Emerging Markets

Executive Summary If a loss of wealth persists for a year or more, it hurts the economy. The recent $40 trillion slump in global financial wealth is larger than that suffered in the pandemic of 2020, the global financial crisis of 2008, and the dot com bust of 2000-01. Partly countering this slump in global financial wealth is a $20 trillion uplift in global real estate wealth. However, Chinese home prices are already stagnating. And the recent disappearance of US and European homebuyers combined with a flood of home-sellers warns that US and European home prices will cool over the next 6 months. With the loss of wealth likely to persist, it will amplify a global growth slowdown already in train, aided and abetted by central banks that are willing to enter recession to slay inflation. The optimal asset allocation over the next 6-12 months is: overweight bonds, neutral stocks, and underweight commodities. A variation on this theme is: overweight conventional bonds and stocks versus inflation-protected bonds and commodities. Fractal trading watchlist: US telecoms versus utilities, and copper. We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation The World Is $20 Trillion Poorer. Why That Matters The World Is $20 Trillion Poorer. Why That Matters Bottom Line: On a 6-12 month horizon, overweight bonds, neutral stocks, and underweight commodities. Feature Since the end of last year, the world has lost $40 trillion of financial wealth, evenly split between the crashes in stocks and bonds (Chart I-1). The slump in financial wealth, both in absolute and proportionate terms, is the worst suffered in a generation, larger than that in the pandemic of 2020, the global financial crisis of 2008, and the dot com bust of 2000-01.1 Chart I-1Global Stocks And Global Bonds Have Both Slumped By $20 Trillion Global Stocks And Global Bonds Have Both Slumped By $20 Trillion Global Stocks And Global Bonds Have Both Slumped By $20 Trillion Partly countering this $40 trillion slump in global financial wealth is a $20 trillion uplift in global real estate wealth. But in total, the world is still $20 trillion ‘asset poorer’ than at the end of last year. Given that global GDP is around $100 trillion, we can say that we are asset poorer, on average, by about one fifth of our annual income. Does this loss of wealth matter? A Loss Of Wealth Matters If It Persists For A Year Or More Some argue that we shouldn’t worry about the recent slump in our wealth, because we are still wealthier than we were, say, at the start of the pandemic (Chart I-2). Yet this is a facile argument. Whatever loss of wealth we suffer, there is always some point in the past against which we are richer! Chart I-2We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation We Have Just Suffered The Worst Loss Of Financial Wealth In A Generation Another argument is that people do not care about a short-lived dip in their wealth. This argument has more truth to it. For example, in the extreme event of a flash crash, an asset price can drop to zero and then bounce back in the blink of an eyelid. In this case, most people would be oblivious, or unconcerned, by this momentary collapse in their wealth. But people do care if the slump in their wealth becomes more prolonged. How long is prolonged? The answer is, if the slump persists for a year or more. Why a year? Because that is the timeframe over which governments, firms, and households make their income and spending plans. Governments and firms do this formally in their annual budgets that set tax rates, wages, bonuses, and investment spending. Households do it informally, because their wages, bonuses, and taxes – and therefore disposable incomes – also adjust on an annual basis. Into this yearly spending plan will also come any change in wealth experienced over the previous year. For example, firms often do this formally by converting an asset write-down to a deduction from profits, which will then impact the firm’s future spending. This illustrates that what impacts your spending is not the level of your wealth, but the yearly change in your wealth. Spending Is Impacted By The Change In Wealth The intellectual battle here is between Economics and Psychology. The economics textbooks insist that it is the level of your wealth that impacts your spending, whereas the psychology and behavioural finance textbooks insist that it is the change in your wealth that impacts your spending. (Chart I-3and Chart I-4). In my view, the psychologists and behavioural finance guys have nailed this better than the economists, through a theory known as Mental Accounting Bias. Chart I-3The Change And Impulse Of Stock Market Wealth Are Both Negative The Change And Impulse Of Stock Market Wealth Are Both Negative The Change And Impulse Of Stock Market Wealth Are Both Negative Chart I-4The Change And Impulse Of Bond Market Wealth Are Both Negative The Change And Impulse Of Bond Market Wealth Are Both Negative The Change And Impulse Of Bond Market Wealth Are Both Negative Nobel Laureate psychologist Daniel Kahneman points out that we categorise our money into different accounts, which are sometimes physical, sometimes only mental – and that there is a clear hierarchy in our willingness to spend these ‘mental accounts’. Put simply, we are willing to spend our income mental account, but we are much less willing to spend our wealth mental account. Still, wealth can generate income through interest payments and dividends, which we are willing to spend. Clearly, the level of income generated will correlate with the amount of wealth – $10 million of wealth will likely generate much more income than $1 million of wealth. So, economists get the impression that it is the level of wealth that impacts spending, but the truth is that it is the income generated by the wealth that impacts spending.    We are willing to spend our income ‘mental account’, but we are much less willing to spend our wealth ‘mental account’. What about someone like Amazon founder Jeff Bezos who has immense wealth but seemingly negligible income – Mr. Bezos receives only a token salary, and his huge holding of Amazon shares pays no dividend – how then can we explain his largesse? The answer is that Mr. Bezos’ immense wealth generates tens of billions in trading income. So again, it is his income that is driving his spending. Wealth also generates an ‘income substitute’ via capital gains. For example, you should be indifferent between a $100 bond giving you $2 of income, or a $98 zero-coupon bond maturing in one year at $100, giving you $2 of capital gain. In this case the capital gain is simply an income substitute and fully transferred into the spending mental account. Nowhere is this truer than in China, where the straight-line appreciation in house prices through several decades has allowed homeowners to regard a reliable capital gain as an income substitute (Chart I-5). Which justifies rental yields on Chinese housing that are the lowest in the world and lower even than the yield on risk-free cash. In other words, which justifies a stratospheric valuation for Chinese real estate. Image Usually though, we tend to transfer only a proportion of our capital gains or losses into our spending mental account. As described previously, a firm will do this formally by transferring an asset write-down into the income statement. And households will do it informally by transferring some proportion of their yearly change in wealth into their spending mental account. The important conclusion is that spending is impacted by the yearly change in wealth. Meaning that spending growth is impacted by the yearly change in the yearly change in wealth, known as the wealth (1-year) impulse, where a negative impulse implies negative growth. Cracks Appearing In The Housing Market Given the recent slump in financial wealth, the global financial wealth impulse is in deeply negative territory. Yet by far the largest part of our wealth comprises housing, meaning the value of our homes2 (Chart I-6). In China, the recent stagnation of house prices means that the housing wealth impulse has turned negative. Elsewhere in the world though, the recent boom in house prices means that the housing wealth impulse is still positive, meaning a tailwind – albeit a rapidly fading tailwind – to spending (Chart I-7 and Chart I-8). Chart I-6Housing Comprises By Far The Largest Part Of Our Wealth Housing Comprises By Far The Largest Part Of Our Wealth Housing Comprises By Far The Largest Part Of Our Wealth Chart I-7Chinese House Prices Have Stagnated, US House Prices Have Surged The World Is $20 Trillion Poorer. Why That Matters The World Is $20 Trillion Poorer. Why That Matters Chart I-8The Chinese Housing Wealth Impulse Is Negative, The US Housing Wealth Impulse Is Fading The Chinese Housing Wealth Impulse Is Negative, The US Housing Wealth Impulse Is Fading The Chinese Housing Wealth Impulse Is Negative, The US Housing Wealth Impulse Is Fading In China, the recent stagnation of house prices means that the housing wealth impulse has turned negative. Still, as we explained in The Global Housing Boom Is Over, As Buying Becomes More Expensive Than Renting, the disappearance of homebuyers combined with a flood of home-sellers is a tried and tested indicator that US and European home prices will cool over the next 6 months. US new home prices have already suffered a significant decline in June (Chart I-9). Some of this is because US homebuilders are building smaller and less expensive homes. Nevertheless, it seems highly likely that the non-China housing wealth impulse will also turn negative later this year. Chart I-9US New Home Prices Fell Sharply In June US New Home Prices Fell Sharply In June US New Home Prices Fell Sharply In June To be clear, the wealth impulse is just one driver of spending growth. Nevertheless, it does have the potential to amplify the growth cycle in either direction. With global growth clearly slowing, and central banks willing to enter recession to slay inflation, the rapidly fading global wealth impulse will amplify the slowdown. Therefore, the optimal asset allocation over the next 6-12 months is: Overweight bonds. Neutral stocks. Underweight commodities. A variation on this theme is: Overweight conventional bonds and stocks versus inflation-protected bonds and commodities. Fractal Trading Watchlist After a 35 percent decline since March, copper has hit a resistance point on its short-term fractal structure, from which it could experience a countertrend move. Hence, we are adding copper to our watchlist. Of note also, the underperformance of US telecoms versus utilities has reached the point of fragility on its 260-day fractal structure that has signalled previous major turning points in 2012, 2014, and 2017 (Chart I-10). Hence, the recommended trade is long US telecoms versus utilities, setting a profit target and symmetrical stop-loss at 8 percent. Chart I-10US Telecoms Versus Utilities Are At A Potential Turnaround US Telecoms Versus Utilities Are At A Potential Turnaround US Telecoms Versus Utilities Are At A Potential Turnaround Fractal Trading Watchlist: New Additions Copper’s Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1     The value of global equities has dropped by $20tn to $80tn, the value of global bonds by $20tn to around $100tn, while the value of global real estate has increased by $20tn to an estimated $370tn. 2     Strictly speaking, housing wealth should be measured net of the mortgage debt that is owed on our homes. But as the wealth impulse is a change of a change, and mortgage debt changes very slowly, it does not matter whether we calculate the impulse from gross or net housing wealth. Chart 1CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point CNY/USD At A Potential Turning Point Chart 2Copper's Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Copper's Selloff Has Hit Short-Term Resistance Chart 3US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 4CAD/SEK Is Reversing CAD/SEK Is Reversing CAD/SEK Is Reversing Chart 5Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Financials Versus Industrials Has Reversed Chart 6The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended The Outperformance Of Resources Versus Biotech Has Ended Chart 7The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended The Outperformance Of Resources Versus Healthcare Has Ended Chart 8FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 9Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Netherlands' Underperformance Vs. Switzerland Has Ended Chart 10The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 11The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 12Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Food And Beverage Outperformance Is Exhausted Chart 13German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse German Telecom Outperformance Has Started To Reverse Chart 14Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Chart 15ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation ETH Is Approaching A Possible Capitulation Chart 16The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 17The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 18A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 19Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 20Norway's Outperformance Has Ended Norway's Outperformance Has Ended Norway's Outperformance Has Ended Chart 21Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Cotton Versus Platinum Has Reversed Chart 22Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Switzerland's Outperformance Vs. Germany Is Exhausted Chart 23USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal USD/EUR Is Vulnerable To Reversal Chart 24The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 25A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 26GBP/USD At A Potential Turning Point GBP/USD At A Potential Turning Point GBP/USD At A Potential Turning Point Chart 27US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 28The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted The Outperformance Of Oil Versus Banks Is Exhausted   Fractal Trading System Fractal Trades The World Is $20 Trillion Poorer. Why That Matters The World Is $20 Trillion Poorer. Why That Matters The World Is $20 Trillion Poorer. Why That Matters The World Is $20 Trillion Poorer. Why That Matters 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area     Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed     Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations     Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations    

Executive Summary   Copper prices still face substantial downside (15-20% from current levels). The global copper market is shifting from a deficit to a considerable surplus over the next 12 to 18 months. Global copper supply will likely grow by 4-4.5% year on year in both 2022H2 and 2023, surpassing global copper demand growth of 2-3% during the same period. Global copper ore output will increase thanks to a slew of new projects and expansions this year and next year. Regarding copper demand in 2022H2 and 2023, China will be the main driver due to a moderate boost in traditional infrastructure investment, an acceleration in the build-up of green sources of electricity generation and surging penetration of new energy vehicles (NEV). Global Copper Supply Balance: Shifting From A Deficit To A Surplus Global Copper Supply Balance: Shifting From A Deficit To A Surplus Global Copper Supply Balance: Shifting From A Deficit To A Surplus Bottom Line: According to our projections, the global copper market will move from a deficit to a material surplus later this year and in 2023. This will continue weighing on copper and related equity prices.     Even though copper prices have plunged over 30% from their peak, we expect them to fall further (Chart 1). Chart 1Copper Prices & Copper Mining Stocks: The Decline Is Not Over Copper Prices & Copper Mining Stocks: The Decline Is Not Over Copper Prices & Copper Mining Stocks: The Decline Is Not Over The main reason is that the global copper market will swing from a deficit to a surplus over the next 12 to 18 months (Chart 2). Global copper output growth is currently accelerating and will average 4% in 2022 and 4.5% in 2023. This will outpace the 2-3% annual growth in global copper demand during the same period. Chart 2Global Copper Supply Balance: Shifting From A Deficit To A Surplus Global Copper Supply Balance: Shifting From A Deficit To A Surplus Global Copper Supply Balance: Shifting From A Deficit To A Surplus Beware Of Rising Copper Supply In 2022-23 The global copper market balance is in the process of swinging from a 283,000-ton deficit at the end of 2021 to a 464,000-ton surplus at the end of 2023, based on our calculations. In comparison, the International Copper Study Group (ICSG) expects a smaller surplus of 350,000 tons next year. There are two key estimates for our global copper supply balance calculation. Supply We expect global copper output to grow at 4% in 2022 and a slightly faster rate of 4.5% in 2023 as many new mines/expansions are coming on stream. Table 1 lists 12 major global copper mines that will add new copper ore supply in 2022. The combined copper ore output of these projects will increase the global copper ore supply by about 4.5% this year. Table 1Major Global New Copper Ore Supply In 2022 Global Copper Market: No Bottom Yet Global Copper Market: No Bottom Yet Robust copper ore production growth in the Democratic Republic of Congo (Congo), Zambia, Peru and China will boost the global copper ore supply in the next 12 to 18 months. Congo has been the largest contributor to global copper ore growth, accounting for over 60% of the increase in global copper ore output during the past five years. This country has already become the third largest producer of copper ore in the world. Chart 3Congo, Zambia and Peru Will Continue Boosting Their Copper Ore Supply Congo, Zambia and Peru Will Continue Boosting Their Copper Ore Supply Congo, Zambia and Peru Will Continue Boosting Their Copper Ore Supply Its Kamoa-Kalula copper mine listed in Table 1 began producing copper concentrates in May 2021 and its production will increase exponentially into 2023 (Chart 3, top panel). Zambia is another country with substantial potential for copper ore output (Chart 3, middle panel). President Hakainde Hichilema, who was elected last year, expects to increase the country’s annual copper ore production from 800,000 tons to three million tons in terms of copper content in 10 years. This will translate into new supply of 220,000 tons per year and constitutes about 1% growth in global copper ore supply this year and next year.  Peru is the world’s second largest copper ore producer. Despite the number of strikes rising in past two years, the country's copper ore output has stayed at a near historical high level (Chart 3, bottom panel).  China, which is the world’s fourth largest producer, is also set to boost its copper ore output within the next few years. The increase in supply will be driven by the construction of Tibet's Qulong copper mine, the second phase expansion of the Duobaoshan and the Jiama copper mines, and the Chifeng Fubo project. Chart 4New Mines Are Also Coming On Stream In Chile, Australia and Canada New Mines Are Also Coming On Stream In Chile, Australia and Canada New Mines Are Also Coming On Stream In Chile, Australia and Canada Copper ore output in other top producers such as Chile, Australia and Canada have already declined considerably in the past several years due to lower ore quality, the pandemic, drought, and protests (Chart 4). Nevertheless, new mines coming on stream will likely prevent copper ore output from falling further in these countries. For example, the Australian government expects the country’s copper mine output to increase by 15% in the 2022-2023 financial year and by another 7% in the 2023-2024 financial year. Regarding Chile, the world’s largest copper ore producer (representing 26% of the world total), we expect copper ore output to increase over the next 12 to 18 months after declining for three consecutive years. The reason for this optimism is that the Quebrada Blanca Phase 2 (QB2) project is expected to begin production in the second half of 2022. The company estimates that QB2 copper output over the first five years will average 286,000 tons per year. This is equal to 1.3% of annual global copper output. The same company is also considering a third phase for the project, which could significantly boost capacity in the longer term. That said, investments in Chilean copper mining may struggle over the long term if the proposed mining royalties increase1 gets passed in September. Table 2The World’s Top 10 Copper Producing Companies’ Capex investment In 2022 & 2023 Global Copper Market: No Bottom Yet Global Copper Market: No Bottom Yet At a company level, Table 2 shows that the capex of the world’s top 10 copper producing companies has been planned to increase by 21% in 2022 and remain at an elevated level in 2023. Such large capex seems to support the strong copper ore output growth forecasts shown in Table 1.   Demand We expect global copper consumption to grow by 2.5% in 2022 and a slightly higher rate of 3% in 2023. Table 3 shows our growth estimates for this year and next year for China, the US, the EU, and the rest of world. This year and in 2023, red metal consumption will likely rebound in China and will experience a slowdown in the rest of the world (Chart 5). We expect copper demand growth in China to recover from last year’s contraction to post 3% growth this year and then accelerate to 4% in 2023. A detailed discussion of Chinese copper demand is presented below. Copper demand growth in both the US and the EU is set to slow as their pandemic-triggered overspending on goods ex-autos has run its course (Chart 6). Given that the US lags the EU in terms of NEV sales/production and new energy development, we expect a lower growth in the US (0-2%) versus in the EU (2-4%). The ongoing energy crisis in the EU has incentivized the bloc to expedite its transition to green sources of energy. As a result, its copper demand will rise faster than copper demand in the US. Chart 5Global Copper Consumption: A Moderate Rise Across Regions Global Copper Consumption: A Moderate Rise Across Regions Global Copper Consumption: A Moderate Rise Across Regions Chart 6Decelerating Copper Demand Growth In The US and The EU Decelerating Copper Demand Growth In The US and The EU Decelerating Copper Demand Growth In The US and The EU Using these economies’ respective shares in global copper consumption in 2021, we estimate global copper consumption growth of 2.5% for 2022 and 3% for 2023 (Table 3). We are well aware that global copper demand from green sources – electric vehicles, wind turbines, solar panels and charging poles – will continue booming. Yet, their share of global copper consumption is about 4.2% according to our estimates (Table 4). It is too small to have any substantial effect on global copper demand in next 18 months. Table 3Global Copper Consumption Growth Forecast For 2022 & 2023 Global Copper Market: No Bottom Yet Global Copper Market: No Bottom Yet Table 4Global Green Demand For Copper Global Copper Market: No Bottom Yet Global Copper Market: No Bottom Yet Bottom Line: Global copper demand growth will likely fall short of copper supply in the next 18 months. Consequently, we expect the global copper market to swing from a supply deficit to a supply surplus over the next 12 to 18 months. Chinese Copper Demand Why do we expect Chinese copper demand to grow at 3% in 2022 and 4% in 2023?  Table 5 illustrates our rough estimates of the copper consumption growth from China’s main sources of red metal consumption.  Table 5Chinese Underlying Copper Consumption: Growth Estimates For 2022 & 2023 Global Copper Market: No Bottom Yet Global Copper Market: No Bottom Yet The power sector is the largest copper user as this metal is among the best conductors of electricity. The metal is used in high-, medium-, and low-voltage power networks. Chart 7The Power Sector Will Be The Main Driver Of Chinese Copper Demand The Power Sector Will Be The Main Driver Of Chinese Copper Demand The Power Sector Will Be The Main Driver Of Chinese Copper Demand Authorities will ensure a rapid expansion of renewable energy like wind power and solar power, as well as continue construction of smart power grids as the country strives to achieve its ambitious targets for 2030 peak carbon dioxide emissions and 2060 net-zero carbon dioxide emissions. Investment in the new and old power sector grew by about 4% y/y in nominal terms in the past 12 months (Chart 7). Production of power generation equipment output has risen by 8% y/y in real terms during the same period. All together, we forecast that the copper consumption from the power sector will grow by approximately 5% year on year both this year and next year. Chart 8Mean-Reversion IN The Appliance Sector Mean-Reversion IN The Appliance Sector Mean-Reversion IN The Appliance Sector The output of air conditioner, freezer and refrigerator production are all currently in contraction (Chart 8). The global “stay-at-home” economy significantly boosted Chinese exports of air conditioners, freezers, and refrigerators in 2020 and 2021. These appliances are all durable goods, and consumers who had already purchased them are unlikely to buy again this year and next year. Thus, we expect a 3% contraction in copper use this year and a slight growth of 2% next year from this industry Capital expenditures in the transportation network will improve from current zero growth, and production of traditional automobiles may increase again (Chart 9). Meanwhile, NEV output and construction of charging poles will continue booming (Chart 10). NEV uses more copper per car than the traditional autos, and charging poles also use copper. Putting all this together, we forecast a 3% and 4% year-on-year growth of copper consumption in the transportation sector in 2022 and 2023, respectively. Assuming there will be two million more NEVs this year, copper use will increase by an additional 160,000 tons, equaling to about a 1.2% increase in Chinese copper consumption. Chart 9Copper Demand From The Transportation Sector: Supported By Rebounding Traditional Auto Sales... Copper Demand From The Transportation Sector: Supported By Rebounding Traditional Auto Sales... Copper Demand From The Transportation Sector: Supported By Rebounding Traditional Auto Sales... Chart 10...As Well As Surging NEV Sales ...As Well As Surging NEV Sales ...As Well As Surging NEV Sales Copper or copper base alloys are used in printed circuit boards, electronic connectors, as well as in many semiconductor products. The tech-related new infrastructure, which includes information transmission, software, and information technology services, such as 5G networks, industrial internet, and data centers, will remain the government’s focus in the coming years. Tech-related new infrastructure investment increased by 20% year on year in the January – June period (Chart 11). We expect year-on-year copper usage growth in this sector to be 15% in 2022 and 12% in 2023. Chart 11Copper Demand Will Benefit From Strong Tech Investment Copper Demand Will Benefit From Strong Tech Investment Copper Demand Will Benefit From Strong Tech Investment Chart 12Chinese Property Market Is Negative For Copper Demand Chinese Property Market Is Negative For Copper Demand Chinese Property Market Is Negative For Copper Demand   The Chinese property market is in deep trouble. Our broad measure of China’s building construction activity/building area starts contracted 15% year on year in the second quarter of this year, and completions grew only moderately at 5% during the same period (Chart 12). Assuming half of this sector’s usage is in building area starts and the other half in completions, we expect the copper consumption in this sector to contract by 10% y/y in 2022. Next year, we expect the contraction to narrow to 5% as the government implements policies to support completions. Bottom Line: Chinese copper demand will increase moderately by 3% in 2022 and 4% in 2023. Investment Implications The global copper market is moving towards a surplus. This is one of reasons behind the red metal’s 30% price plunge since March 4, 2022. Copper inventories on global exchanges are low. Yet, that is not a sufficient reason to be bullish on copper prices as we elaborate in Box 1. Box 1 What About Copper Inventories? We believe inventory data released by exchanges – LME, COMEX and Shanghai Futures Exchange - do not provide a full picture of copper inventories. First, troughs in copper inventories – often but not always – coincide with peaks in copper prices and tops in inventories with bottoms in their prices (Chart 13). Hence, low inventory levels are not a reason to be bullish on copper prices. Chart 13Level of Copper Inventories In Exchanges Is Not A Good Forward-looking Indicator For Prices Copper Inventories In Exchanges: These Do Not Provide A Full Picture Of Copper Inventories Copper Inventories In Exchanges: These Do Not Provide A Full Picture Of Copper Inventories Second, inventory data from commodity exchanges may overstate the supply tightness as there might have been some build-up in unreported inventories. The basis is that many end-users (companies) around the world might purchase copper for the purposes of hoarding and speculation. These inventories are not counted in the data published by commodity exchanges.   Chart 14Copper: Bearish Sentiment Is Not Extreme Yet Copper: Bearish Sentiment Is Not Extreme Yet Copper: Bearish Sentiment Is Not Extreme Yet Net speculative positions of copper in the US as a share of total open interest have already tanked to near multi-year low levels (Chart 14, top panel). However, bearish sentiment is still far from the extreme level (Chart 14, bottom panel). Putting all together, copper prices are vulnerable to the downside over the next 6 to 12 months. We expect a 15%-20% downside in copper prices from the current level. Shares prices of copper miners always move closely with red metal prices. Equity portfolios should underweight copper miners.   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Footnotes 1     The proposed tax reform applies to copper producers of more than 50,000 tons and combines the ad-valorem component based on the copper price with a tax based on mining operating margins (MOM). The ad-valorem component has two regimes depending on whether the production volume is above or below 200,000 tons. For the larger producers, the effective rate applied will move in a range of 1% to 4% of revenue depending on the copper price, while below 200,000 tons the rate will be between 1.0% and 1.6% of revenue. Source: "Proposed Tax Reform Weakens Cost Positions for Chilean Miners,” Fitch Ratings, July 7, 2022, www.fitchratings.com. Strategic Themes Cyclical Recommendations

Executive Summary Iran Reaches Nuclear Breakout Biden And Putin Court The Middle East Biden And Putin Court The Middle East The next geopolitical crisis will stem from the Middle East. The US, Russia, and China are striving for greater influence there and Iran’s nuclear quest is reaching a critical juncture. The risk of US-Israeli attacks against Iran remains 40% over the medium term and will rise sharply if Iran attempts to construct a deliverable nuclear device. Saudi Arabia may increase oil production but only if global demand holds up, which OPEC will assess at its August 3 meeting. Global growth risks will prevail in the short term and reduce its urgency. Russia will continue to squeeze supplies of energy and food for the outside world. The restart of Nord Stream 1 and the Turkey-brokered grain export proposal are unreliable signals. Russia’s aim is victory in Ukraine and any leverage will be used. The US may be done with the Middle East but the Middle East may not be done with the US. Structurally we remain bullish on gold and European defense stocks but we are booking 17% and 18% gains on our current trades. The deterioration in global growth and likely pullback in inflation will temporarily undercut these trades. Tactical Recommendation Inception Date Return LONG GOLD (CLOSED) 2019-06-12 17.1% LONG EUROPEAN AEROSPACE & DEFENSE / EUROPEAN TECH EQUITIES (CLOSED) 2022-03-18 17.9% Bottom Line: Global demand is weakening, which will weigh on bond yields and commodities. Yet underlying oil supply constraints persist – and US-Iran conflict will exacerbate global stagflation. Feature Chart 1Equity Volatility And Oil Price Volatility Equity Volatility And Oil Price Volatility Equity Volatility And Oil Price Volatility US President Joe Biden visited Saudi Arabia last week in a belated attempt to make amends with OPEC, increase oil production, and reduce inflation ahead of the midterm election. Biden also visited Israel to deter Iran, which is the next geopolitical crisis that markets are underrating. Meanwhile Russian President Vladimir Putin went to Iran on his second trip outside of Russia since this year’s invasion of Ukraine. Putin sought an ally in his conflict with the West, while also negotiating with Turkish President Recep Erdogan, who sought to position himself as a regional power broker. In this report we analyze Biden’s and Putin’s trips and what they mean for the global economy and macro investors. Macroeconomics is bearish for oil in the short term but geopolitics is bullish for oil in the short-to-medium term. The result is volatility (Chart 1). OPEC May Pump More Oil But Not On Biden’s Time Frame Here are the important developments from Biden’s trip: A credible threat against Iran: The US and Israel issued a joint declaration underscoring their red line against Iranian nuclear weaponization.1 Meanwhile the Iranians claimed to have achieved “nuclear breakout,” i.e. enough highly enriched uranium to construct a nuclear device (Chart 2). A balance-of-power coalition to contain Iran: Israel and Saudi Arabia improved relations on the margin. Each took action to build on the strategic détente between Israel and various Arab states that is embodied in the 2020 Abraham Accords.2 This strategic détente has staying power because it is a self-interested attempt by the various nations to protect themselves against common rivals, particularly Iran (Chart 3). Biden also tried to set up a missile defense network with Israel and the Arabs, although it was not finalized.3 Chart 2Iran Reaches Nuclear Breakout Biden And Putin Court The Middle East Biden And Putin Court The Middle East A reaffirmed US-Saudi partnership: The US and Saudi Arabia reaffirmed their partnership despite a rocky patch over the past decade. The rocky patch arises from US energy independence, China’s growth, and US attempts to normalize ties with Iran (Chart 4). These trends caused the Saudis to doubt US support and to view China as a strategic hedge. Chart 3Iran: Surrounded And Outgunned Biden And Putin Court The Middle East Biden And Putin Court The Middle East ​​​​​​ President Biden came into office aiming to redo the Iran deal and halt arms sales to Saudi Arabia. Since then he has been chastened by high energy prices, a low approval rating, and hawkish Iranian policy. On this trip he came cap in hand to the Saudis in a classic example of geopolitical constraints. If the US-Iran deal is verifiably dead, then US-Saudi ties will improve sustainably. (Though of course the Saudis will still do business with China and even start trading with China in the renminbi.) What global investors want to know is whether the Saudis and OPEC will pump more oil. The answer is maybe someday. The Saudis will increase production to save the global business cycle but not the Democrats’ election cycle. They told Biden that they will increase production only if there is sufficient global demand. Global Brent crude prices have fallen by 6% since May, when Biden booked his trip, so the kingdom is not in a great rush to pump more. Its economy is doing well this year (Chart 5). Chart 4Drivers Of Saudi Anxiety Drivers Of Saudi Anxiety Drivers Of Saudi Anxiety ​​​​​ Chart 5Saudis Won't Pump If Demand Is Weak Saudis Won't Pump If Demand Is Weak Saudis Won't Pump If Demand Is Weak ​​​​​​ At the same time, if global demand rebounds, the Saudis will not want global supply constraints to generate punitive prices that cap the rebound or kill the business cycle. After all, a global recession would deplete Saudi coffers, set back the regime’s economic reforms, exacerbate social problems, and potentially stir up political dissent (Chart 6). Related Report  Geopolitical StrategyThird Quarter Geopolitical Outlook: Thunder And Lightning Hence the Saudis will not increase production substantially until they have assessed the global economy and discussed the outlook with the other members of the OPEC cartel in August and September, when the July 2021 agreement to increase production expires. We expect global demand to weaken as Europe and China continue to struggle. Our Commodity & Energy Strategist Bob Ryan argues that further escalation in the energy war between the EU and Russia could push prices above $220 per barrel by Q4 2023, whereas an economic collapse could push Brent down to $60 per barrel. His base case Brent price forecast remains $110 per barrel on average in 2022 and $117 per barrel in 2023 (Chart 7). Chart 6Saudis Will Pump To Prevent Recession Saudis Will Pump To Prevent Recession Saudis Will Pump To Prevent Recession ​​​​​​ Chart 7BCA's July 2022 Oil Price Forecast BCA's July 2022 Oil Price Forecast BCA's July 2022 Oil Price Forecast ​​​​​​ The geopolitical view suggests upside oil risks over the short-to-medium time frame but the macroeconomic view suggests that downside risks will be priced first. Bottom Line: Saudi Arabia may increase production but not at any US president’s beck and call. The Saudis are not focused on US elections, they benefit from the current level of prices, and they do not suffer if Republicans take Congress in November. The downside risk in oil prices stems from demand disappointments in global growth (especially China) rather than any immediate shifts in Saudi production discipline. Volatility will remain high. US-Iran Talks: Dying But Not Dead Yet In fact the Middle East underscores underlying and structural oil supply constraints despite falling global demand. While Iran is a perennial geopolitical risk, the world is reaching a critical juncture over the next couple of years. Investors should not assume that Iran can quietly achieve nuclear arms like North Korea. Since August 2021 we have argued that the US and Iran would fail to put back together the 2015 nuclear deal (the Joint Comprehensive Plan of Action or JCPA). This failure would in turn lead to renewed instability across the Middle East and sporadic supply disruptions as the different nations trade military threats and potentially engage in direct warfare. This forecast is on track after Biden’s and Putin’s trip – but we cannot yet say that it is fully confirmed. Biden’s joint declaration with Israeli Prime Minister Yair Lapid closed any daylight that existed between the US and Israel. Given that there was some doubt about the intentions of Biden and the Democrats, it is now crystal clear that the US is determined to prevent Iran from getting nuclear weapons even if it requires military action. The US specifically said that it will use “all instruments of national power” to prevent that outcome. Chart 8Iran Not Forced To Capitulate Iran Not Forced To Capitulate Iran Not Forced To Capitulate Judging by the tone of the statement, the Israelis wrote the document and Biden signed it.4 Biden’s foreign policy emphasizes shoring up US alliances and partnerships, which means letting allies and partners set the line. Israel’s Begin Doctrine – which says that Israel is willing to attack unilaterally and preemptively to prevent a hostile neighbor from obtaining nuclear weapons – has been reinforced. The US is making a final effort to intimidate Iran into rejoining the deal. By clearly and unequivocally reiterating its stance on nuclear weapons, and removing doubts about its stance on Israel, there is still a chance that the Iranian calculus could change. This is possible notwithstanding Ayatollah Khamenei’s friendliness with Putin and criticisms of western deception.5 After all, why would the Iranians want to be attacked by the US and Israeli militaries? Iran will need to think very carefully about what it does next. Khamenei just turned 83 years old and is trying to secure the Islamic Republic’s power transition and survival after his death. Here are the risks: Iran’s economy, buoyed by the commodity cycle, is not so weak as to force Khamenei to capitulate. Back in 2015 oil prices had collapsed and his country was diplomatically isolated. Today the economy has somewhat weathered the storm of the US’s maximum pressure sanctions (Chart 8). Iran is in bad shape but it has not been brought to its knees. Another risk is that Khamenei believes the American public lacks the appetite for war. Americans say they are weary of Middle Eastern wars and do not feel particularly threatened by Iran. However, this would be a miscalculation. US war-weariness is nearing the end of its course. The US engages in a major military expedition roughly every decade. Americans are restless and divided – and the political elite fear populism – so a new foreign distraction is not as unlikely as the consensus holds. Moreover a nuclear Iran is not an idle threat but would trigger a regional nuclear arms race and overturn the US grand strategy of maintaining a balance of power in the Middle East (as in other regions). In short, the US government can easily mobilize the people to accept air strikes to prevent Iran from going nuclear because there is latent animosity toward Iran in both political parties (Chart 9). Chart 9Risk: Iran Overrates US War-Weariness Biden And Putin Court The Middle East Biden And Putin Court The Middle East Another risk is that Iran forges ahead believing that the US and Israel are unwilling or unable to attack and destroy its nuclear program. The western powers might opt for containment like they did with North Korea or they might attack and fail to eliminate the program. This is hard to believe but Iran clearly cannot accept US security guarantees as an alternative to a nuclear deterrent when it seeks regime survival. At the same time Russia is courting Iran, encouraging it to join forces against the American empire. Iran is planning to sell drones to Russia for use in Ukraine, while Russia is maintaining nuclear and defense cooperation with Iran. Putin’s trip highlighted a growing strategic partnership despite a low base of economic ties  (Chart 10).6 Chart 10Russo-Iranian Ties Russo-Iranian Ties Russo-Iranian Ties ​​​​​​ Chart 11West Vulnerable To Middle East War Biden And Putin Court The Middle East Biden And Putin Court The Middle East While Russia does not have an interest in a nuclear-armed Iran, it is not afraid of Iran alone, and it would benefit enormously if the US and Israel got bogged down in a new war that destabilized the Middle East. Oil prices would rise, the US would be distracted, and Europe would be even more vulnerable (Chart 11). Chart 12China's Slowdown And Dependency On Middle East China's Slowdown And Dependency On Middle East China's Slowdown And Dependency On Middle East China’s interest is different. It would prefer for Iran to undermine the West by means of a subtle and long-term game of economic engagement rather than a destabilizing war in the region that would upset China’s already weak economy. However, Beijing will not join with the US against Iran, especially if Iran and Russia are aligned. Ultimately China needs to access Iranian energy reserves via overland routes so that it gains greater supply security vis-à-vis the American navy (Chart 12). Since June 2019, we have maintained 40% odds of a military conflict with Iran. The logic is outlined in Diagram 1, which we have not changed. Conflict can take various forms since the western powers prefer sabotage or cyber-attacks to outright assault. But in the end preventing nuclear weapons may require air strikes – and victory is not at all guaranteed. We are very close to moving to the next branch in Diagram 1, which would imply odds of military conflict rise from 40% to 80%. We are not making that call yet but we are getting nervous. Diagram 1Iran Nuclear Crisis: Decision Tree Biden And Putin Court The Middle East Biden And Putin Court The Middle East Moreover it is the saber rattling around this process – including an extensive Iranian campaign to deter attack – that will disrupt oil distribution and transport sooner rather than later. Bottom Line: The US and Iran could still find diplomatic accommodation to avoid the next step in our decision tree. Therefore we are keeping the odds of war at a subjective 40%. But we have reached a critical juncture. The next step in the process entails a major increase in the odds of air strikes. Putin’s Supply Squeeze Will Continue As we go to press, financial markets are reacting to President Putin’s marginal easing of Russian political pressure on food and energy supplies. First, Putin took steps toward a deal, proposed by Turkish President Erdogan, to allow Ukrainian grain exports to resume from the Black Sea. Second, Putin allowed a partial restart of the Nord Stream 1 natural gas pipeline, after a total cutoff occurred during the regular, annual maintenance period. However, these moves should be kept into perspective. Nord Stream 1 is still operating at only 40% of capacity. Russia reduced the flow by 60% after the EU agreed to impose a near-total ban on Russian oil exports by the end of the year. Russia is imposing pain on the European economy in pursuit of its strategic objectives and will continue to throttle Europe’s natural gas supply. Russia’s aims are as follows: (1) break up European consensus on Russia and prevent a natural gas embargo from being implemented in future (2) pressure Europe into negotiating a ceasefire in Ukraine that legitimizes Russia’s conquests (3) underscore Russia’s new red line against NATO military deployments in Finland and Sweden. Europe, for its part, will continue to diversify its natural gas sources as rapidly as possible to reduce Russia’s leverage. The European Commission is asking countries to decrease their natural gas consumption by 15% from August to March. This will require rationing regardless of Russia’s supply squeeze. The collapse in trust incentivizes Russia to use its leverage while it still has it and Europe to try to take that leverage away. The economic costs are frontloaded, particularly this winter. The same goes for the Turkish proposal to resume grain exports. Russia will continue to blockade Ukraine until it achieves its military objectives. The blockade will be tightened or loosened as necessary to achieve diplomatic goals. Part of the reason Russia invaded in the first place was to seize control of Ukraine’s coast and hold the country’s ports, trade, and economy hostage. Bottom Line: Russia’s relaxation of food and energy flows is not reliable. Flows will wax and wane depending on the status of strategic negotiations with the West. Europe’s economy will continue to suffer from a Russia-induced supply squeeze until Russia achieves a ceasefire in Ukraine. So will emerging markets that depend on grain imports, such as Turkey, Egypt, and Pakistan. Investment Takeaways The critical juncture has arrived for our Iran view. If Iran does not start returning to nuclear compliance soon, then a fateful path of conflict will be embarked upon. The Saudis will not give Biden more oil barrels just yet. But they may end up doing that if global demand holds up and the US reassures them that their regional security needs will be met. First, the path for oil over the next year will depend on the path of global demand. Our view is negative, with Europe heading toward recession, China struggling to stimulate its economy effectively, and the Fed unlikely to achieve a soft landing. Second, the path of conflict with Iran will lead to a higher frequency of oil supply disruptions across the Middle East that will start happening very quickly after the US-Iran talks are pronounced dead. In other words, oil prices will be volatile in a stagflationary environment. In addition, while inflation might roll over for various reasons, it is not likely to occur because of any special large actions by Saudi Arabia. The Saudis are waiting on global cues. Of these, China is the most important. We are booking a 17% gain on our long gold trade as real rates rise and China’s economy deteriorates (Chart 13). This is in line with our Commodity & Energy Strategy, which is also stepping aside on gold for now. Longer term we remain constructive as we see a secular rise in geopolitical risk and persistent inflation problems. Chart 13Book Gains On Gold ... For Now Book Gains On Gold ... For Now Book Gains On Gold ... For Now We are booking an 18% gain on our long European defense / short European tech trade. Falling bond yields will benefit European tech (Chart 14). We remain bullish on European and global defense stocks. Chart 14Book Gains On EU Defense Vs Tech ... For Now Book Gains On EU Defense Vs Tech ... For Now Book Gains On EU Defense Vs Tech ... For Now ​​​​​​ Chart 15Markets Underrate Middle East Geopolitical Risk Biden And Putin Court The Middle East Biden And Putin Court The Middle East ​​​​​ Stay long US equities relative to UAE equities. Middle Eastern geopolitical risk is underrated (Chart 15). Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1      The White House, “The Jerusalem U.S.-Israel Strategic Partnership Joint Declaration,” July 14, 2022, whitehouse.gov. 2     Israel and the US will remove international peacekeepers from the formerly Egyptian Red Sea islands of Tiran and Sanafir, which clears the way for Saudi Arabia to turn them into tourist destinations. Saudi Arabia also removed its tight airspace restrictions on Israel, enabling civilian Israeli airlines to fly through Saudi airspace on normal basis. Of course, Saudi allowance for Israeli military flights to pass through Saudi airspace would be an important question in any future military operation against Iran. 3     The US has long wanted regional missile defense integration. The Biden administration is proposing “integrated air defense cooperation” that would include Israel as well as the Gulf Cooperation Council (GCC). A regional “air and missile defense architecture” would counter drones and missiles from rival states and non-state actors such as Iran and its militant proxies. Simultaneously the Israelis are putting forward the proposed Middle East Air Defense Alliance (MEAD) in meetings with the same GCC nations. Going forward, Iran’s nuclear ambitions will give more impetus to these attempts to cooperate on air defense. 4     This is apparent from the hard line on Iran and the relatively soft line on Russia in the document. Israel is wary of taking too hard of a line against Russia because of its security concerns in Syria where Russian forces are present. See footnote 1 above. 5     Khamenei called for long-term cooperation between Russia and Iran; he justified Russia’s invasion of Ukraine as a defense against NATO encroachment; he called for the removal of the US dollar as the global reserve currency. See “Khamenei: Tehran, Moscow must stay vigilant against Western deception,” Israel Hayom, July 20, 2022, israelhayom.com. 6     Russia’s natural gas champion Gazprom signed an ostensible $40 billion memorandum of understanding with Iran’s National Oil Company to develop gas fields and pipelines. See Nadeen Ebrahim, “Iran and Russia’s friendship is more complicated than it seems,” CNN, July 20, 2022, cnn.com. However, while there are longstanding obstacles to Russo-Iranian cooperation, the West’s tough new sanctions on Russia and EU diversification will make Moscow more willing to invest in Iran. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Listen to a short summary of this report.     Executive Summary The odds of a recession in the US are lower than widely perceived. The probability of a recession is higher in Europe, although this week’s partial resumption of gas flows through the Nord Stream 1 pipeline, along with increased use of coal-fired power plants, should soften the blow. Chinese growth should rebound in the second half of the year. However, the specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening property sector will continue to weigh on activity. With the Twentieth Party Congress slated for later this year, it is increasingly likely that the authorities will open up a firehose of stimulus. Fading recession risks will buoy stocks in the near term. However, a brighter economic outlook also means that the Fed, and several other central banks, may see little need to cut policy rates in 2023, as the markets are currently discounting. The end result is that government bond yields will rise from current levels, implying that stock valuations will not return to last year’s levels even if a recession is averted. After Rapidly Raising Rates, Markets Expect Some DM Central Banks To Start Easing Next Year The Downside Of A Soft Landing The Downside Of A Soft Landing Bottom Line: We recommend a modest overweight on global equities for now but would turn neutral if the S&P 500 were to rise above 4,050.   Dear Client, I am delighted to announce that Ritika Mankar, CFA, has joined the Global Investment Strategy team. Ritika will be writing occasional special reports on a variety of topical issues. Next week, she will make the case that the US economy’s ability to spawn mega-sized companies may become increasingly compromised over the next decade. Best regards, Peter Berezin, Chief Global Strategist The Case for a Soft Landing in the US Chart 1Cyclicals Underperformed Defensives As Recession Risks Intensified Cyclicals Underperformed Defensives As Recession Risks Intensified Cyclicals Underperformed Defensives As Recession Risks Intensified Over the last few months, investors have become concerned that the Fed and many other central banks will need to engineer a recession in order to bring inflation down to more comfortable levels. While these fears have abated over the past trading week, they still continue to dominate market action (Chart 1). We place the odds of a US recession at about 40%. This is arguably more optimistic than the consensus view. According to Bank of America, the majority of fund managers saw recession as likely in this month’s survey. Not surprisingly, investors consider recession to be a major risk for equities over the next 12 months (Chart 2). Chart 2Many Investors Now See Recession As Baked In The Cake The Downside Of A Soft Landing The Downside Of A Soft Landing Even if a recession does occur, we have contended that it will likely be a mild one, perhaps so mild that it will be difficult to distinguish it from a soft landing. A number of things make a soft landing in the US more probable than in the past: Labor supply has scope to increase. The labor participation rate is still 1.2 percentage points below its pre-pandemic level, two-thirds of which is due to decreased participation among workers under the age of 55 (Chart 3). The share of workers holding multiple jobs is also below its pre-pandemic level (Chart 4). The number of multiple job holders has been rising briskly lately. That is one reason why job growth in the payroll survey – which double counts workers if they hold more than one job – has been stronger than job growth in the household survey. Increased labor supply would obviate the need for the Fed to take drastic actions to curtail labor demand in its effort to restore balance to the labor market. Chart 3Labor Supply Has Scope To Rise Labor Supply Has Scope To Rise Labor Supply Has Scope To Rise Chart 4The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels The Number Of Multiple Job Holders Is Still Below Pre-Pandemic Levels A high level of job openings creates a moat around the labor market. There are almost two times as many job openings as there are unemployed workers in the US (Chart 5). Many firms are likely to pull job openings before they cut jobs in response to a slowing economy. A high level of job openings will also allow workers who lose their jobs to find employment more quickly than usual, thus limiting the rise in so-called frictional unemployment. It is worth noting that the job openings rate has declined from a record 7.3% in March to a still-high 6.9% in May, with no change in the unemployment rate over this period. Chart 5A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market A High Level Of Job Openings Creates A Moat Around The Labor Market A steep Phillips curve implies that only a modest increase in unemployment may be necessary to knock down inflation towards the Fed’s target. Just as was the case in the 1960s, the Phillips curve has proven to be kinked near full employment (Chart 6). Unlike in the late 1960s, however, when rising realized inflation caused long-term inflation expectations to reset higher, expectations have remained well anchored this time around (Chart 7). Chart 6The Phillips Curve Is Kinked At Very Low Levels Of Unemployment The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 7Long-Term Inflation Expectations Are Well Anchored Long-Term Inflation Expectations Are Well Anchored Long-Term Inflation Expectations Are Well Anchored   The unwinding of pandemic and war-related dislocations should push down inflation. A recent study by the San Francisco Fed estimates that about half of May’s PCE inflation print was the result of supply-side disturbances (Chart 8). While the ongoing war in Ukraine and the threat of another Covid wave in China will continue to unsettle global supply chains, these problems should fade over time. Falling inflation would allow real wages to start rising again. This would bolster confidence, making a soft landing more likely (Chart 9). Chart 8Supply Factors Explain Half Of The Increase In Prices Over The Past Year The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 9Positive Real Wage Growth Will Bolster Consumer Confidence Positive Real Wage Growth Will Bolster Consumer Confidence Positive Real Wage Growth Will Bolster Consumer Confidence A lack of major financial imbalances makes the US economy more resilient to economic shocks. As a share of disposable income, US household debt is 34 percentage points below its 2008 peak (Chart 10). Relative to net worth, household debt is at multi-decade lows. About two-thirds of mortgages carry a FICO score above 760 compared to only one-third during the housing bubble (Chart 11). Non-mortgage consumer credit also remains in good shape, as my colleague Doug Peta elaborated in this week’s US Investment Strategy report. While corporate debt has risen over the past decade, the ratio of corporate debt-to-assets today is still below where it was during the 1990s. Moreover, thanks to stronger corporate profitability, the interest coverage ratio is near an all-time high (Chart 12).   Chart 10AUS Household Debt Is Not Especially High Anymore (I) US Household Debt Is Not Especially High Anymore (I) US Household Debt Is Not Especially High Anymore (I) Chart 10BUS Household Debt Is Not Especially High Anymore (II) US Household Debt Is Not Especially High Anymore (II) US Household Debt Is Not Especially High Anymore (II) Chart 11FICO Scores For Residential Mortgages Have Improved Considerably Since The Pre-GFC Housing Bubble The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 12Corporate Balance Sheets Are In Decent Shape Corporate Balance Sheets Are In Decent Shape Corporate Balance Sheets Are In Decent Shape Chart 13Tight Supply Limits The Downside Risks To Housing Tight Supply Limits The Downside Risks To Housing Tight Supply Limits The Downside Risks To Housing Just like the US does not suffer from major financial imbalances, it does not suffer from any major economic imbalances either. The homeowner vacancy rate is near a record low, which should put a floor under residential investment (Chart 13). Outside of investment in intellectual property, which is not especially sensitive to the business cycle, nonresidential investment is still below pre-pandemic levels and not much above where it was as a share of GDP during the Great Recession (Chart 14). Spending on consumer durable goods has retraced four-fifths of its pandemic surge, with little ill-effect on aggregate employment (Chart 15). Chart 14Outside Of IP, Nonresidential Investment Is Still Low Outside Of IP, Nonresidential Investment Is Still Low Outside Of IP, Nonresidential Investment Is Still Low Chart 15Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Spending On Durable Goods Has Been Normalizing Without Derailing The Economy Europe: A Deep Freeze Will Likely Be Avoided Chart 16Russia Can Potentially Cause Significant Economic Damage In The EU If It Closes The Taps The Downside Of A Soft Landing The Downside Of A Soft Landing The macroeconomic picture is less benign outside the US. Four years ago, German diplomats laughed off warnings that their country had become dangerously dependent on Russian energy. They are not laughing anymore. German industry, just like industry across much of Europe, is facing a major energy crunch. The IMF estimates that output losses associated with a full Russian gas shutoff over the next 12 months could amount to as much as 2.7% of GDP in the EU (Chart 16). In Central and Eastern Europe, output could shrink by 6%. Among the major economies, Germany and Italy are the most at risk. Fortunately, Europe is finally stepping up to the challenge. The highly ambitious REPowerEU plan seeks to displace two-thirds of Russian gas by the end of 2022. The plan does not include any additional energy that could be generated by increased usage of coal-fired power plants, a strategy that the European political establishment (including the German Green Party!) has only recently begun to champion. It is possible that EU leaders felt the need to generate a crisis mentality to justify the decision to burn more coal. Dire warnings about how Europe is prepared to ration gas also send a message to Russia that the EU is ready to suffer in order to thwart Putin’s despotic regime. Whether Europe actually follows through is a different story. It is worth noting that the Nord Stream 1 pipeline resumed operations this week after Germany received, over Ukrainian objections, a repaired turbine from Canada. The resumption of partial flows through the pipeline, along with increased fiscal support for households and firms, reduces the risks of a “deep freeze” recession in Europe. The unveiling of the ECB’s new Transmission Protection Instrument (TPI) this week should also help anchor sovereign credit spreads across the euro area. While the exact conditions under which the TPI will be engaged have yet to be fleshed out, we expect the terms to be fairly liberal, reflecting not only the lessons learned from last decade’s euro debt crisis, but also to serve as a powerful bulwark against Putin’s efforts to destabilize the EU economy. China: Government’s Growth Target Looks Increasingly Unrealistic Stronger growth in China would help European exporters (Chart 17). Chinese real GDP grew by just 0.4% in the second quarter from a year earlier as the economy was battered by Covid lockdowns. Activity should pick up in the second half of the year, but at this point, the government’s 5.5% growth target looks completely unachievable. The specter of future lockdowns, the shift in global spending away from manufactured goods towards services, and the weakening Chinese property sector are all weighing on the economy (Chart 18). Chart 17European Exporters Would Welcome A Stronger Chinese Economy European Exporters Would Welcome A Stronger Chinese Economy European Exporters Would Welcome A Stronger Chinese Economy The authorities will likely seek to stimulate the economy by allowing local governments to bring forward $220 billion in bond issuance that had been originally slated for 2023. The problem is that land sales – the main source of local government revenue – have collapsed. Worried about the ability of local governments to service their obligations, both retail investors and banks have shied away from buying local government debt. Chart 18A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy A Slowing Property Market And Covid Lockdowns Have Been Weighing On The Chinese Economy Meanwhile, the inability of property developers to secure adequate financing to complete construction projects has left a growing number of home buyers in the lurch. In most cases, these properties were purchased off-the-plan. Understandably, home buyers have balked at the prospect of having to make mortgage payments on properties that they do not possess.  With the Twentieth Party Congress slated for later this year, it is increasingly likely that the authorities will open up a firehose of stimulus, including increased assistance for property developers and banks, as well as income-support measures for households. While such measures will not address China’s myriad structural problems, they will help keep the economy afloat. Equity Valuations in a Soft-Landing Scenario A few weeks ago, the consensus view was that stocks would tumble in the second half of the year as the global economy fell into recession but would then rally in 2023 as central banks began lowering rates. We argued the opposite, namely that stocks would likely rebound in the second half of the year as the economy outperformed expectations but would then face renewed pressure in 2023 as it became clear that the Fed and several other central banks had no reason to cut rates (Chart 19). Chart 19After Rapidly Raising Rates, Markets Expect Some DM Central Banks To Start Easing Next Year The Downside Of A Soft Landing The Downside Of A Soft Landing Chart 20Real Rates Have Jumped This Year Real Rates Have Jumped This Year Real Rates Have Jumped This Year In a baseline scenario where a recession is averted, we argued that the S&P 500 could rise to 4,500 (60% odds). In contrast, we noted that the S&P 500 could fall to 3,500 in a mild recession scenario (30% odds) and to 2,900 in a deep recession scenario (10% odds). It is worth stressing that even at 4,500, the S&P 500 would still be 11% lower in real terms than it was on January 4th. At the stock market’s peak in January, the 10-year TIPS yield stood at -0.91%, while the 30-year TIPS yield stood at -0.27%. Today, they stand at 0.58% and 0.93%, respectively (Chart 20). If real rates do not return to their prior lows, it is unlikely that equity valuations will return to their prior highs. This limits the upside for stocks, even in a soft-landing scenario. The sharp rally in stocks over the past week has priced out some of this recession risk, moving equity valuations closer towards what we regard as fair value. As we noted last week, we will turn neutral on equities if the S&P 500 were to rise above 4,050. As we go to press, we are only 1.3% from that level.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on         LinkedIn & Twitter Global Investment Strategy View Matrix The Downside Of A Soft Landing The Downside Of A Soft Landing Special Trade Recommendations Current MacroQuant Model Scores The Downside Of A Soft Landing The Downside Of A Soft Landing    

Executive Summary Upside Oil Price Risk Dominates Upside Oil Price Risk Dominates 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 Inventories Will Tighten Inventories Will Tighten Chart 2Markets Will Backwardate Further Markets Will Backwardate Further Markets 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 Tighter Oil Markets On The Way Tighter Oil Markets On The Way Chart 4Capital Discipline Drives US Shale Production Growth Capital Discipline Drives US Shale Production Growth Capital 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 Markets Remain Finely Balanced Markets Remain Finely Balanced Chart 6Brent Backwardation Will Steepen Brent Backwardation Will Steepen Brent Backwardation Will Steepen Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Tighter Oil Markets On The Way Tighter Oil Markets On The Way 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 Upside Oil Price Risk Dominates Upside 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 Tighter Oil Markets On The Way Tighter Oil Markets On The Way Chart 9 Nominal Broad US Dollar Index Going Up Nominal Broad US Dollar Index Going Up       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 Investors Should Mind Surging US Wages 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… No Rebound In EM Stocks And Currencies... No Rebound In EM Stocks And Currencies... Chart 2…Nor In EM Credit Space And Local Bonds ...Nor In EM Credit Space And Local Bonds ...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 Russian Oil Export Volumes Have Dropped Only By 5% Since January Russian 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 US And Chinese Oil Consumption Is Weak US 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 Oil And Food Prices In EM Currencies Oil And Food Prices In EM Currencies Chart 6The Simultaneous Drop In Various Commodity Prices Cannot Be Explained By Supply The Simultaneous Drop In Various Commodity Prices Cannot Be Explained By Supply The 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 Oil Prices Often Lag Global Cyclical Stocks Oil 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 Investors Are Still Bullish On Oil Investors Are Still Bullish On Oil Chart 9A Triple Top In Oil Prices And Global Energy Stocks A Triple Top In Oil Prices And Global Energy Stocks A 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 Investors Should Mind Surging US Wages Investors 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 Unit Labor Costs, Not Oil, Drive US Core Inflation Unit 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 US Core Inflation Is Broadening And Is Well Above The Fed's Target US 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 Global Trade Will Shrink In H2 2022 Global 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 Rising EM USD Bond Yields (Shown Inverted) Point To Lower Share Prices Rising 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 Chinese Housing: Sales And Prices Are Falling Chinese Housing: Sales And Prices Are Falling Chart 16Chinese Property Developers: Stock And Bond Prices Continue Plunging Chinese Property Developers: Stock And Bond Prices Continue Plunging Chinese 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 EM Domestic Bonds: Do Not A Catch Falling Knife EM 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 Can The Economy Recover Without Housing Revival 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 High-Frequancy(Daily) Economic Indicators High-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 The Odds Of Renewed Lockdowns Are Rising The Odds Of Renewed Lockdowns Are Rising Chart 3Sluggish Sentiment Among Chinese Households And Enterprises Sluggish Sentiment Among Chinese Households And Enterprises Sluggish Sentiment Among Chinese Households And Enterprises Chart 4China: Can The Economy Recover Without Housing Revival Can The Economy Recover Without Housing Revival 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 Credit Growth Was Largely Driven By LG Bond Issuance June'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... Corporate Loan Growth Improved In June... Corporate Loan Growth Improved In June... Chart 7… But Corporate Loan Demand Remains Very Weak ... But Corporates Remain Low Demand Very Weak ... But Corporates Remain Low Demand 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 Household Loan Demand Is Still Depressed Household Loan Demand Is Still Depressed Chart 9The Credit And Fiscal Impulse Will Be Moderate The Credit And Fiscal Impulse Will Be Moderate The 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 No Snapback In Housing Sales No Snapback In Housing Sales Chart 11Downbeat Sentiment Among Home Buyers Downbeat Sentiment Among Home Buyers Downbeat Sentiment Among Home Buyers Chart 12Real Estate Developers' Deteriorating Funding Will Further Dampen Housing Construction Real Estate Developers' Deteriorating Funding Will Further Dampen Housing Construction Real 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 Chinese Logistics And Backlog Orders Pressures Have Eased In June Chinese 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 External Demand For Chinese Export Goods Will Be Dwindling External Demand For Chinese Export Goods Will Be Dwindling Chart 15Signs Of Moderation In China's Exports Signs Of Moderation In China's Exports Signs 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 Developed Economies' Household Demand For Goods ex-Autos Will Experience Mean Reversion Developed Economies' Household Demand For Goods ex-Autos Will Experience Mean Reversion Chart 17Well-Stocked Shelves In The US Bode Poorly For Chinese Exports Well-Stocked Shelves In The US Bode Poorly For Chinese Export Well-Stocked Shelves In The US Bode Poorly For Chinese Export 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 Shrinking Real Estate Investment Will Remain A Drag On Chinese Investment Growth In 2H Shrinking Real Estate Investment Will Remain A Drag On Chinese Investment Growth In 2H Chart 19Contracting Import Volume Reflects China's Sluggish Domestic Demand Contracting Import Volume Reflects China's Sluggish Domestic Demand Contracting 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 Broad-Based Contraction In ... Chinese Imports Of Key Commodities Deteriorated In June Broad-Based Contraction In ... Chinese Imports Of Key Commodities Deteriorated In June Chart 20BBroad-Based Contraction In Imports ... Imports And key Imports Categories Chinese Domestic Demand Has Been Absent Over The Past 12 Months ... Imports And key Imports Categories Chinese Domestic Demand Has Been Absent Over The Past 12 Months Chart 21Rising New Covid Cases In China Will Constrain Domestic Consumption Recovery Rising New Covid Cases In China Will Constrain Domestic Consumption Recovery Rising 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 Skyrocketed Unemployment Rate Among Young Workers Is A Big Problem Of Chinese Labor Market Skyrocketed 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 low Confidence In Future Income Contributes To Households' Unwillingness To Consume low 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 RMB Is Still Vulnerable RMB 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 Contracting Exports Will Weigh On The RMB Contracting Exports Will Weigh On The RMB Chart 26Onshore Equity Market Foreign Outflow Pressures Remain, At Least In The Near Term Onshore Equity Market Foreign Outflow Pressures Remain, At Least In The Near Term Onshore 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 A-Shares Has Not Broken Above 200-Day Moving Average A-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 A Tell-Sign Of Major Downtrend A Tell-Sign Of Major Downtrend Chart 29Chinese Tech Stocks Still Appear Fragile Chinese Tech Stocks Still Appear Fragile Chinese 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 Two Large-Cap Chinese Stocks Two 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 China’s Recovery: U Or V Shaped? China’s Recovery: U Or V Shaped? Table 2China Financial Market Performance Summary China’s Recovery: U Or V Shaped? China’s Recovery: U Or V Shaped? Footnotes Strategic Themes Cyclical Recommendations