 TTF Futures trade on July 15, with a return of 89.6%. We were stopped out of our Long 1Q23 TTF Futures trade on July 15, with a  return of 83.1%.  Strategic Recommendations Trades Closed in 2022

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: Can The Economy Recover Without Housing Revival The rebound in China’s business activity in June reflects the release of pent-up demand from the economic reopening after lockdowns in April and May. China’s credit growth recovered meaningfully in June due to large local government (LG) bond issuance. Private sector sentiment and credit demand remain sluggish. Home sales relapsed in the first two weeks of July after a one-off improvement in June, corroborating that the housing market’s fundamentals remain gloomy. Despite posting strong growth in June, Chinese exports are facing strong headwinds from weakening external demand. A contraction in exports is very likely in the second half of this year. Chinese domestic demand remains weak. Renewed rolling lockdowns are likely in view of the escalating Covid-19 cases related to a more infectious Omicron subvariant. The RMB will probably continue to depreciate relative to the US dollar in the next few months. Bottom Line: Investors should maintain a neutral stance on Chinese onshore stocks and an underweight stance on investable stocks in a global equity portfolio. The risk-reward profile of Chinese onshore and offshore stocks in absolute terms is not yet attractive.   Chart 1High-Frequancy(Daily) Economic Indicators The recent recovery in economic activity in June mainly reflects the release of pent-up demand after reopening from lockdowns in April and May. Odds are that this rebound will fade. The relapse in house sales and slowdown in steel production during the first two weeks of July suggest that China’s economy is still struggling to gain traction (Chart 1). China’s business cycle recovery will be more U shaped rather than a repeat of the V-shaped resurgence experienced following the early 2020 lockdown. At that time, a quick and strong revival in the property market and exports shored up China’s recovery in 2H20. In contrast, the economy’s progress in the second half of this year will be dragged down by shrinking exports, weak consumption and depressed demand for housing. China’s recovery will be more U shaped than V shaped for the following reasons: New financing schemes for infrastructure investment recently announced by authorities will not lead to a surge in infrastructure investments in 2H22. The basis is that these new funding sources will largely offset a shortfall in local government (LG) revenues from this year’s land sales, as we discussed in last week’s report. Thus, there will be little new stimulus for infrastructure beyond what was already approved in the budget plan earlier this year. Rolling lockdowns will persist as long as China’s stringent dynamic zero-Covid policy remains in place. The recent flare-up of the more infectious Omicron BA.5 subvariant cases in a few cities raise the likelihood of more lockdowns. The number of cities under mobility restrictions or some form of lockdown climbed during the second week of July (Chart 2). These cities account for around 11% of China’s GDP. The rolling lockdowns will continue to disrupt the economy. Private sector sentiment remains in the doldrums. The willingness to spend or invest among households and enterprises remains very depressed (Chart 3). This will ensure that the multiplier effect of fiscal and credit stimulus will be small. Chart 2The Odds Of Renewed Lockdowns Are Rising Chart 3Sluggish Sentiment Among Chinese Households And Enterprises Chart 4China: Can The Economy Recover Without Housing Revival Since 2008 there has been no recovery in the mainland economy without buoyant real estate construction and surging property prices (Chart 4).  Chinese exports are set to contract as the demand for goods from US and European consumers continues to shrink. ​​​​​ Bottom Line: In absolute terms, the risk-reward profile of Chinese stocks is not yet attractive. We continue to recommend that investors maintain a neutral stance on China’s onshore stocks and underweight allocation on Chinese investable stocks within a global equity portfolio.   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Peeling Off Credit Data Chart 5June's Credit Growth Was Largely Driven By LG Bond Issuance June’s strong credit growth was again driven by large LG bond issuance (Chart 5, top panel). Consequently, the credit impulse – calculated as a 12-month change in the flow of total social financing (TSF) as a percentage of nominal GDP – is much more muted when LG bond issuance is excluded (Chart 5, bottom panel). Medium- to long-term corporate loan growth only ticked up in June, but short-term bill financing has dropped dramatically (Chart 6). While it is difficult to quantify, it is highly likely that the modest upturn in corporate credit flow was due to (1) corporates’ pent-up demand for financing after the spring lockdowns and (2) the PBoC’s moral suasion used to boost the banks’ credit origination. Meanwhile, a PBoC survey released on June 29-30, showed that loan demand for all types of industrial enterprises plunged sharply in Q2, suggesting that sentiment is very weak among corporates (Chart 7). Chart 6Corporate Loan Growth Improved In June... Chart 7… But Corporate Loan Demand Remains Very Weak Household loan demand, which is highly correlated with home sales, remains shaky too (Chart 8, top panel). Medium- to long-term consumer loans continued to plunge, and the annual change in household loan origination remains negative (Chart 8, bottom panel). Chart 8Household Loan Demand Is Still Depressed Chart 9The Credit And Fiscal Impulse Will Be Moderate Overall, our projections for the combined credit and fiscal spending impulse for the rest of this year suggest that the aggregate fiscal and credit impulse will be improving but will be smaller than in 2020, 2016, 2013 and 2009 (Chart 9). Property Market: A Vicious Cycle Unfolding Home sales relapsed in the first two weeks of July after a one-off rebound in June. The weakness was broad-based across all city tiers. This implies that June’s bounce was driven by pent-up demand after lockdowns and does not represent a sustained revival (Chart 10). Sentiment among home buyers remains downbeat. The percentage of households planning to buy homes slipped further according to the PBoC’s urban household survey released on June 29 (Chart 11, top panel). Moreover, the percentage of households expecting home prices to rise has dived to the lowest level since early 2015 according to the same survey (Chart 11, bottom panel). Chart 10No Snapback In Housing Sales Chart 11Downbeat Sentiment Among Home Buyers Chart 12Real Estate Developers' Deteriorating Funding Will Further Dampen Housing Construction Property developers are caught in a vicious cycle.  Financing has not strengthened because the “three red lines” policy remains in place, and developers’ borrowing from banks shows no signs of amelioration (Chart 12, top panel). Critically, the plunge in the sector’s financing is resulting in shrinking housing completions (Chart 12, bottom panel). As property developers are suffering from liquidity shortages, they are dragging on existing construction projects. The upshot is that many Chinese cities are seeing delays in the completion of new homes. The latter is depressing buyers’ sentiment, generating a reluctance to buy properties, and curtailing deposits and advances to developers. In recent years, deposits and advances accounted for 50% of property developers’ financing. Without a substantial improvement in their financing, developers will not be in a position to service their excessive debts and deliver houses they have presold in the recent years. The latter will undermine their financing, closing the vicious cycle. In short, real estate developers’ liquidity shortfalls are evolving into solvency problems. These will continue dampening construction activity. An Export Contraction Ahead China’s exports were robust in June as supply chain and logistic disruptions faded. This was corroborated by last month’s advance in suppliers’ delivery times and production subindexes of China’s official Purchasing Managers’ Index (PMI) (Chart 13). Chart 13Chinese Logistics And Backlog Orders Pressures Have Eased In June Yet, China’s new exports orders remain in contractionary territory (Chart 14). Moreover, the softness of Shanghai’s export container freight index is also signaling weakness in China’s exports (Chart 15).   Chart 14External Demand For Chinese Export Goods Will Be Dwindling Chart 15Signs Of Moderation In China's Exports The shift in consumer spending in developed economies from manufactured goods to services has created headwinds for Chinese exports. US and European consumption of goods (ex-autos) is set to decline below its long-term trend (Chart 16). Given that retail inventories in the US have skyrocketed well above their pre-pandemic trend, US demand for consumer goods and, hence, Chinese exports will dwindle significantly when US retailers start to destock (Chart 17). Falling real household disposable income in the US and Europe will also fortify the downward trend in demand for consumer goods that China is a major producer of. Therefore, we expect shrinking Asian and Chinese exports in the second half of this year. Chart 16Developed Economies’ Household Demand For Goods ex-Autos Will Shrink Chart 17Well-Stocked Shelves In The US Bode Poorly For Chinese Exports Very Sluggish Domestic Demand Both consumer spending and capital expenditure remain in the doldrums. Traditional infrastructure investments picked up strongly in June, while investments in the real estate sector weakened further (Chart 18). Contracting exports will weigh on investments in manufacturing. Even as infrastructure investment recovers modestly, the downtrend in manufacturing and property fixed-asset investments will cap China’s capital spending in 2H22. Capital spending in traditional infrastructure, real estate and manufacturing account for 24%, 19% and 31% of fixed-asset investment, respectively. Chart 18Shrinking Real Estate Investment Will Remain A Drag On Chinese Investment Growth In 2H Chart 19Contracting Import Volume Reflects China's Sluggish Domestic Demand Imports for domestic consumption (excluding imports for processing and re-exports) are a good proxy for domestic demand trajectory. In June, import volumes contracted deeply at 12% on a year-on-year basis, reflecting sluggish domestic demand (Chart 19). Worryingly, import volume contraction is widespread from key commodities to semiconductors and capital goods (Chart 20A and 20B). Chart 20ABroad-Based Contraction In Imports Chart 20BBroad-Based Contraction In Imports Chart 21Rising New Covid Cases In China Will Constrain Domestic Consumption Recovery Moreover, the recent increase in Covid-19 cases and ensuing lockdowns in China will curb household consumption and the service sector’s activities in the next few months (Chart 21). Newly released labor market data show a mixed picture. The nationwide urban survey-based unemployment rate fell in June, but the unemployment rate among younger workers surged to the highest point since data collection began in 2018 (Chart 22, top panel). Reflecting weak employment conditions, new urban job creation in the first half of the year withered compared with the same period last year (Chart 22, bottom panel). Rapidly deteriorating income prospects are reinforcing households’ downbeat sentiment. A PBoC survey released on June 29 shows that confidence of future income in Q2 plummeted to its lowest level during the past two decades, while the preference for more saving deposits soared to the highest level since data collection began in 2002 (Chart 23). The latter entails that households’ consumption recovery will be gradual and halting, at best, in the second half of this year.  Chart 22Skyrocketed Unemployment Rate Among Young Workers Is A Big Problem Of Chinese Labor Market Chart 23Low Confidence In Future Income Contributes To Households' Unwillingness To Consume The RMB Is Facing Downside Risks In The Near Term Chart 24RMB Is Still Vulnerable The RMB has depreciated by about 6% against the US dollar since March, and we believe this trend will continue in the next few months. China’s interest rate differential versus the US dollar has fallen deeper into negative territory, and the gap may widen even more given that the inflation and monetary policy cycles in China and the US will continue to diverge (Chart 24, top panel). Thus, Chinese fixed-income market outflow pressures could endure this year (Chart 24, bottom panel). Moreover, as discussed in the section above, Chinese exports are set to shrink in the second half of the year. This will also weigh on the RMB. Notably, Chinese companies have started to increase their demand for USD. The net FX settlement rate by banks on behalf of clients has fallen below zero, albeit only marginally (Chart 25). This means more non-financial enterprises (such as exporters and investors) bought from than sold foreign currency to banks (Chart 25, bottom panel). Furthermore, foreign outflows from the onshore equity market have resumed and will likely be sustained, at least through the next few months (Chart 26). Foreign investors will likely flee from Chinese onshore stocks as global stocks continue selling off and China’s economic recovery disappoints in the second half of this year. Chart 25Contracting Exports Will Weigh On The RMB Chart 26Onshore Equity Market Foreign Outflow Pressures Remain, At Least In The Near Term Chinese Equity Market Technicals: Tell-Tale Signs Chart 27A-Shares Has Not Broken Above 200-Day Moving Average The rebound in China’s onshore CSI 300 stock index had been obstructed at its 200-day moving average (Chart 27). A failure to break above this technical resistance would imply non-trivial downside – a retest of its recent lows, at least. The relative performance of the MSCI China All-Share Index – which includes all onshore- and offshore-listed stocks – versus the global equity index has petered off at its previous troughs (Chart 28). This is a tell-tale sign of a major relapse. Chart 28A Tell-Sign Of Major Downtrend Chart 29Chinese Tech Stocks Still Appear Fragile The Hang Seng Tech index – which tracks Chinese offshore tech stocks/platform companies – has also failed to break above its 200-day moving average (Chart 29). This entails that the bear market in these share prices might not be yet over. Chart 30Two Large-Cap Chinese Stocks China’s two largest stocks (by market capitalization) – Tencent and Alibaba – may not be out of the woods:  Alibaba has failed at its 200-day moving average (Chart 30, top panel). Tencent has failed to rebound at all (Chart 30, bottom panel). Odds are it will likely drop more.   Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Footnotes Strategic Themes Cyclical Recommendations