Sectors

Highlights Covid-19 has wreaked havoc in the markets, but the Hotels, Restaurants & Leisure, and Airline industries have been most affected. These industries constitute what we call the “travel complex” as they share common drivers of profitability: First, they have been significantly affected by restrictions imposed on individuals and businesses in response to Covid-19 and, second, they rely on discretionary spending. Recovery of the group was proceeding swimmingly until the Delta variant derailed it in late summer, with reports pouring in about dining rooms closing, airline bookings flagging, and hotel occupancy dipping. What is next? The Delta variant is cresting. Our base case is that herd immunity is not far off. Of course, the travel complex is vulnerable to any new virus scare, and this is a risk investors need to keep in mind. Rising rates will be a mild tailwind for the group, as it tends to outperform in that regime. But this is not a key driver of its performance. Consumer confidence and financial wellbeing are at the core of this group’s profitability. So far, Americans still have money to spare and generally prefer to spend it on services. It is disconcerting that the Consumer Confidence Indicator has turned, but we are not too alarmed just yet: Jobs are still plentiful, and Americans are going back to work. August retail sales surprised on the upside. In Part 1 of the report this week, we take a deep dive into the Hotel, Resort, and Cruise Lines industry. We find the industry attractive for the following reasons: Hotel occupancy has increased, and the amount of money consumers are prepared to spend in hotel stays has surged. Sales are expected to increase by 75%, albeit from low levels, over the next 12 months. Hotels have also discovered many new sources of revenue. Earnings growth is impossible to estimate since last year the industry was losing money; however, margins have just turned positive. Companies also have significant pricing power to pass on expenses to their guests, and have the ability to mend their margins, eventually going back to the historical 20%. Lastly, the industry is cheap relative to its own history on a forward PE basis. According to our Technical Indicator, it is also oversold. The Hotels, Resorts, and Cruise Lines industry has a significant potential to return to its former “glory”, and we believe that it is a sound tactical and cyclical investment. We recommend overweighing this industry. NB: Please stay tuned for Part 2 of the report, on Restaurants and Airlines, next week. Feature Part 1: Hotels, Resorts And Cruise Lines In this two-part publication, we will provide an in-depth overview of Hotels, Restaurants, and Airlines. These industries constitute what we call the “travel complex” as they share many common drivers of profitability: First, they are the industries most exposed to Covid-related fears as well as corresponding government health directives, and, second, they rely on the discretionary spending of both consumers and businesses. In this publication, we will examine the macroeconomic backdrop for the entire travel complex, and then zoom into the Hotels, Resorts, and Cruise Lines industry (“Hotels”). Next week, we will provide an in-depth overview of Restaurants and Airlines. Sneak preview: We are bullish on Hotels and are overweight this industry in our portfolio. Hotels, Restaurant And Leisure, Along With Airlines, Were The Poster Child For Post-Covid Recovery… Covid-19 has wreaked havoc in the markets, but the travel complex was most affected. Airlines, hotels, and restaurants have suffered tremendous losses, and all have required government bailouts either directly, or indirectly through the Paycheck Protection Program (PPP). The travel complex rebounded mightily as the vaccine became widely available in February, and Americans suffering from cabin fever boarded planes, traveled, and ate out (Chart 1). Chart 1Hotels And Airlines Are Still Trading Below Their Pre-Covid Levels Table 1Travel Complex Is Lagging S&P 500 …Everything Changed This Summer All these positive developments began to reverse over the summer as Delta made its appearance in the US, and even the vaccinated succumbed to fears of infection. Airlines were one of the worst performers in the index. Hotels and restaurants were doing better, but their performance did not shoot the lights out either (Table 1). Restaurants: According to a National Restaurant Association survey of 1,000 adults, in recent weeks nearly one in five Americans say they are no longer going out to restaurants, 9% have canceled existing plans to eat out, and 37% of adults said they ordered delivery or takeout instead of dining in a restaurant. Chains like McDonald’s and Chick-fil-A are slowing their dining room reopenings. As data from restaurant analytics firm Black Box Intelligence demonstrate, sales that had grown steadily earlier this summer have fallen.1 Airlines: Several major airlines have warned in regulatory filings that their third quarter may not look as rosy as hoped. United Airlines has noted a deceleration in customer bookings, while Southwest Airlines reported a continued softness in bookings—even in leisure—and elevated trip cancelations. Similarly, American Airlines has said that, after a strong July, it saw a softness in near-term bookings in August and an increase in near-term cancelations. All three have suggested that the Delta variant is having a dampening effect on business.2 Hotels: Marriott International said that revenue per available room in August of 2021 was down 27% from the 2019 level – a drop from the 23% decline seen in July. However, the CEO of the company sounded sanguine: “The trends seem to be stabilizing as we get into the early days of September”. Most of the decline came from lockdowns in China. The most recent data shows revenue per available room was down 44 percent off 2019 levels — not ideal but an improvement from the 57 percent decline seen a week prior.3 With bad news abundant, the natural question is whether these industries are still a good tactical and cyclical investment. Delta Variant Clearly, a resurgence in infections has had an adverse effect on the travel complex. However, there are early signs that the Covid-19 Delta variant is cresting (Chart 2). Around 75% of the U.S. population has had at least one vaccine shot. Globally, 31.5 million doses/day are being administered. At this rate, it will take just eight months to vaccinate 75% of the global population. Herd immunity is not far off. Our base case is that Covid-19 and its multiple variants are unlikely to disappear, but consumers and businesses are learning how to live with it. We believe that the surge of Delta infections will subside over the fall, and the entire travel complex will continue to recuperate from the Covid-inflicted damage. Of course, the resurgence of Covid-19 cases and newer variants could undermine a recovery. This is a risk investors need to monitor. Chart 2The Covid-19 Delta Variant Is Cresting Macroeconomic Backdrop Rising Rates Are A Tailwind For The Travel Complex Direction and rate of change in yields dictate which US equity sectors and industries will do well. There are many crosscurrents in both economic data and Fed speak currently that obscure the answer to this question. Analysis of the performance of travel industries by rates regime suggests that all of them tend to do better when rates are rising, as higher rates indicate stronger economic growth (Chart 3). Airlines are most sensitive to an economic slowdown and will underperform most if rates stay “lower for longer”. Consumers Still Have Money To Spend On Services But Less Than Before Chart 3Travel Outperforms When Rates Are Rising Travel is a quintessential representation of discretionary spending on services. Consumers travel and eat out when they are confident about the future and have a healthy income and excess savings. Chart 4Disposable Income And Savings Are Returning To Trend The helicopter money drop has increased consumer income and padded their savings. However, income gains were not permanent and, recently, disposable income has returned to trend (Chart 4, Panel 1). Further, much of the excess savings has been spent (Chart 4, Panel 2). In another unpleasant twist, over the past few months, wage gains (4.8%) have lagged price increases (5.2%), reducing the purchasing power of American consumers. In response to these developments, the consumer mood has soured: The Consumer Confidence Indicator has slumped to a six-month low of 114 from 125 a month earlier. The next 12-month inflation expectations have surged to 6.5%. While it is disconcerting that consumer confidence has turned, we are not too alarmed just yet: Jobs are still plentiful, and Americans are likely to go back to work as the majority of children are now attending schools in person. In short, Americans are not destitute, but the pattern of spending is normalizing and returning to the pre-pandemic trend. The August retail sales print at 0.7% surprised on the upside and proves that US consumers have not tightened their belts. It is also a positive for the travel complex that demand for services exceeds demand for goods: Consumer expenditure on goods is above trend and has recently turned, while spending on services is below pre-pandemic levels, and the rebound is running its course (Chart 5). Inflation Is Not A Concern For The Travel Complex CPI readings for the travel complex this summer looked outright scary: In July, airfares were up 19% YoY and the price of hotel stays was up 24% YoY. These numbers have come down to 6.7% and 19.6% in August. Indeed, these readings make us wonder whether travel is still affordable to consumers. The answer is a resounding “yes” – reported surges in prices are a function of a base effect and, compared to the same time two years ago, the two-year CAGR of prices looks reasonable for all the industries (Chart 6). Chart 6Price Increases For The Travel Complex Are Moderate Chart 5Real Spending On Services Is At Pre-Pandemic Levels: Room For Further Rebound Analysis By Industry: Hotels, Resorts, And Cruise Lines Hotels is a $55B industry4 which is forecast to produce 31.4% growth in 2021 (Table 2). Its market cap is $239Bn and it constitutes 0.6% of the S&P 500 index. The US Hotel industry suffered about $125 billion5 in aggregate lost revenues due to the pandemic in 2020. Hotel operators were in total cash-conservation mode – slashing capex budgets by 75%, suspending dividends, and raising capital. Some 670,000 workers lost their jobs or were furloughed – only half of these workers have returned so far (Chart 7). Table 2Hotels (GICS 4) Constituents After a tough year, Hotels have now mostly reopened. Demand is expected to surge by 31.4% YoY in 2021, and per room revenue has reached $94, higher than the pre-Covid-19 level. Many hotels have returned to profitability. However, hotel occupancy in the US is yet to return to the pre-pandemic level: It currently stands at around 50% compared to 70% plus pre-Covid (Chart 8). Chart 7Industry Was Decimated By Covid And Is Recovering Slowly Chart 8Occupancy Rates Are Returning Back To Normal Sources Of Revenue Hotels started to recover during the first half of 2021 and revenues are expected to continue to surge to well above the pre-pandemic level in 2022. Analysts expect hotel sales to rebound by 75% over the next 12 months (Chart 9). There are multiple sources of revenue, and a reduction in business travel and international tourism is likely to be replaced by other creative options. Leisure Travel: Significant pent-up demand has been driving a recovery in hotel stays, but it is mostly in leisure travel. According to AHLA, 56% of consumers say they expect to travel for leisure, roughly the same amount as in an average year. Consumer spending on hotels has rebounded and is close to the pre-pandemic normal (Chart 10). Chart 9Blockbuster Sales Growth Is Expected (Off Low Base) Chart 10Consumers Eagerly Spend On Hotels Business travel is still lagging. According to AHLA, business travel was down by 85% compared to 2019 through April 2021, and since then has only begun ticking up slightly. However, going forward, this trend may turn as companies start positioning their in-person visits as a competitive advantage. Bleisure travel: A new post-Covid trend has developed: Workers combine business travel with leisure, prolonging hotel stays. Another creative idea is “working from a hotel” packages to appeal to remote workers tired of being cooped up at home. International tourism: Covid-related restrictions in the rest of the world, and especially cessation of travel from China, is still denting hotel revenue. With global vaccination rates improving by the day, this segment won’t take long to rebound. Profitability While there is forecast to be a pronounced rebound in hotel sales growth over the next 12 months, it is less obvious whether and when the industry will return to its former levels of profitability (Chart 11). After all, not only was the travel complex damaged by the pandemic, but now hotel operators also incur additional Covid-related cleaning expenses. Currently, analysts expect the next 12 months EPS to rebound to about a quarter of January 2020 trailing EPS ($10 vs $34). While this looks measly, from an investment standpoint it presents an opportunity as eventually, albeit slowly, earnings will return to trend. Historical earnings growth is not calculable as the industry was losing money until very recently. Chart 11Earnings Are Expected To Grow Again Margins And Pricing Power Margins crossed the zero threshold in Q2-2021, but are still almost 20 percentage points below the long-term average (Chart 12). While hotel costs have increased with the pandemic, this industry has significant pricing power to pass on its costs to consumers (Chart 13). Chart 12The Hotel Industry Has Returned To Profitability Chart 13Hotels Have Significant Pricing Power And Can Pass Extra Costs To Guests Valuations And Technicals The Hotels industry is trading at 30x forward PE and on a 5-year normalized basis, it is trading with a discount to the S&P 500, which is unusual (Chart 14). In terms of our Technical Indicator, the industry is somewhat oversold, and now looks more attractive than it did earlier this year (Chart 15). Chart 14Hotels Are Trading With A Discount To S&P 500 Which Is Unusual Chart 15Hotels Are Slightly Oversold Cruise Lines Cruise Lines were the worst-hit and the slowest to recover among the sub-industries, but they are expected to make a comeback in 2022 with a significant surge in revenue growth. Most of the drivers for these companies are similar to Hotels and Resorts – but recovery is delayed due to restrictions that kept cruise ships anchored much longer than initially expected. Investment Implications We stay with our overweight in Hotels, Resorts, and Cruise Lines. We will summarize the reasons: The Delta variant is cresting. Our base case is that herd immunity is not far off. Of course, the industry is also vulnerable to any new virus scare, and this is a risk that investors need to keep in mind. Rising rates will be a mild tailwind for the industry, as it tends to outperform in that regime. But this is not a key driver of its performance. Consumer confidence and financial wellbeing are at the core of Hotel profitability. So far, Americans still have money to spare and prefer to spend it on services. It is disconcerting that the Consumer Confidence Indicator has turned, but we are not too alarmed just yet: Jobs are still plentiful, and Americans are going back to work. Hotel occupancy has increased, and the amount of money consumers are prepared to spend on hotel stays has surged. Sales are expected to increase by 75%, albeit from lower levels, over the next 12 months. Hotels have also discovered many new sources of revenue. Historical earnings growth is not available as until recently the industry was losing money; however, margins have just turned positive. Companies also have the significant pricing power to pass on expenses to their guests and have the ability to mend their margins, eventually going back to the historical 20%. Lastly, the industry is cheap relative to its own history on a forward PE basis. According to our Technical indicator, it is also oversold. The Hotels, Resorts, and Cruise Lines industry has significant potential to return to its former “glory”, and we believe that it is a sound tactical and cyclical investment. We recommend overweighing this industry. Bottom Line The Hotels, Resorts, and Cruise Lines industry has been severely damaged by the pandemic, and the road to recovery may be long. It is also vulnerable to any new virus scare. However, with Delta cresting, financially healthy US consumers choosing to spend their money on services and experiences, sell-side forecasts pointing to surging sales, and companies possessing substantial pricing power mean that we are bullish on the industry.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Footnotes 1     Restaurants Close Dining Rooms Again as Delta-Driven Infections Spread, WSJ, September 13, 2021.   2     Travel Investors Need More Drive, WSJ, September 12, 2021. 3    Hotel Industry News: Marriott CEO Sees Hotels Bouncing Back Quickly After Delta Variant Slump, Skift, September 9, 2021. 4    IBISWorld, August 23, 2021. 5    Oxford Economics. Recommended Allocation

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

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

Following this week’s CPI release, we update our Corporate Pricing Power Indicator (CPPI). As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity prices growth rates for each of the 60 industry groups we track. Table 1 on the next page highlights short-term pricing power trends and each industry's spread to overall inflation. 83% of the industries we cover are lifting selling prices, at a faster clip than overall inflation. Commodity-sensitive industries dominate the top of Table 1 with steel and energy industries leading the way with 75% to 10% price increase as they have enjoyed a slingshot post-COVID-19 recovery. One notable exception is the forest products industry with a tape reading of -47% due to the ongoing bear market in lumber futures. We expect the rest of the commodity complex to give up leadership as headwinds from a slowdown in China filter through the global markets. Pricing power of auto manufacturers is also on the rise – empty dealership lots and reduced supply result in a significant upward pressure on prices. There is already evidence that price increases and shortages in supply are starting to discourage consumers from making purchases. Meanwhile, most other consumer goods and services categories populate the middle of the Pricing Power table, suggesting that there is a limit to companies’ ability to raise consumer prices without damaging the demand. We also note that it is reassuring that prices of semiconductors have come down, as it may be an early indication that supply chain is starting to unclog and shortages, such as the one in semiconductors, are starting to resolve. Finally, yesterday was Lehman Bankruptcy Day – 13 years have passed. Time flies. Bottom Line: Outside of commodities and building materials, price increases are moderating. Table 1

Highlights Since June, 6 structured recommendations achieved their profit targets: short building and construction (XLB) versus healthcare (XLV); long USD/CAD; long USD/HUF; long Nike versus L’Oréal; short corn versus wheat; and short marine transport versus market. Additionally, short AMC Entertainment expired in profit, while short Australian versus Canadian 30-year bonds expired flat. Within the open trades, 3 are in profit. Against this, 2 structured recommendations hit their stop-losses: short Austria versus Chile; and short lead versus platinum. Additionally, short France versus Japan expired in loss. Within the open trades, 6 are in loss. This results in a ‘win ratio’ at a very pleasing 59 percent. Even more commendably, the 9 unstructured recommendations have all anticipated reversals or exhaustions – most notably for the ZAR, BRL, and stocks versus bonds. Feature Chart of the WeekFractal Fragility Correctly Signalled The Exhaustion Of Stocks Versus Bonds A major advance in our understanding of financial markets is that the Efficient Market Hypothesis (EMH) is only partly true. The market is efficient only when a wide spectrum of investment horizons is setting the price, signified by the market having a rich fractal structure. The market is efficient only when a wide spectrum of investment horizons is setting the price, signified by the market having a rich fractal structure. The eponymous Fractal Market Hypothesis (FMH) teaches us that when the fractal structure becomes extremely fragile, the information and interpretation of longer-term investors is missing from the recent price setting. Meaning that the market has become inefficient. When the longer-term investors do re-enter the price setting process, the question is: will they endorse the most recent trend as a justification of a change in the fundamentals. In which case, the trend will continue. Or will they reject it as an unjustified deviation from a fundamental anchor. In which case, the trend will reverse. In most cases, it is the latter: a rejection and a reversal. As most investors are unaware of the FMH, it gives a competitive advantage to the few investors that use it to signal a potential countertrend reversal. On this basis, we have used it – and continue to use it – to identify countertrend investment opportunities with truly excellent results. Fractal Trade Update This a brief review and update of the 29 short-term trades that we have recommended since our last update on 3rd June 2021, including recommendations that were open on that date. The 29 recommendations have comprised 20 structured trades – which include profit-targets, symmetrical stop-losses, and expiry dates – plus a further 9 recommendations without structured exit points. In summary, 6 structured recommendations achieved their profit targets: short building and construction (XLB) versus healthcare (XLV); long USD/CAD; long USD/HUF; long Nike versus L’Oréal; short corn versus wheat; and short marine transport versus market. Additionally, short AMC Entertainment expired in profit, while short Australian versus Canadian 30-year bonds expired flat. Within the open trades, 3 are in profit. Against this, 2 structured recommendations hit their stop-losses: short Austria versus Chile; and short lead versus platinum. Additionally, short France versus Japan expired in loss. Within the open trades, 6 are in loss. This results in a ‘win ratio’ at a very pleasing 59 percent – counting a win as achieving the profit target, a loss as hitting the (symmetrical) stop-loss, and pro-rata for partial wins and losses. Even more commendably, the 9 unstructured recommendations have all anticipated reversals or exhaustions. The sections below review the structured and unstructured recommendations in chronological order. The 20 Structured Trades 1.  6th May: Short Building and Construction (PKB) vs. Healthcare (XLV) Achieved its profit target of 15 percent. 2.  6th May: Short MSCI France vs. Japan Expired after three months in partial loss but went on to become very profitable – implying that a longer holding period was required (Chart I-2). Chart I-2Short France Versus Japan Became Very Profitable 3.  13th May: Long USD/CAD Achieved its profit target of 3.7 percent and went on to reach a high-water mark of 5.7 percent. 4.  20th May: Long 10-year T-bond vs. TIPS Open, in profit, having reached a high-water mark of 2.7 percent (versus a 3.6 percent target). 5.  3rd June: Short MSCI Austria vs. Chile Hit its stop-loss of 7 percent, albeit after previously reaching a high-water mark of 5.3 percent – implying that the profit target needed to be tighter. 6.  10th June: Short AMC Entertainment Expired at a 4 percent profit, having reached a high-water mark of 65.3 percent (versus a 100 percent target) (Chart I-3). Chart I-3Fractal Analysis Works Very Well For Meme Stocks 7.  10th June: Long USD/HUF Achieved its 3 percent profit target, before continuing to a high-water mark of 7.6 percent (Chart I-4). Chart I-4HUF/USD Corrected By 7.6 Percent 8.  17th June: Long Nike vs. L’Oréal Achieved its 9 percent profit target, before continuing to a high-water mark of 31.3 percent (Chart I-5). Chart I-5L’Oréal Underperformed Nike By 31 Percent 9.  24th June: Short Corn vs. Wheat  Achieved its 12 percent profit target, before continuing to a high-water mark of 38.7 percent (Chart I-6). Chart I-6Corn Underperformed Wheat By 39 Percent 10.  1st July: Short US REITs vs. Utilities  Open, in profit, having reached a high-water mark of 3 percent (versus a 5 percent target). 11.  8th July: Short Marine Transport vs. Market Achieved its profit target of 16.5 percent. 12.  15th July: Short Lead vs. Platinum Hit its stop loss of 6.4 percent. 13.  15th July: Short Australia vs. Canada 30-year T-Bonds Expired flat. 14.  5th August: Short Tin vs. Platinum Open, in loss, albeit having reached a high-water mark of 9.3 percent (versus a 16.5 percent target). 15.  12th August: Long MSCI Hong Kong vs. MSCI World Open, in loss. 16.  12th August: Long New Zealand vs. Netherlands Open, in loss. 17.  19th August: Short India vs. China Open, in loss (Chart I-7). Chart I-7The Outperformance Of India Versus China Is Fractally Fragile 18.  26th August: Short Sugar vs. Soybeans Open, in loss. 19.  2nd September: Short Aluminum vs. Gold Open, in loss (Chart I-8). Chart I-8The Outperformance Of Base Metals Versus Precious Metals Is Fractally Fragile 20.  9th September: Short US Medical Equipment vs. Healthcare Services Open, in profit. The 9 Unstructured Trades 1.  10th June: Short ZAR/USD ZAR/USD subsequently corrected by 12 percent. 2.  24th June: Short Copper Copper’s rally subsequently exhausted. 3.  1st July: Short MSCI ACWI vs. 30-year T-bond The rally in stocks versus bonds has subsequently exhausted (Chart of the Week). 4.  8th July: Short BRL/COP BRL/COP subsequently corrected by 4 percent. 5.  8th July: Short Saudi Tadawul All-Share vs. FTSE Malaysia All Share KLCI The rally in Saudi Arabian equities versus Malaysian equities subsequently exhausted. 6.  12th August: Long NOK/GBP        NOK/GBP has subsequently rallied by 3 percent. 7.  26th August: Short Hungary vs. EM Hungary’s outperformance is losing steam. 8.  26th August: Short USD/PLN USD/PLN subsequently corrected by 3 percent. 9.  2nd September: Short Trade Weighted US Dollar Index The dollar rally is meeting near-term resistance.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Mohamed El Shennawy Research Associate Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations