China

HighlightsThe power shortage in China due to depleted coal inventories and low hydro availability will push copper and aluminum inventories lower, as refineries there – which account for roughly one-half of global capacity – are shut to conserve power (Chart of the Week).Given the critical role base metals will play in the decarbonization of the global economy, alternative capacity will have to be incentivized ex-China by higher prices to reduce refining-concentration risk in the future.Unexpectedly low renewable-energy output in the EU and UK following last year's cold winter will keep competition with China for LNG cargoes elevated this winter.  It also highlights the unintended consequences of phasing down fossil-fuel generation without sufficient back-up.The US Climate Prediction Center kept its expectation for a La Niña at 70-80%, which raises the odds of a colder-than-normal winter for the Northern Hemisphere.  Normal-to-warmer temps cannot be entirely dismissed, however.Increased production of highly efficacious COVID-19 vaccines globally – particularly in EM economies – will stoke economic growth and release pent-up demand among consumers.We remain long 1Q22 natgas exposure via call spreads; long commodity index exposure (S&P GSCI and COMT ETF) to benefit from increasing backwardation as inventories of industrial commodities fall; and long the PICK ETF to benefit from expected tightening of base metals markets.FeatureNatgas prices are surging in the wake of China's and Europe's scramble to cover power shortages arising from depleted coal inventories and low hydroelectric generation in the former, and unexpectedly low output from renewables in the latter (Chart 2).1Given all the excitement of record-high gas prices in the EU and surging oil prices earlier this week, it is easy to lose sight of the longer-term implications of these developments for the global decarbonization push. Chart of the WeekBase Metals Refining Concentrated In China  Chart 2Surge In Gas Prices Continues Global copper inventories have been tightening (Chart 3) along with aluminum balances (Chart 4).2 Power shortages in China- which accounts for ~40% of global refined copper output and more than 50% of refined aluminum - are forcing shutdowns in production by authorities seeking to conserve energy going into winter. In addition, the upcoming Winter Olympics in February likely will keep restrictions on steel mills, base-metals refiners, and smelters in place, so as to keep pollution levels down and skies blue. Chart 3Supply-Demand Balance Tightening In Copper  Chart 4Along With Aluminum Balances... This will keep prices well supported and force manufacturers to draw on inventories, which will keep forward curves for copper (Chart 5) and aluminum (Chart 6) backwardated. Higher costs for manufactured goods can be expected as well, which will exacerbate the cost-push inflation coming through from clogged global supply chains. This slowdown in global supply chains is largely the result of global aggregate demand improving at a faster rate than supply.3 Chart 5Copper Prices And Backwardation  Chart 6...Will Increase Along With Aluminum The pressures on base metals markets highlight the supply-concentration risks associated with the large share of global refining capacity located in China. This makes refined base metals supplies and inventories globally subject to whatever dislocations are impacting China at any point in time. As the world embarks on an unprecedented decarbonization effort, this concentration of metals refining capacity becomes increasingly important, given the centrality of base metals in the build-out of renewable-energy and electric-vehicles (EVs) globally (Chart 7).In addition, increasing tension between Western states and China supports arguments to diversify supplies of refined metals in the future (e.g., the US, UK and Australia deal to supply US nuclear-powered submarine technology to Australia, and the tense Sino-Australian trade relationship that led to lower Chinese coal inventories).4 Chart 7The Need For Refined Metals Grows EU's Renewables Bet SoursUnlike China, which gets ~ 11% of its electricity from renewables and ~ 63% of its power from coal-fired generation (Chart 8), the EU gets ~ 26% of its power from renewables and ~ 13% from coal (Chart 9). In fact, the EU's made a huge bet on renewables, particularly wind power, which accounts for ~55% of its renewables supply. Chart 8China's Dependence On Coal …  Chart 9… Greatly Exceeds The EU's Unexpectedly low renewable-energy output in the EU and UK this summer – particularly wind power – forced both to scramble for natgas and coal supplies to cover power needs.5 As can be seen in Chart 9, the EU has been winding down its fossil-fuel-fired electric generation in favor of renewables. When the wind stopped blowing this year the EU was forced into an intense competition with China for LNG cargoes in order to provide power and rebuild storage for the coming winter (Chart 10). Chart 10The Scramble For Natgas Continues The current heated – no pun intended – competition for natgas going into the coming winter is the result of two policy errors, which will be corrected by Spring of next year. On China's side, coal inventories were allowed to run down due to diplomacy, which left inventories short going into winter. In the EU, wind power availability fell far short of expectations, another result of a policy miscalculation: Nameplate wind capacity is meaningless if the wind stops blowing. Likewise for sun on a cloudy day.Natgas Price Run-Up Is TransitoryThe run-up in natgas prices occasioned by China's and the EU's scramble for supplies is transitory. Still, uncertainty as to the ultimate path global gas prices will take is at its maximum level at present.The US Climate Prediction Center kept its expectation for a La Niña at 70-80%, which raises the odds of a colder-than-normal winter for the Northern Hemisphere. Even so, this is a probabilistic assessment: Normal-to-warmer temps cannot be dismissed, given this probability. A normal to warmer winter would leave US inventories and the availability to increase LNG exports higher, which would alleviate much of the pricing pressure holding Asian and European gas prices at eye-watering levels presently.Going into 1Q22, we expect increased production of highly efficacious COVID-19 vaccines globally – particularly in EM economies – will stoke economic growth and release pent-up demand among consumers as hospitalization and death rates continue to fall (Chart 11).6 At that point, we would expect economic activity to pick up significantly, which would be bullish for natgas. We also expect US and Russian natgas production to pick up, with higher prices supporting higher rig counts in the US in particular. Chart 11Expect Continued COVID-19 Progress Investment ImplicationsAs the world embarks on an unprecedented decarbonization effort, it is important to follow the supply dynamics of base metals, which will provide the materials needed to build out renewable generation and EVs.The current price pressure in natural gas markets resulting from policy miscalculations cannot be ignored. Still, this pressure is more likely to be addressed quickly and effectively than the structural constraints in base metals markets.On the base metals side, producers remain leery of committing to large capex projects at the scale implied by policy projections for the renewables buildout.7In addition, current market conditions highlight concentration risks in these markets – particularly on the refining side in base metals, where much of global capacity resides in China. On the production and refining side of EV materials, battery technology remains massively concentrated to a few countries (e.g., cobalt mining and refining in the Democratic Republic of Congo and China, respectively).This reinforces our view that oil and gas production and consumption likely will not decay sharply unless and until these capex issues and concentration risks are addressed. For this reason, we remain bullish oil and gas. Robert P. Ryan Chief Commodity & Energy Strategistrryan@bcaresearch.comAshwin ShyamResearch AssociateCommodity & Energy Strategyashwin.shyam@bcaresearch.com Commodities Round-UpEnergy: BullishDelegates at OPEC 2.0's Ministerial Meeting on Monday likely will agree to increase the amount of oil being returned to markets by an additional 100-200k b/d. This would take the monthly production rate of production being restored from 400k b/d to 500-600k b/d. Depending on how quickly mRNA vaccine production in large EM markets is rolled out, this incremental increase could remain in place into 2Q22. This would assuage market concerns prices could get to the point that demand is destroyed just as economic re-opening is beginning in EM economies. Our view remains that the producer coalition led by Saudi Arabia and Russia will continue to balance the need for higher revenues of member states with the fragile recovery in EM economies. We continue to expect prices in 2022 to average $75/bbl and $80/bbl in 2023 (Chart 12). This allows OPEC 2.0 states to rebuild their balance sheets and fund their efforts to diversify their economies without triggering demand destruction.Base Metals: BullishA power crunch and decarbonization policies in China are supporting aluminum prices at around 13-year highs, after reaching a multi-year peak earlier this month (Chart 13). The energy-intensive electrolytic process of converting alumina to metal makes aluminum production highly sensitive to fluctuations in power prices. High power prices and electricity shortages are impacting aluminum companies all over China, one of which is Yunnan Aluminium. According to the Financial Times, the company accounts for 10% of total aluminum supply in the world’s largest producer.Precious Metals: BullishGold prices dipped following a hawkish FOMC meeting last week. More Fed officials see a rate hike in 2022, compared to the previous set of projections released in June. Fed Chair Jay Powell also hinted at a taper in the asset purchase program on the back of a rebounding US economy, provided a resurgence in COVID-19 does not interrupt this progress. A confirmation of what markets were expecting – i.e., paring asset purchases by year-end – and possible rate hikes next year have buoyed the US dollar and Treasury yields. The USD competes directly with gold for safe-haven investment demand. Higher interest rates will increase the opportunity cost of holding the yellow metal. As a result, gold prices will be subdued when the USD is strengthening. We remain bearish the USD, and, therefore, bullish gold. Chart 12Oil Forecasts Hold Steady  Chart 12Aluminum Prices Recovering   Footnotes1     Please see China's Yunnan imposes output curbs on aluminium, steel, cement makers published by reuters.com on September 13, 2021.2     NB: Global aluminum inventory data are unreliable and we do not publish them.3    Please see, e.g., Supply Chains, Global Growth, and Inflation, published by gspublishing.com on September 20, 2021.4    Please see US-China: War Preparation Pushes Commodity Demand, a Special Report we published on August 26, 2021, for further discussion.5    We discuss this in last week's report entitled Natgas Markets Continue To Tighten, which is available at ces.bcaresearch.com.6    Please see Upside Price Risk Rises For Crude, which updated our oil-price balances and forecasts. We highlight the recent agreements to mass produce the highly effective mRNA COVID-19 vaccines globally as bullish for oil prices. It also will be bullish for natgas and other commodities.7     Please see Assessing Risks To Our Commodity Views, which we published on July 8, 2021, for additional discussion. Investment Views and ThemesStrategic RecommendationsTactical TradesCommodity Prices and Plays Reference TableTrades Closed in 2021Summary of Closed Trades

Highlights Evergrande has not only crossed regulatory gridlines but also regulators’ bottom lines; the government will use the example of Evergrande to impose discipline on real estate developers. The policy response will likely prioritize domestic homebuyers and suppliers to minimize systemic risks and damage to the real economy. However, a bigger risk stems from the possibility that policymakers overestimate the resilience of the economy and ignore signs of a significant spillover to other segments in the economy. The existing policy restrictions on China’s housing sector will not be reversed; the sector is on a structural downshift and will face risks of further consolidation and profit growth compression. Feature China Evergrande Group continues to stir up the global markets. Last Thursday the company missed a deadline to pay USD $83.5m in bond interest. The firm has now entered a 30-day grace period; it will default if that deadline also passes without payment. Chart 1Roller-Coaster Ride Continues... Evergrande has not remarked on the potential default nor have China’s authorities or state media offered any clues about a potential rescue package. Meanwhile, the PBoC injected large amounts of liquidity into the banking system of late, a clear sign of support for the markets. Evergrande share prices continued their roller-coaster ride (Chart 1). Evergrande’s tumult is indicative of an industry-wide problem.  Real estate developers have expanded their businesses and profits through high-debt growth models. China’s policymakers have been trying to crack down on this business practice since 2017 and their clampdown has significantly intensified since August 2020. In this report, we follow up on last week’s Special Alert and share our thoughts on the potential market implications and policy response to the evolving Evergrande situation. The “Three Red Lines” Versus The “Bottom Lines” Evergrande has not only crossed the “three red lines” – three debt metrics China’s authorities laid out a year ago to reduce the housing sector’s leverage – but it has also crossed the bottom lines of policymakers. Therefore, we do not expect the government to lend a financial hand to bail out the corporation and its shareholders. Meanwhile, as discussed in our Special Alert, we expect that there will be some kind of a rescue plan to help onshore homebuyers and suppliers recover their losses. The authorities’ silence in the past three months as investors’ concerns about Evergrande’s debt situation escalated speaks volumes about plans for the overleveraged company. The Evergrande episode is not idiosyncratic; it represents an industry-wide problem linked to the sector’s high-debt growth model.  However, Evergrande has become China’s and the world’s most indebted property developer; the “three red lines” policy last year has pushed the company into a severe liquidity crunch.  Evergrande not only borrowed heavily to pursue an aggressive expansion strategy (“disorderly expansion of capitals”), but did so as President Xi Jinping famously remarked “houses are for living, not for speculation” in late 2016. Between 2016 and 2020, Evergrande’s total liabilities almost doubled and its stock prices jumped by 460%. Evergrande’s founder was ranked the richest man in China in 2017, building his company’s fortune on excessive leverage. The way that the company accumulated wealth conflicts with the government’s new mantra of building “common prosperity”, a policy shift to reduce income and wealth inequality. Furthermore, Evergrande paid its offshore investors in June this year while it continued to borrow from onshore banks and offload its onshore assets. This move did not bode well for China’s domestic stake- and shareholders, along with policymakers. Chart 2Housing Price Inflation Has Been Subdued Outside Of Top-Tier Cities In contrast with policymakers’ silence about the future of Evergrande and its shareholders, the authorities have reportedly urged the company to finish and deliver its housing projects.  Evergrande’s projects are mostly in tier-three cities where post-pandemic home price inflation has been subdued compared with top-tier cities (Chart 2). As such, policymakers will be less concerned about fueling home prices in these cities and more willing to work out a plan to finish and deliver those housing projects. Bottom Line: Beijing may rescue the stakeholders of Evergrande rather than its shareholders. Contagion Risks We discussed our baseline scenario for Evergrande’s bankruptcy and restructuring in last week’s Special Alert. Our message has been that the well-telegraphed Evergrande default might not create an imminent systemic crisis or crash in China’s financial markets. However, it will likely reinforce the credit tightening that has been underway in China over the past 12 months.  This will delay and weaken the transmission of liquidity easing into the real economy. So far things are not bad enough for policymakers to reflate the economy in any meaningful way. Since the contagion risks from Evergrande’s debt crisis to China’s onshore financial markets seem to be contained, policy easing in the coming months will likely be gradual. Regulators have shown no sign of reversing the existing policy restrictions. Therefore, a bigger risk to China’s financial markets stems from the possibility that policymakers overestimate the resilience of the economy and ignore signs of a spillover to other segments in the economy. Real estate activity and investment in China are set to slow structurally (discussed in the section below). If policymakers allow a disruptive deceleration in the sector's growth while being reluctant to ramp up support in other industries, China’s economic growth could downshift much more than policymakers would like to see. A rapid deceleration in the real economic activity and jitters in the financial markets could reinforce each other and spiral out of control. The facts below explain why risks of an imminent systemic crisis in China’s and global financial markets are limited (Table 1): The exposure of China’s banks to real estate developers is small relative to the banks’ total lending.  Although about 40% of total bank loans are property-related, only 6% are in loans to real estate developers. The majority of the 40% is in mortgage loans, construction loans and other loans collateralized by land and property. Evergrande’s outstanding bank debt accounts for less than 0.1% of China’s total onshore loan balances. The company owes about 1% of China’s existing trust loans and 0.04% of domestic bonds. The company has quality assets, as we discussed in last week’s report, that could cover most of its onshore outstanding debt. Widespread mortgage loan defaults are unlikely to happen, even if Evergrande does not strike a debt restructuring deal with the government. Strict housing and home-sale regulations cap the upside and limit the downside in home prices. Moreover, conservative loan-to-value ratio requirements have contributed to China’s low default rates on mortgage loans.1 Evergrande’s overseas liabilities are more significant, with its USD $20 billion bonds accounting for about 10% of China's corporate USD bonds issued by real estate developers. On the other hand, major US financial institutions have minimal direct exposure to China and Hong Kong SAR. Table 1Evergrande Debt, An Overview* Despite limited systemic risks to the financial markets, a lack of government intervention could result in a disruptive bankruptcy of the company, risking substantial ripple effects on other parts of the economy. Evergrande’s accounts payable and bills amount to nearly RMB 700 billion, owed to companies in the upstream and downstream industry supply chains.  In addition, Evergrande’s contract liabilities are as high as RMB 170 billion and are associated with the pre-sold but unfinished residential units in more than 200 cities. We think policymakers and Evergrande will ultimately agree on a debt restructuring plan. Evergrande could transfer some of its hard assets to state-owned banks or enterprises and the banks could either extend or restructure Evergrande’s existing loans to help finish and deliver the company’s housing projects. Regardless of how the debt is restructured, a government-led rescue will likely prioritize domestic homebuyers and suppliers. Evergrande shareholders and investors in offshore, USD-denominated corporate bonds will suffer large losses. Bottom Line: Our base case scenario is that the government will restructure Evergrande’s debt to prevent the company’s crisis from evolving into a systemic financial risk. Will Policymakers Reverse Restrictive Housing Policies? Even though China’s monetary and fiscal policies have eased at margin, policy restrictions on the property market remain in place. The bar for regulators to significantly ease or to reverse policy tightening in the real estate industry is much higher than in past cycles. Furthermore, the government’s efforts to contain the sector’s leverage and home price inflation are structural rather than cyclical. Our view is based on the following observations: Chart 3China's Housing Demand Is On A Structural Downshift China’s housing demand is on a structural downshift due to China’s falling birthrate and working-age population.  The decline in demand will likely accelerate in the next four to five years (Chart 3). Therefore, it is unreasonable to expect that the growth in real estate investment in the coming years will continue growing at the same rate as in the past cycles.  The government is determined to improve housing affordability by capping home prices in the coming years while increasing lower-income household wage growth. Previous “big bang” stimulus and soaring home prices have widened rather than narrowed income and wealth inequality. Beijing’s current primary focus is “common prosperity,” which aims to reduce inequality. This overarching policy initiative will prevent policymakers from backtracking on reforms in the property sector. Things are not bad enough for a major shift in policy direction. Demand for housing is down, but from a very elevated level (Chart 4). The growth of home sales is now reverting to its pre-pandemic rate. In a previous report we pointed out that the current policy backdrop resembles that of 2H2018 and 2019, when the stimulus was very measured despite a slowing economy and an escalating trade war with the US. Demand for housing in the first eight months of this year is stronger than in 2018/19, thus policymakers may not feel pressure to loosen restrictions in the housing sector.  Chart 4Post-Pandemic Housing Demand Stronger Than 2018/19 Chart 5Real Estate Investment Relatively Steady Despite Contracting Housing Starts Growth in real estate investment has been steady despite contracting housing starts (Chart 5).  The government’s deleveraging pressure on the sector since August last year has forced developers to hurry and finish their existing projects (Chart 5, bottom panel). This has helped to reduce developers’ project inventories and discourage them from hoarding land reserves, and the policy intention is unlikely to change (Chart 6). Additionally, the government has prioritized home price stability by capping prices and fine-tuning the supply of land (Chart 7). In other words, housing starts have become less market-driven and weaker readings may reflect regulators’ policy intentions to rein in land supplies.2 Local governments may increase the supply of land when real estate investment softens too fast, but home sales and project completions will have to decelerate more significantly. Chart 6Developers Have Been Rushing To Finish Existing Projects Chart 7Government Prioritizes Home Price Stability By Capping Prices And Fine-Tuning Land Supply Funding constraints will not be removed soon and restrictive policies apply to both developers and banks. Banks need to meet the “two red lines” while developers must bring their leverage ratios below the “three red lines” by end-2023. The “two red lines”, which the PBoC unveiled in January this year, set the upper limit on the portion of household mortgages and real estate loans in banks’ total lending.  Despite aggressively scaling back lending to the housing sector, the lending ratio in many banks – including China’s six large banks and various medium-sized banks – still exceeded the upper limit. These banks will have to continue to reduce their property-related lending while the other banks will maintain a lower percentage of loans to the housing sector than in the past. Consequently, binding constraints on developers and banks will continue to weigh on the housing market in the coming years, suggesting that the property market downturn will last longer than in previous cycles. Chinese policymakers are unlikely to have much appetite for more robust construction activity in the current environment with supply-side constraints for both raw materials and energy. More than 10 provinces in China are currently under power rationing and have cut factory production amid electricity supply issues and a push to enforce environmental regulations. We expect supply shortages and production decreases to continue through the winter, limiting the upside potential of the country’s economic activity. Bottom Line: China’s reforms in the property sector are structural and the leadership is much less likely to use housing as counter-cyclical policy support to the economy than in previous cycles. Investment Implications China’s growth and its ever-important property market activity have slowed. Given the policymakers’ higher pain threshold for a slower economy and lower appetite for leverage, policy easing will likely be gradual and piecemeal in the near term. The current monetary, fiscal, and industry policy backdrops resemble China’s response in H2 2018 and early 2019. Chinese stock prices rose briefly in early 2019 on the expectation of a sizable stimulus, but the rally was short-lived (Chart 8). Furthermore, we do not rule out the possibility that policymakers will be overconfident in their capability to stabilize the economy as they balance structural reforms against growth volatility. They may choose to wait until there are signs of a significant spillover to other segments in the economy before backtracking the deleveraging campaign in the property sector and lending more support to the market/economy. In this scenario, the near-term response in the equity market will likely be very negative. China-related asset prices will not stabilize until policymakers decisively and significantly dial-up their reflationary response. Property sector stocks in China’s on- and offshore markets have been beaten down by policy tightening and lately the Evergrande saga (Chart 9). We maintain our view that these stocks have not reached their bottom. The property downturn in China is a structural change and authorities are unlikely to reverse current restrictions on the sector to support the economy. Chart 8Chinese Stock Price Rally In 2019 Was Short-Lived Chart 9Chinese Real Estate Stocks Have Not Reached Their Bottom The real estate sector’s contribution to China’s economic growth is expected to gradually decline in the medium to long term. The industry will be further reformed and consolidated, and more developers will be forced to abandon their high-leverage, high-growth business expansion model. The outlook for the real estate industry’s profit growth will become less certain.  Investors will require higher risk premiums for real estate sector stocks, which means that these stocks’ valuations will be further compressed.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1 Chinese homeowners’ down payment ratios on a first property is 30% and 50% on a second property. 2Land auctions were delayed in July and August due to overwhelming demand from developers in the first half of the year. Market/Sector Recommendations Cyclical Investment Stance

Highlights The Evergrande crisis is not China’s Lehman moment. Nonetheless, Chinese construction activity will decelerate further in response to this shock. Global equities are frothy enough that a weaker-than-expected Chinese construction sector will remain a near-term risk to stocks prices. European markets are more exposed to this risk than US ones. Tactically, this creates a dangerous environment for cyclicals in general and materials in particular. Healthcare and Swiss stocks would be the winners. Despite these near-term hurdles, we maintain a pro-cyclical portfolio stance, which we will protect with some temporary hedges. We will lift these hedges if the EURO STOXX corrects into the 430-420 zone. A busy week for European central banks confirms our negative stance on EUR/GBP, EUR/SEK, and EUR/NOK. While EUR/CHF has upside, Swiss stocks should outperform Euro Area defensives. Stay underweight UK Gilts in fixed-income portfolios. Feature The collapse of property developer Evergrande creates an important risk for European markets. It threatens to slow Chinese construction activity further, which affects European assets that are heavily exposed to the Chinese real estate sector, directly and indirectly. This risk is mostly frontloaded, as Chinese authorities cannot afford a complete meltdown of the domestic property sector. Moreover, this economy has slowed significantly and more policy support is bound to take place. Additionally, forces outside China create important counterweights that will allow Europe to thrive despite the near-term clouds. While we see more short-term risk for European stocks and cyclical sectors, the 18-month cyclical outlook remains bright. Similarly, European stocks will not outperform US ones when Chinese real estate activity remains a source of downside surprise; but they will afterward. China’s Construction Slowdown Is Not Over The Evergrande crisis is not China’s Lehman moment. Beijing has the resources to prevent a systemic meltdown and understands full well what is at stake. At 160% of GDP, China’s nonfinancial corporate debt towers well above that of other major emerging markets and even that of Japan in the 1980s (Chart 1). If an Evergrande bankruptcy were allowed to topple this debt mountain, China would experience the kind of debt-deflation trap that proved so disastrous in the 1930s. A further deterioration of conditions in Chinese real estate activity is nonetheless in the cards, even if the country avoids a global systemic financial shock. First, the inevitable restructuring of Evergrande will result in losses for bond holders, especially foreign ones. Consequently, risk premia in the Chinese off-shore corporate bonds market will remain wide following the resolution of the Evergrande debacle. While Chinese banks are likely to recover a large proportion of the funds they lent to the real estate giant, they too will face higher risk premia. At the margin, the rising cost of capital will curtail the number of projects real estate developers take on over the coming two to three years. Second, the eventual liquidation of Evergrande will hurt confidence among real estate developers. This process may take many forms, but, as we go to press, the most discussed outcome is a breakup and restructuring where state-owned enterprises and large local governments absorb Evergrande’s operations. Evergrande’s employees, suppliers, and clients who have deposited funds while pre-ordering properties will be made whole one way or the other. However, shareholders and management will not. Wiping out shareholders and senior management will send a message to the operators of other developers, which will negatively affect their risk taking (Chart 2). Chart 1China Cannot Afford A Lehman Moment Chart 2Downside To Chinese Construction Activity   Third, one of President Xi Jinping’s key policy objectives is to tame rampant income inequality in the Chinese economy. Rapidly rising real estate prices and elevated unaffordability only worsen this problem. Hence, Beijing wants to avoid blind stimulus that mostly pushes house prices higher but that would have also boosted construction activity. Thus, if credit growth is pushed through the system, the regulatory tightening in real estate will not end. This process is likely to result in further contraction in floor space sold and started. Bottom Line: The Evergrande crisis is unlikely to morph into China’s Lehman moment. However, its fallout on the real estate industry means that Chinese construction activity will continue to contract in the coming six to twelve months or so. Chinese Construction Matters For European Equities The risk of further contraction in Chinese construction activity implies a significant near-term risk for European equities, especially relative to US ones. Even after the volatility of the past three weeks, global equities remain vulnerable to more corrective action. Speculative activity continues to grip the bellwether US market. Our BCA Equity Speculation Index is still around two sigma. Previous instances of high readings did not necessarily herald the end of bull markets; however, they often resulted in sideways and volatile trading, until the speculative excesses dissipated (Chart 3). The case for such volatile trading is strong. The Fed is set to begin its taper at its November meeting. Moreover, an end of the QE program by the middle of next year and the upcoming rotation of regional Fed heads on the FOMC will likely result in a first rate hike by the end of 2022. Already, the growth rate of the global money supply has declined, and the real yield impulse is not as supportive as it once was. Therefore, the deterioration in our BCA Monetary Indicator should perdure (Chart 4), which will heighten the sensitivity of global stocks to bad news out of China. Chart 3Rife With Speculation Chart 4Liquidity Deterioration At The Margin Chart 5Still Too Happy Investor sentiment is also not as washed out as many news stories ascertain. The AAII survey shows that the number of equity bulls has fallen sharply, but BCA’s Complacency-Anxiety Index, Equity Capitulation Indicator and Sentiment composite are still inconsistent with durable market bottoms. Moreover, the National Association of Active Investment Managers’ Exposure Index is still very elevated. When this gauge is combined with the AAII bulls minus bears indicator, it often detects floors in the US dollar-price of the European MSCI index (Chart 5). For now, this composite sentiment measure is flashing further vulnerability for European equities, especially if China remains a source of potential bad news in the coming months. Economic linkages reinforce the tactical risk to European stocks. Chinese construction activity affects the Euro Area industrial production because machinery and transportation goods represent 50% of Europe’s export to China (Chart 6). This category is very sensitive to Chinese real estate activity. Moreover, Europe’s exports to other nations are also indirectly affected by the demand from Chinese construction. Financial markets bear this footprint. Excavator sales in China are a leading indicator of construction activity. Historically, they correlate well with both the fluctuations of EUR/USD and the performance of Eurozone stocks relative to those of the US (Chart 7). Hence, if we anticipate that the problems Evergrande faces will weigh on excavator sales in the coming months, then the euro will suffer and Euro Area stocks could continue to underperform. Chart 6Europe's Exports To China Are Sensitive To Construction Activity Chart 7A Near-Term Risk To European Assets   Similarly, the fallout from Evergrande’s problem will extend to the performance of European equity sectors. The sideways corrective episode in cyclical relative to defensive shares is likely to continue in the near term. This sector twist remains frothy, and often declines when Chinese credit origination is soft (Chart 8). Materials stocks are the most likely to suffer due to their tight correlation with Chinese excavator sales (Chart 9); meanwhile, healthcare equities will reap the greatest benefit as a result of their appealing structural growth profile and their strong defensive property. Geographically, Swiss stocks should perform best (Chart 9, bottom panel), because they strongly overweigh healthcare and consumer staple names. Moreover, as we recently argued, the SNB’s monetary policy is an advantage for Swiss stocks compared to Eurozone defensives.1 Additionally, Dutch equities, with their 50% weighting in tech and their small 12% combined allocation to industrials and materials, could also enjoy a near-term outperformance as investors digest the sectoral impact of weaker Chinese construction activity. Chart 8The Vulnerability Of Cyclicals/Defensives Remains Chart 9Responses To Weaker Construction   Bottom Line: No matter how the Evergrande story unfolds, its consequence on Chinese construction activity may still cause market tremors. Global equity benchmarks may be rebounding right now, but, ultimately, they remain vulnerable to this slowdown. Any negative surprise out of China is likely to cause Europe to underperform because of its greater exposure to Chinese construction activity. Investment Conclusion: This Too Shall Pass The risks to the European equity market and its cyclicals sectors will prove transitory and will finish by the end of the year. Beijing will tolerate some pain to the real estate sector, but the stakes are too high to let the situation fester for long. The main problem is China’s large debt. Already sequential GDP growth in the first half of 2021 was worse than the same period in 2020, and credit accumulation is just as weak as in early 2018 (Chart 10). In this context, if real estate activity deteriorates too much, aggregate profits will contract and, in turn, will hurt the corporate sector’s ability to service its debt. Employment and social tensions create another stress point that will force Beijing’s hand. At 47, the non-manufacturing PMI employment index is already well into the contraction zone (Chart 11). Weakness in construction activity will hurt the labor market further. In an environment where protests have been springing up all over China, the Communist Party does not want to see more stress applied to workers. Chart 10In The End, Stimulus Will Come Chart 11Worsening Chinese Employment Conditions   These two constraints will force Beijing to alleviate the pain caused by a weaker construction sector. As a result, we still expect the Chinese credit and fiscal impulse to re-accelerate by Q2 2022. Developments outside of China will create another important offset that will allow risk assets to thrive once their immediate froth has receded. Strong DM capex will be an important driver of global activity next year. As Chart 12 shows, capex intentions in the US and the Euro Area are rapidly expanding, which augurs well for global investments. Moreover, re-building depleted inventories (Chart 13) will be a crucial component of the solution to global supply bottlenecks. Both activities will add to global demand. As an example, ship orders are already surging. Chart 12DM Capex Intentions Are Firming Chart 13Don't Forget About Inventories     We maintain a pro-cyclical stance in European markets after weighing the near-term negatives against the underlying positive forces. For now, hedging the tactical risk still makes sense and our long telecommunication / short consumer discretionary equities remain the appropriate vehicle – so does being long Swiss stocks versus Euro Area defensives. However, we will use any correction in the EURO STOXX (Bloomberg: SXXE Index) to the 430-420 zone to unload this protection. Bottom Line: The potential market stress created by a slowdown in Chinese construction activity will be a temporary force. Beijing will not tolerate a much larger hit to the economy, especially as tensions are rising across the country. Thus, even if the stimulus response to the Evergrande crisis will not be immediate, it will eventually come, which will support Chinese economic activity. Additionally, the capex upside and inventory rebuilding in advanced economies will create an offset for slowing Chinese growth. Consequently, while we maintain a pro-cyclical bias over the medium term, we are also keeping in place our hedges in the near term, looking to shed them if SXXE hits the 430-420 zone. A Big Week For Central Banks Chart 14The BoE's Is Listening To The UK's Economic Conditions... Last week, four European central banks held their policy meetings: The Riksbank, the Swiss National Bank, the Norges Bank, and the Bank of England. No major surprises came out of these meetings, with central banks discourses and policy evolving in line with their respective economies. The BoE veered on the hawkish side, highlighting that rates could rise before its QE program is over. This implies a small possibility of a rate hike by the end of 2021. However, our base case remains that the initial hike will be in the first half of 2022. The BoE is behaving in line with the message from our UK Central Bank Monitor (Chart 14). Moreover, the combination of rapid inflation and strong house price appreciation is incentivizing the BoE to remove monetary accommodation, especially because UK financial conditions are extremely easy (Chart 14, bottom panel). One caution advanced by the MPC is the uncertainty surrounding the impact of the end of the job furlough scheme this month. However, the global economy will be strong enough next spring to mitigate the risks to the UK. The results of last week’s MPC meeting and our view on the global and UK business cycles support the short EUR/GBP recommendation of BCA’s foreign exchange strategist,2 as well as the underweight allocation to UK Gilts of our Global Fixed Income Strategy group.3 The Norges Bank is the first central bank in the G-10 to hike rates and is likely to do so again later this year. While Norwegian core inflation remains low, house prices are strong, monetary conditions are extremely accommodative, and our Norway Central Bank Monitor is surging (Chart 15). The Norwegian central bank will continue to focus on these positives, especially in light of our Commodity and Energy team’s view that Brent will average more than $80/bbl by 2023.4 In this context, we anticipate the NOK to outperform the euro over the coming 24 months. Nonetheless, the near-term outlook for Norwegian stocks remains fraught with danger. Materials account for 17% of the MSCI Norway index and are the sector most vulnerable to a deterioration in Chinese construction activity. The Riksbank continues to disregard the strength of the Swedish economy. Relative to economic conditions, it is one of the most dovish central banks in the world. The Swedish central bank is completely ignoring the message from our Sweden Central Bank Monitor, which has never been as elevated as it is today (Chart 16). Moreover, the inexpensiveness of the SEK means that Swedish financial conditions are exceptionally accommodative. At first glance, this picture is bearish for the SEK. However, easy monetary conditions will cause Sweden’s real estate bubble to expand. Expanding real estate prices and transaction volumes will boost the profits of Swedish financials, which account for 27% of the MSCI Sweden index. Moreover, Swedish industrials remain one of our favorite sectors in Europe, and they represent 38% of the same index. As a result, equity flows into Sweden should still hurt the EUR/SEK cross. Chart 15...And The Norges Bank, To Norway's Chart 16The Riksbank Is Blowing Real Estate Bubbles Chart 17The CHF Still Worries The SNB Finally, the SNB proved reliably dovish. Our Switzerland Central Bank Monitor is rising fast as inflation and house prices improve (Chart 17). However, the SNB is rightfully worried about the expensiveness of the CHF, which generates tight Swiss financial conditions (Chart 17, bottom panel). Consequently, the SNB will keep fighting off any depreciation in EUR/CHF. Thus, the SNB will be forced to expand its balance sheet because the ECB is likely to remain active in asset markets longer than many of its peers. This process will be key to the outperformance of Swiss stocks relative to other European defensive equities.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1 Please see European Investment Strategy “The ECB’s New Groove,” dated July 19, 2021, available at eis.bcarsearch.com 2 Please see Foreign Exchange Strategy “Why Are UK Interest Rates Still So Low?,” dated March 10, 2021, available at fes.bcarsearch.com 3 Please see European Investment Strategy “The UK Leads The Way,” dated August 11, 2021, available at eis.bcarsearch.com 4 Please see Commodity & Energy Strategy “Upside Price Risk Rises For Crude,” dated September 16, 2021, available at fes.bcarsearch.com   Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance

Highlights Evergrande is just a canary in the coalmine warning of the vulnerability of global real estate, which is now trading on its highest valuation ever. US house prices are now more extended versus rents than at the peak of the credit boom. US bond yields cannot move up very far before severely choking mortgage demand and hence the housing market (not to mention the stock market). We reiterate our structural recommendation to own the US 30-year T-bond, whose ultimate low in yield will come in the next deflationary shock. New structural recommendation: buy the China 30-year government bond Stay structurally long real estate. Even though valuations are high, they will get even higher when 30-year bond yields reach their ultimate low.  Fractal analysis: Uranium and Palm Oil. Feature Chart of the WeekThe $300 Trillion Global Real Estate Market Dwarfs The $90 Trillion Global Economy The recent woes of China’s systemically important real estate developer Evergrande confirm the concern we voiced in our October 29, 2020 Special Report: The Real Risk Is Real Estate. To be clear, we do not expect any Evergrande default to topple the global financial dominoes á la 2008. The Chinese government is able and almost certainly willing to prevent its own Lehman moment. A more realistic concern is that the rich valuation of real estate, both in China and globally, is vulnerable to the slightest of shocks, and Evergrande is just a canary in the coalmine. Even A 10 Percent Decline In Chinese House Prices Would Constitute A Major Shock According to global real estate specialist Savills, four of the top six world cities for real estate inflation in 2021 are in China. Through just the first half of the year, prime real estate prices have surged by 14 percent in Shanghai, 13 percent in Hangzhou, 9 percent in Shenzhen, and 8 percent in Guangzhou.1 This surge in Chinese property prices has lifted Chinese valuations to nosebleed levels. Today, prime real estate yields in China’s major cities are barely above 1 percent, just a third of the global average of 3 percent. From such nosebleed valuations, a fire sale of Evergrande’s inventory – as creditors tried to recover debts – could weigh down real estate prices. And the repercussions would extend beyond China’s property sector. Prime real estate yields in China’s major cities are barely above 1 percent, just a third of the global average of 3 percent. Without a social safety net and with limited places to park their money, Chinese savers have for years been encouraged to buy homes, in the widespread belief that property is the safest investment, whose price is only supposed to go up. With the bulk of people’s wealth in property acting as a perceived economic safety net, even a 10 percent decline in house prices would constitute a major shock to the household sector’s hopes and expectations of what property is (Chart I-2). Chart I-2Even A 10 Percent Decline In Chinese House Prices Would Constitute A Major Shock In turn, the ensuing ‘negative wealth effect’ would unleash a major headwind to household spending in the world’s second largest economy. Nosebleed Property Valuations Everywhere The precarious valuation of real estate is not just a Chinese concern. US house prices are now more extended versus rents than at the peak of the credit boom (Chart I-3). Chart I-3US House Prices Are Now More Extended Versus Rents Than At The Peak Of The Credit Boom Yet the phenomenon extends globally. Through the past ten years, world prime residential prices are up by 70 percent while rents are up by just 25 percent.2 As a mathematical identity, this means that the bulk of the increase in global real estate prices is due to valuation expansion (Chart I-4). Savills confirms this by pointing out that its global prime residential yield has fallen below 3 percent for the first time, and constitutes the lowest global rental yield since the firm began tracking the data in 2005. Chart I-4The Bulk Of The Increase In Global Real Estate Prices Is Due To Valuation Expansion The culprit for the richest ever valuation of global real estate is the structural collapse in global bond yields. And the culprit for the structural collapse in bond yields is persistently ultra-low policy interest rates combined with trillions of dollars of quantitative easing (Chart I-5). Chart I-5The Culprit For The Richest Ever Valuation Of Global Real Estate Is The Structural Collapse In Global Bond Yields But now, policy makers risk being hoisted by their own petard. The tight relationship between bond yields and real estate yields means that bond yields have very limited scope to rise before pulling the bottom out of the $300 trillion global real estate market. Given that this dwarfs the $90 trillion global economy, even a 10 percent correction amounting to $30 trillion would constitute a devastating negative wealth effect (Chart of the Week). Nosebleed Property Valuations Reinforce The Structural Case For 30-Year Bonds Some people counter that in an inflationary shock, property – as the ultimate real asset – ought to perform well even as bond yields rise. However, when valuations start off in nosebleed territory as now, the initial intense headwind from deflating valuations obliterates the tailwind from inflating incomes. An easy way to understand this intense headwind is through the concept of affordability. In the US the 15-year mortgage rate tracks the 10-year T-bond yield plus a usually consistent spread of around 1 percent. Hence, if the 10-year T-bond yield rose from 1.3 to 2 percent, the mortgage rate would rise from 2.3 to 3 percent, a proportionate increase of 30 percent. For the marginal buyer using an interest-only mortgage, this means that already stretched affordability versus income would worsen by 30 percent.3 Therefore, for the marginal buyer to keep his bid on the property the same, his income would have to inflate by 30 percent. But in an inflationary shock that pushed up the bond yield by 0.7 percent, it is implausible that wages would rise by 30 percent. Let’s say, at a push, that wages rose by 10 percent. To keep affordability and mortgage demand the same, property prices would have to plunge by 20 percent. In fact, earlier this year we saw the extreme vulnerability of US mortgage demand to higher bond yields. When the bond yield collapsed at the start of the pandemic in 2020, the mortgage rate declined more sedately. Hence, in the early stage of bond yield rebound, the US mortgage rate did not increase (Chart I-6). Chart I-6In 2020, The US Mortgage Rate Briefly Decoupled From Its Usual Relationship With The Bond Yield But by early 2021, the mortgage rate had normalised its relationship with the bond yield, so the snap-up in yields earlier this year lifted mortgage rates point for point. The worrying result was that US mortgage applications for house purchases collapsed by one third (Chart I-7). Chart I-7As Bond Yields Rose Earlier This Year, US Mortgage Applications Collapsed By One Third Fortunately, the negative feedback from markets and the economy meant that the snap-up in bond yields was brief. As yields have subsequently fallen back, mortgage demand has stabilised. Yet the crucial lesson is that US bond yields cannot move up very far before severely choking mortgage demand and hence the housing market (not to mention the stock market). To repeat, US house prices are more stretched versus rents than at the peak of the credit boom in 2007. With this precarious dynamic, we reiterate our structural recommendation to own the US 30-year T-bond, whose ultimate low in yield will come in the next deflationary shock. As bond yields rose earlier this year, US mortgage applications collapsed by one third. But today we are adding a new structural recommendation. Given that Chinese real estate valuations are even more precariously balanced than those in the US, and that purchases have been lending-fuelled, Chinese long-dated bonds are an excellent structural investment for those investors who can accept the capital control risks. As a structural holding, buy the China 30-year government bond (Chart I-8). Chart I-8The Ultimate Low In The US And China 30-Year Bond Yield Is Still To Come As for the highly-valued real estate asset-class, the paradox is that valuations will reach their ultimate high when 30-year bond yields reach their ultimate low. Until then, stay structurally long real estate. Uranium Is The Latest ‘Meme Theme’ The recent near-vertical ascent in uranium plays have left many investors scratching their heads and wondering: what’s going on? The answer, in large part, is that uranium plays have become the latest ‘meme theme’. On Reddit’s Wall Street Bets forum, the Canadian uranium miner Cameco has become the second most discussed stock, with one post likening the current opportunity to that in Gamestop, the original meme stock. Of course, as in all meme themes, there must be a loose narrative to latch on to. In this case, it is that as a zero carbon-emitting source of energy, uranium demand should rise while supply remains tight. Still, fractal analysis suggests that meme investors have moved prices too far too fast. Elsewhere, fractal analysis suggests that the spectacular rally in palm oil is also susceptible to a reversal. In this case, the rally has been due to supply bottlenecks in Indonesia and Malaysia, which we expect ultimately to ease (Chart I-9) Chart I-9The Spectacular Rally In Palm Oil Is Susceptible To Reversal Nevertheless, this week our favoured trade is to short the meme theme rally in uranium plays (Chart I-10). A good expression is to short the UK stock Yellow Cake, setting the profit target and symmetrical stop-loss at 13 percent. Chart I-10Short The Meme Theme Rally In Uranium Plays   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The other two cities in the top six are Los Angeles and Miami. 2 Based on Savills Prime Index: World Cities – Capital Values, and World Cities – Rents and Yields, June 2011 through June 2021. 3 This calculation assumes an interest only mortgage. The increase would be less for a capital repayment mortgage, but it would still be substantial. 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 - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights We cannot predict how China will manage Evergrande precisely but we have a high conviction that it will do whatever it takes to prevent contagion across the property sector. However, China’s stimulus tools are losing their effectiveness over time. The country is due for a prolonged struggle with financial and economic instability regardless of whether Evergrande defaults. A messy default would obviously exacerbate the problem. China’s regulatory crackdowns target private companies and will continue to weigh on animal spirits in the private sector. The government will be forced to use fiscal policy to compensate. The US’s and China’s switch from engagement to confrontation poses a persistent headwind for investor sentiment toward China. The new consensus that investors should buy into China’s “strategic sectors” to avoid arbitrary regulatory crackdowns is vulnerable to its own logic and to sanctions by the US and its allies. Feature China poses a unique confluence of domestic and foreign political risks and global markets are now pricing them. Property giant Evergrande could default on $120 million in onshore and offshore interest payments as early as September 23, or next month, prompting investors to run for cover. Is this crisis fleeting or part of a larger systemic failure? It is a larger systemic failure. We expect a slow-motion, Japanese-style crisis over the coming decade, marked with periodic bailouts and stimulus packages. We recommend investors stay the course: steer clear of China and stay short the renminbi and Taiwanese dollar. Tactically, stick with large caps, defensive sectors, and developed markets within the global equity universe. Strategically, prefer emerging markets that benefit from forthcoming Chinese (and American) stimulus. 1. A “Minsky Moment” Cannot Be Ruled Out The chief fear is whether the approaching default of Evergrande marks China’s “Minsky Moment.” Hyman Minsky’s financial instability hypothesis held that long periods of stable revenues lead to risky financial deals and large accumulations of systemic risk that are underpriced. When revenues cannot cover interest payments, a crash ensues followed by deleveraging. Minsky’s hypothesis speaks to debt crises in an entire economy, yet nobody knows for sure whether China’s economy has reached such a breaking point. China’s national savings rate stands at 45.7% of GDP and nominal growth exceeds the long-term government bond yield. However, a sharp drop in asset prices, especially in the property sector, could change everything, as it could lead to balance sheet recession among corporates and a fall in national income. Evergrande is supposed to make an $84 million interest payment on offshore debt and a $36 million payment on onshore debt this week, and after 30 days it would default. It owes $37 billion in debt payments over the next 12 months but only has $13 billion cash on hand (as of June 30, 2021). Authorities can opt for a full bailout or a partial bailout, in which the company defaults on offshore bonds but not onshore. They could even let the company fail categorically, though that would produce exactly the kind of precipitous drop in property asset prices that would lead to wider financial contagion. State intervention to smooth the crisis is more likely – and the government can easily pressure other companies into acquiring Evergrande’s assets and business divisions. Chart 1Yes, This Could Be China's Minsky Moment Chart 1 shows that China’s corporate debt-to-GDP ratio stands head and shoulders above other countries that experienced financial crises in recent decades, courtesy of our Emerging Markets Strategy. While China can undoubtedly bear large debts due to its savings, the implication is that China has large enough financial imbalances to suffer a full-fledged financial crisis, even if the timing is hard to predict. Household credit is also elevated at 61.7% of GDP, and the household debt-to-disposable-income ratio is now higher than in the United States. About two-thirds of China’s corporate debt is held by state-owned or state-controlled entities, prompting some investors to dismiss the gravity of the risk. However, financial crises often involve the transfer of debt from the state to private sector or vice versa. 59% of bond defaults in H1 2021 have involved state companies. Total debt is the main concern. Don’t take our word for it: China’s Communist Party has warned for the past decade about the danger of “implicit guarantees” and “moral hazard” that encourage financial excesses in the corporate sector. The Xi Jinping administration has tried to induce a deleveraging process since it came to power in 2012-13. Xi’s “three red lines” for the property sector precipitated the current turmoil. Even if Evergrande’s troubles are managed, China’s systemic risks will continue to boil over as its potential growth rate slows and the government continues trying to wring out financial excesses. Chart 2Policy Uncertainty, Financial Stress Can Rise Higher More broadly China is experiencing an unprecedented overlap of economic and political crises: The population is aging and labor force is shrinking; The economic model since 2009 has been changing from export-manufacturing to domestic-oriented, investment-driven growth; Indebtedness is spreading from corporates to households and ultimately the government; The governance model is shifting from “single-party rule” to “single-person rule” or autocracy; The population is reaching middle class status and demanding better quality of life; The international trade environment is turning from hyper-globalization to hypo-globalization; The geopolitical backdrop is darkening with the US and its allies attempting to contain China’s ambitions of regional supremacy. Almost all of these changes bring more risks than opportunities to China over the long haul. The need for rapid policy shifts provides the ostensible reasoning for President Xi Jinping’s decision not to step down but to remain president for the foreseeable future. He will clinch this position at the twentieth national party congress in fall 2022. The implication is that policy uncertainty will continue climbing up to at least 2019 peaks while offshore equity markets will continue to trend lower, as they have done since the onset of the US trade war (Chart 2). Credit default swap rates have so far been subdued but they are showing signs of life. A sharp rise in policy uncertainty and property sector stress would pull them up. Domestic equities (A-shares) have rallied since 2019 but we would expect them to fall back given China’s historic confluence of structural and cyclical challenges, which will create further negative surprises (Chart 2, bottom panel). 2. Beijing Will Provide Bailouts And Stimulus Ad Nauseum Evergrande’s future may be in doubt but Beijing will throw all its power at stopping nationwide financial contagion. True, a policy miscalculation is possible. A tardy or failed intervention cannot be ruled out. However, investors should remember that a clear pattern of bailouts and stimulus has emerged over the course of the Xi Jinping administration whenever a “hard landing” or financial collapse loomed. The government tightens controls on bloated sectors until the financial fallout threatens to undermine general economic and social stability, at which point the government eases policy. It is often forced to stimulate the economy aggressively. Chart 3 shows these cycles in two ways: China’s control of credit through the state-controlled banks, and the frequency of news stories mentioning important terms associated with financial and economic distress: defaults, layoffs, and bankruptcies. These three terms used to be unheard of among China watchers. Under the Xi administration, a higher tolerance of creative destruction has served as the way to push forward reform. The current rise in distress is not extended, suggesting that more bad news is coming, but it also shows that the government has repeatedly been forced to provide stimulus even under the Xi administration. Chart 3Xi Jinping Has Bailed Out System Three Times Already Could this time be different? Not likely. The American experience and the pandemic will also force China’s government to ease policy: China learns from US mistakes. The US lurched from Lehman’s failure into a financial crisis, an impaired credit channel, a sluggish economic recovery, a spike in polarization, policy paralysis, a near-default on the national debt, a surge in right- and left-wing populism, the tumultuous Trump presidency, widespread social unrest, a contested leadership succession, and a mob storming the nation’s capitol (Chart 4). This is obviously the nightmare of any Chinese leader and a trajectory that the Xi administration will avoid at any cost. Chart 4Lehman Brothers A Powerful Disincentive For China To Let Evergrande Fail Chinese households store their wealth in the property sector, so any attempt at policy restraint or austerity faces a massive constraint. Only a few countries are comparable to China with respect to the share of non-financial household wealth (property and land) within total household wealth. All of them are hosts of property sector bubbles, including the bubbles in Spain and Ireland back in 2007 (Chart 5). A property collapse would destroy the savings of the Chinese people over four decades of prosperity. Chart 5Property Is The Bedrock Of Chinese Households Social instability is already flaring up. Almost all China experts agree that “social stability” is the Communist Party’s bottom line. But note that the Evergrande saga has already led to protests, not only at the company’s headquarters in Shenzhen but also in other cities such as Shenyang, Guangzhou, Chongqing. Protests were filmed and shown on social media (posts have been censored). Protesters demanded repayment for wealth management products gone sour and properties they are owed that have not been built. This is only a taste of the cross-regional protests that would emerge if the broader property sector suffered. The lingering COVID-19 pandemic is still relevant. Investors should not underrate the potential threat that the pandemic poses to the regime. Severe epidemics have occurred about 11% of the time over the course of China’s history and they often have major ramifications. Disease has played a role in the downfall of six out of ten dynasties – and in four cases it played a major role. It would be suicidal for any regime to add self-inflicted economic collapse to a lingering pandemic (Table 1). Table 1Disease Threatens Chinese Dynasties – Not A Time To Self-Inflict A Recession Easing policy does not necessarily mean bringing out the “bazooka” and splurging on money and credit growth, though that is increasingly likely as the crisis intensifies. Notably the July Politburo statement specifically removed language that said China would “avoid sharp turns in policy.” In other words, sharp turns might be necessary. That can only mean sharp reflationary turns, as there is very little chance of doubling down on policy tightening. A counterargument holds that the Chinese government is now exclusively focused on power consolidation to the neglect of financial and economic stability. Perhaps the leadership is misinformed, overconfident, or thinks a financial collapse will better purge its enemies – along the lines of the various political purges under Chairman Mao Zedong. Wealthy tech magnates and property owners could conceivably challenge the return of autocracy. After all, the US political establishment almost “fell” to a rich property baron – why couldn’t China’s Communist Party? Political purges should certainly be expected ahead of next year’s party congress. But not to the point of killing the economy. The government would not be trying to balance policy tightening and loosening so carefully if it sought to induce chaos. It must be admitted, however, that the change to autocracy means that the odds of irrational or idiosyncratic policy have gone up substantially and permanently. Of course, the high likelihood that Beijing will provide bailouts and stimulus should not be read as a bullish investment thesis, even though it would create a pop in oversold assets. The Chinese system is saturated with money and credit, which have been losing their effectiveness in driving growth. Financial imbalances get worse, not better, with each wave of credit stimulus. Beijing is caught between a rock and a hard place. Hence stimulus comes only reluctantly and reactively. But it does come in the end because a financial crash would threaten the life of the regime and preclude all other policy priorities, domestic and foreign. 3. Yes, China’s Regulatory Crackdown Targets The Private Sector Global growth and other emerging economies will get most of the benefit once China stimulates, since China’s own firms will still face a negative domestic political backdrop. Bullish investors argue that the government’s regulatory tightening is misunderstood and overblown. The claim is that China is not targeting the private sector generally but only isolated sectors causing social problems. Costs need to be reduced in property, education, and health to improve quality of life. China shares the US’s and EU’s desire to rein in tech giants that monopolize their markets, abuse consumer data and privacy, and benefit from distorted tax systems. Most of these arguments are misleading. China does not have a strong record on data privacy, equality, social safety nets, rule of law, or “sustainable” growth (as opposed to “unsustainable,” high-debt, high-polluting growth). China actively encourages state champions that monopolize key sectors. Many developed markets have better records in these areas, notably in Europe, yet China is eschewing these regulatory models in preference for an approach that is arbitrary and absolutist, i.e. negative for governance. As for the private sector, animal spirits have been in a long decline throughout the past decade. This is true whether judging by money velocity – i.e. the pace of economic activity relative to the increase in money supply – or by households’ and businesses’ marginal propensity to save (Chart 6). The 2015-16 period shows that even periodic bouts of government stimulus have not reversed the general trend. Regulatory whack-a-mole and financial turmoil will not improve the situation. Chart 6Private Sector Animal Spirits Depressed Throughout Xi Era Chart 7Even Official Data Shows Consumer Confidence Flagging Surveys of sentiment confirm that the latest developments will have a negative effect (Chart 7). Cumulatively, the changes in China’s domestic and international policy context are being interpreted as negative for business, entrepreneurship, and economic freedom – notwithstanding the government’s claims to expand opportunity in its “common prosperity” plan. 4. The Withdrawal Of US Friendship Is A Headwind For China Chart 8Other Asians Sought US Friendship, Not Conflict, When Export Models Expired All of the successful Asian economies – including China for most of the past forty years of prosperity – have tried to stay on the good side of the United States. By contrast, China and the US today are shifting from engagement to confrontation and breaking up their economic ties (Chart 8). This is a problem for China because the US and to some extent its allies will seek to undermine China’s economy and its autocratic model as part of this great power competition. The rise in geopolitical risk is underscored by the Australia-UK-US (AUKUS) agreement, by which the US will provide Australia with nuclear submarines over the next decade. This was a clear demonstration of the US’s “pivot to Asia” and the fact that the US and China are preparing for war – if only to deter it. China’s return to autocracy and clash with the US and Asian neighbors is also leading to a deterioration of its global image, particularly over issues of transparency and information sharing. The dispute over the origins of COVID-19 is a major source of division with the US and other countries. Transparency is important for investors. The World Bank has discontinued its “Ease of Doing Business” rankings after a scandal was revealed in which China’s ranking was artificially bumped up. The last-published trend is still downward (Chart 9). Most recently China has stepped up censorship of its financial news media amid the current market turmoil, which makes it harder for investors to assess the full extent of property and financial risks.1 The US political factions agree on China-bashing if nothing else. The Biden administration has little political impetus to eschew tariffs and export controls. One important penalty will come from the Securities and Exchange Commission, which is likely to ban Chinese firms from US stock exchanges unless they conform to common accounting standards. Hence the dramatic fall in the share prices of Chinese companies listed via American Depository Receipts (ADRs), in both absolute and relative terms (Chart 10, top panel). This threat prompted China’s recent crackdown on its own firms that were attempting to hold initial public offerings on US exchanges. Chart 9US Conflict Exposes China’s Global Influence Campaign The Quadrilateral Forum – the US, Japan, Australia, and India – has agreed to link the semiconductor supply chain to human rights standards, foreclosing China’s participation in that supply chain. US semiconductor firms are among the most exposed to China but they have not suffered over the course of the US-China tech war, suggesting that US vulnerabilities are limited (Chart 10, bottom panel). Chart 10US Regulators Will Kick Chinese Firms While They Are Down The point is not to exaggerate the strength of the US and its allies but rather the costs to China of actively opposing them. The US has a difficult enough time cobbling together a coalition of states to impose sanctions on Iran over its nuclear program, not to mention forming any coalition that would totally exclude and isolate China. China is far more important to US allies than Iran – it is irreplaceable in the global economy (Chart 11). The EU and China’s Asian neighbors will typically restrain the US’s more aggressive impulses so as not to upset the global recovery or end up on the front lines of a war.2 Chart 11No Substitute For China In Global Economy This diplomatic constraint on the US is probably positive for global growth but not for China per se. American allies are still able to increase the costs on China for pursuing its own state-backed development path and geopolitical sphere of influence. Japan, Australia, and others are likely to veto China’s application to join the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP), while the UK and eventually the US are likely to join it. Investors should view US-China ties as a headwind at least until the two powers manage to negotiate a diplomatic thaw, i.e. substantial de-escalation of tensions. A thaw is unlikely in the lead-up to Xi Jinping’s consolidation of power and the US midterm elections in fall 2022. Presidents Biden and Xi are still working on a bilateral summit, not to mention a more substantial improvement in ties. We doubt a diplomatic thaw would be durable anyway but the important point is that until it happens China will face periodic bouts of negative sentiment from the emerging cold war. Other Asian economies thrived under US auspices – China is sailing in uncharted waters. 5. Global Investors Cannot Separate Civilian From State And Military Investments The word on Wall Street is that investors should align their strategies with those of China’s leaders so as not to run afoul of arbitrary and draconian regulators. For example, instead of “soft tech” or consumer-oriented companies – like those that give people rides, deliver food, or make creative video games – investors should invest in “hard tech” or strategic companies like those that make computer chips, renewable energy, biotechnologies, pharmaceuticals, and capital equipment. There is no question that the trend in China – and elsewhere – is for governments to become more active in picking winners and losers. Industrial policy is back. Investors have no choice but to include policy analysis in their toolbox. However, for global investors, an investment strategy of buying whatever the government says is far from convincing. The most basic investment strategy in keeping with the Xi administration’s goals would be to invest in state-owned enterprises in domestic equity markets. So SOEs should have outperformed the market, right? Wrong. They were in a downtrend prior to the 2015 bubble, the burst of which caused a further downtrend (Chart 12, top panel). Similarly, the preference for “hard tech” over “soft tech” is promising in theory but complicated in practice: hard tech is flat-to-down over the decade and down since COVID-19 (Chart 12, middle panel). It has underperformed its global peers (Chart 12, bottom panel). China’s policy disposition should be beneficial for industrials, health care, and renewable energy. First, China is doubling down on its manufacturing economy. Second, the population is aging and health care is a critical part of the common prosperity plan. Third, green energy is a way of diversifying from dependency on imported oil and natural gas. However, the profile of these sectors relative to their global counterparts is only unambiguously attractive in the case of industrials, which began to outperform even during the trade war (Chart 13). Chart 12State Approved' Trades Still Bring Risks Chart 13Beware 'State Approved' Trades In Table 2 we outline the valuations and political risks of onshore equity sectors. Valuations are not cheap. Domestic and foreign risks are not fully priced. Table 2China Onshore Equities, Valuations, And (Geo)Political Risks There is a bigger problem for global investors, especially Americans: investing in China’s strategic sectors directly implicates investors in the Communist Party’s domestic human rights practices, state-owned enterprises, and national security goals. “Civil-military fusion” is a well-established doctrine that calls for the People’s Liberation Army to have access to the cutting-edge technology developed by civilians and vice versa. These investments will eventually be subject to punitive measures since the US policy establishment believes it can no longer afford to let US wealth buttress China’s military and technological rise. Investment Takeaways China may or may not work out a partial bailout for Evergrande but it will definitely provide state assistance and fiscal stimulus to try to prevent contagion across the property sector and financial system. Bad news in the coming weeks and months will be replaced by good news in this sense. However, the fact that China will eventually be forced to undertake traditional stimulus yet again will increase its systemic financial risks, in a well-established pattern. The best equity opportunities will lie outside of China, where companies will benefit from global recovery yet avoid suffering from China’s unique confluence of domestic and foreign political risks. We prefer developed markets and select emerging markets in Latin America and Asia-ex-China. Chinese households and businesses are downbeat. This behavior cannot be separated from the historic changes in the economy, domestic politics, and foreign policy. It is hard to see an improvement until the government boosts growth and the 2022 political reshuffle is over. American opposition is a bigger problem for China than global investors realize. Not only are the two economies divorcing but other democracies will distance themselves from China as well – not because of US demands but because their own manufacturing, national security, and ideological space is threatened by China’s reversion to autocracy and assertive foreign policy. Investing in China’s “hard tech” and strategic sectors with government approval is not a simple solution. This approach will directly funnel capital into China’s state-owned enterprises, domestic security forces, and military. As such the US and West will eventually impose controls. Investments may not be liquid since China would suffer if capital ever fled these kinds of projects. Both American and Chinese stimulus is looming this winter but the short run will see more volatility. We are closing our long JPY-KRW tactical trade for a gain of 4.4%   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 We have often noted in these pages over the past decade that multilateral organizations overrated improvements in China’s governance based on policy pronouncements rather than structural changes. 2 Still, tensions among the allies should not be overrated since they share a fundamental concern over China’s increasing challenge to the current global order. The EU is pursuing trade talks with Taiwan, and there are ways that the US can compensate France over the nullification of its submarine sales to Australia (most of which are detrimental to China’s security).