China

Highlights Global growth is peaking, but US growth is losing momentum relative to its peers. This has historically been negative for the greenback. Chinese monetary policy is no longer on a tightening path, and might ease going forward. As discounting mechanisms, cyclical currencies should outperform. Our bias is that non-US growth will outperform growth in the US over the next 12-18 months. This will lead to capital reallocation away from the US dollar. While US bond yields could rise towards 2%, real interest rates will remain low compared to history. Our recommendations remain the same: the DXY will struggle to punch above the 94-95 level, but will ultimately touch 80. Feature Chart I-1US Growth Momentum And The Dollar The DXY index is up for the year, but has twice failed to punch the 94 level. The first leg of the rally from January to March occurred within a context of rising global yields, led by the US. The second leg, starting in June was triggered by a perceived hawkish shift from the Federal Reserve. The common denominator for both legs of the rally was that US growth was outperforming growth in the rest of the world. But that is beginning to change. Bloomberg consensus forecasts show a sharp reversal in US growth momentum, relative to its peers (Chart I-1). Historically, this has put a firm ceiling on the greenback. Cycles And The US Dollar The dollar tends to fare worse early in the cycle when growth is rising but inflation is falling (Chart I-2). Admittedly, inflation prints in some developed markets like the US and Canada have been rather strong. But to the extent that these prints reflect transitory factors, it should allow global central banks to remain accommodative, supporting growth. The remarkable thing about Chart I-1 is that the rotation in growth from the US towards other countries has been broad based. Countries such as Canada, New Zealand, Brazil and Mexico are seeing a bottoming in growth momentum relative to the US (Chart I-3). Chart I-2The Dollar Fares Poorly Early In The Cycle Chart I-3A Rotation Of Growth From The US This bottoming in growth momentum is occurring at the same time as local central banks are becoming more orthodox about monetary policy. The Reserve Bank of New Zealand has ended quantitative easing. The Bank of Canada has cut asset purchases in half. Brazil, Mexico and Russia, among other emerging market countries are hiking interest rates. While it is true that inflation in some developed and emerging markets like Canada, the UK, Brazil and Russia is perking up, for most developed markets as a whole, inflation is actually surprising to the upside in the US (Chart I-4). China has been tightening policy amidst very low inflation. Currencies tend to be driven by real rates. A growth rotation away from the US, in addition to more orthodox monetary policies outside the US, will be negative for the greenback. Chart I-4US Relative Inflation And The Dollar What About Chinese Growth? Chinese growth expectations are still cratering relative to the US. The fiasco around the China Evergrande Group has also led to speculation that this could become a systemic event. For developed market currencies, especially those linked to China like the Australian dollar, this is a market-relevant event. Admittedly, offshore markets have started discounting a bigger depreciation in the RMB (Chart I-5). That said, the RMB has been rather resilient against the dollar suggesting that the risk of this becoming a systemic event is rather low (Chart I-6). Chart I-5The Evergrande Risk Is Not Yet Systemic Chart I-6Chinese Equities And The RMB Have Decoupled. We believe currency markets are sending the right signal. For one, the Evergrande debacle is occurring at a time when China is no longer tightening monetary policy. Chart I-7 shows that cyclical currencies in developed markets tend to be coincident with the Chinese credit impulse. As such, any easing in monetary policy will put a bottom in these currencies. Over the years, the Chinese bond market has become more and more liberalized. This two-way risk implies that zombies companies should be allowed to fail while unicorns flourish. It is true that regulatory control has been front and center in the current Chinese equity market malaise. That said, our bias is that liberalization is a reason why portfolio inflows into China continue to accelerate, as the economy moves closer to market-determined prices (Chart I-8). This has supported the RMB, a big weight in the Fed trade-weighted dollar. Chart I-7Chinese Policy And DM Currencies Chart I-8An Unrelenting Increase In Chinese Inflows A lot of EM debt is denominated in US dollars, which could be reprised for default risk. But on this basis, the Fed is ahead of the curve. This was the very reason the Federal Reserve introduced swap lines in 2020 with foreign emerging market central banks and made swapping FX reserves for dollars a permanent facility in its toolkit for monetary policy this year. Non-US domestic authorities have ample ability to decide which entities they allow to fail, and which they bail out from their USD obligations. Cross-currency basis swaps, a proxy for the cost of obtaining dollars offshore, remain well behaved (Chart I-9). Chart I-9No USD Funding Stress So Far In Developed Markets For developed market currencies, the implication is that China risks are currently overstated, while any upside surprise has not been meaningfully discounted. Gauging Investor Positioning The dollar tends to be a momentum currency. But at turning points, it pays to be a contrarian. Let’s begin with what is priced in. First, the overnight index swap curve (OIS) suggests that markets expect the Fed to hike interest rates faster than other G10 central banks (Chart I-10). This will not occur in a world where growth is stronger outside the US, and other central banks are well ahead in their tapering of asset purchases, pursuing much more orthodox monetary policy. Chart I-10The Market Remains Bullish On Fed Rate Hikes Chart I-11Speculators Are Bullish On ##br##The Dollar Second, at the beginning of this report, we highlighted the fact that the dollar is up this year. Part of the reason has been a pilling in of speculators into long greenback positions (Chart I-11). As a trading rule, it has usually been profitable to wait for net speculative positioning and moving averages to roll over before entering fresh dollar short positions (Chart I-12). On this basis, tactical investors might be a bit early, but its is also the case that the macroeconomic environment is moving against the dollar. Once markets start paying attention to the fact that global growth will rotate from the US, pinning the Fed into a more dovish stance, the dollar will quickly depreciate.   Chart I-12A Sentiment Trading Rule Will Wait For The Dollar To Roll Over More Broadly Often forgotten is that the dollar has tended to move in long cycles, usually 10 years between bull and bear markets. The US trade deficit (excluding oil) is hitting new fresh highs this year. These deficits need to be financed by foreign purchases of US securities, either by debt issued or equity raised. Investors could demand a discount to keep financing these deficits. Should the Congressional Budget Office estimates of the current trajectory of US deficits hold true, the dollar has about 10-15% downside from current levels (Chart I-13). Chart I-13Balance Of Payments Bode Negatively For The Greenback Our geopolitical strategists assign 80% odds to the passage of a bipartisan infrastructure bill, and 65% odds to the passage of a reconciliation bill. Either way, the US fiscal picture is set to deteriorate at a time when the Fed is comtemplating scaling back Treasury purchases. Interestingly, 10-15% downside in the US dollar is exactly what is needed to realign the currency competitively (Chart I-14). Consumer prices have been rising globally, but this has been especially pronounced in the US. To the extent that we live in a globalized world with flexible exchange rates, this should allow more competitive countries to see an increase in their trade balances. This is exactly what is occurring, with the US trade deficit hitting new lows. Chart I-14The Dollar Is Expensive On A PPP Basis Risks To The View Currency forecasts are obviously fraught with risks. The biggest risk to the view is a broad-based equity market correction, that reinvigorates inflows into US safe-haven bonds. We are cognizant that this is a risk worth monitoring. For example, investors are preferring to park cash in US Treasurys over gold, two competing safe-haven assets (Chart I-15). This has usually been positive for the greenback. But it also suggests investors view the Fed is going to be orthodox in monetary settings, tightening policy faster than the market expects. This boils down to a judgment call. The US market is much more vulnerable to rate changes than other markets (Chart I-16). As such, a hawkish shift by the Federal Reserve could significantly tighten financial conditions (through a stock market correction), setting the stage for an ultimate low in the dollar equity outflows. Chart I-15Safe-Haven Dollar Flows Face Technical Resistance Chart I-16Higher Bond Yields Will Be Negative For The US Market. Given this two-way risk, we are reintroducing our long CHF/NZD position that correlates well with currency volatility (Chart I-17). We are also long the yen on this basis. In terms of housekeeping, our long AUD/NZD trade was stopped out for a loss. As we iterated in our Aussie report, a lot of pessimism is embedded in the AUD, making it a potent candidate for a powerful mean-reversion rally. We recommend reinstating this position at current levels (a nudge above our stop loss). Chart I-17Buy CHF/NZD As A Hedge Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Data out of the US this week was strong: PPI continues to accelerate in the US, rising 8.3% year on year in August while CPI also remains strong at 5.3% on the headline print. Pricing pressures remain acute in the US. The empire manufacturing survey surprised to the upside in September. The headline number was 34.2 versus expectations of a 17.9 reading. Admittedly, this was driven by an increase in selling prices. Retail sales were surprisingly strong in August, with the control group rising 2.5% month on month versus expectations of a flat number. The US dollar DXY index was relatively flat this week. The markets are at a crossroads, gauging whether strong US data will maintain momentum or revert to a lower equilibrium. Our bias is towards the latter, but admittedly, there are two-way risks to this view.  Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Euro area data remains robust: Industrial production printed a solid 7.7% year-on-year growth in July. The trade surplus for July rose to €20.7 bn. The euro fell by 0.6% this week. The ECB has engineered a dovish tapering of asset purchases, but it remains the case as the interest rate expectations between the euro area and the US are at bombed out levels. This should support positive euro area surprises. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent Japanese data has been on the weak side: Core machinery orders rose 11.1% year on year in July. Exports were strong in August, rising 34% while imports rose 40%. The yen was flat against the dollar this week. Currency volatility is currently depressed, and Japan has been performing poorly economically. To the extent that this is pandemic related, it sets the JPY up for a playable coil spring rebound. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 UK data remains on the mend: Industrial production came in at 3.8% year on year, above expectations. Average weekly earnings, including bonus payments, are rising 8.3% year on year as of July. Job gains continue. The July report pushed the unemployment rate from 4.7% to 4.6%. CPI and RPI remain rather sticky around the 3-5% level. House prices rose 8% year on year in July. The pound fell by 0.4% this week. The broad trend in the pound will now be dictated by what happens to both the dollar and the euro. The BoE is more hawkish than the Fed and the ECB should support gilt yields and the pound. A slowing in US economic momentum is also bullish for the sterling. Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was slated to slow as we expected, and recent numbers highlight this: There were 146K job losses in August. This was well split between part time and full time. NAB business confidence and current conditions moderately improved in August. House price inflation is tracking the global wave, rising 16.8% year on year in Q2. The AUD fell 1% this week. We discussed the AUD at length in our report two weeks ago and believe current weakness is unwarranted. We are reinstating our long AUD/NZD trade this week. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The was scant data out of New Zealand this week: The current account deficit widened in Q2 to -3.3% of GDP. Q2 GDP was an upside surprise but will likely be torpedoed in Q3 by COVID-19. The NZD was down 0.25% this week. We continue to believe the NZD will fare well cyclically, likely touching 75 cents, but our bias remains that hawkish expectations from the RBNZ are already well priced. This will make the kiwi lag other commodity currencies like the Aussie. We are reinstating our long AUD/NZD trade. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data out of Canada this week has been robust: The labor report was strong. Hiring came in at 90K, with a favorable tilt towards full-time work. The unemployment rate fell from 7.5% to 7.1%. The CPI report was equally robust. Core CPI was at 3.5% year on year with most measures of the BoC’s underlying gauge inching higher. Housing starts remained strong in August at 260K, a slight dip from July’s 271K. The CAD was up by 0.44% this week. Last week’s currency report was dedicated to the loonie. With strong oil prices, a relatively hawkish central bank, and easing on tightening pressures from China, the loonie should remain well bid. A minority government will also be bullish for the loonie, as we highlighted last week. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There was scant data out of Switzerland this week: PPI came in at 4.4% in August, an increase from July. The Swiss franc was down 0.22% this week. We are going long CHF/NZD as a hedge against rising currency volatility. Being long the yen also makes sense in this environment. However, given our view that risk sentiment will stay ebullient, the franc will lag the bounce in other cyclical currencies on a longer-term horizon. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Norwegian data is surprising to the upside: CPI was 3.4% year on year in August, above expectations. PPI rose 50% year on year in August. The trade balance posted a healthy surplus of NOK 42.6bn in August. The NOK was up 0.5% this week. We continue to be bullish Scandinavian currencies as a cyclical play on a lower US dollar. The NOK benefits from bombed-out valuations and a more orthodox central bank. Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The most important data from Sweden this week was the CPI report: CPI rose from 1.7% to 2.1% in August. CPIF, the Riksbank’s preferred measure, accelerated to 2.4%. The SEK was flat this week. A bottoming in the Chinese credit impulse will be a positive impact on growth-sensitive Sweden. Meanwhile, this week’s positive CPI report should pare back expectations of more stimulus from the Riksbank. We are short both EUR/SEK and USD/SEK as reflation plays. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020 Trades & Forecasts Forecast Summary Strategic Holdings Tactical Holdings Limit Orders Closed Trades

Dear Client, Next week, in lieu of our regular weekly report, I will be hosting two webcasts where I will discuss our view on China’s economy and financial markets. I will also address the topics that our clients are most concerned about, including China’s regulatory developments, inflation, and policy direction. The webcasts will be held on Wednesday, September 22 at 10:00 am EDT (English), and Thursday, September 23 at 9:00 am HKT (Mandarin). I look forward to discussing with you during the webcast. We will return to our regular publishing schedule on Wednesday, September 29. Best regards, Jing Sima, China Strategist Highlights China is facing cyclical inflationary pressures more than disinflationary ones. Prices of mining, raw materials and manufacturing goods have been rising at record rates. Chinese manufacturers are operating at close to full production, which suggests that there is little slack in demand. Despite soft headline readings in consumer prices, the costs of goods and services have rebounded to pre-pandemic levels. Prices for home durable goods, fuel and utilities have surged to multiyear highs. Measures to boost domestic demand will be limited as long as inflationary pressures continue and manufacturers produce at close to full capacity. Near-term policy support will likely focus on reducing costs for manufacturers and improving wage growth for lower-income households. We are initiating a trade: long industrial stocks/short A-shares.  Feature China’s Producer Price index (PPI) registered a 13-year high in August, at the time when the domestic economy continued to slow. On the other hand, consumer prices (CPI) - both headline and core CPI - have been lackluster. The acceleration in producer inflation and the demand dynamics raise the question whether China is in a stagflation, a situation in which prices climb but wages and demand do not follow. Consequentially, economy policy faces a dilemma between boosting demand and containing inflation. Inflationary pressures have been driven by pandemic-related factors and the supply-side constraints will likely continue into Q1 next year. These inflationary pressures, and more importantly, undercurrents in the inflation prints, will constrain Chinese policymakers’ efforts to reflate the economy. The recent rebound in Chinese infrastructure stocks is overdone. Material stocks are also vulnerable to price setbacks. Global commodity prices will soften, although from very elevated levels. Meanwhile, we are initiating a trade: long Chinese industrial stocks relative to the A-share market. Despite falling profit growth in recent months, China’s leadership is increasing its support, both cyclically and structurally, to the manufacturing sector. Inflation Or Deflation? The details in both the PPI and CPI readings indicate that China is facing more inflationary pressures than disinflationary ones. Producers are raising prices across the board. Although consumer prices will likely remain well below the PBoC's 3% inflation target for the year mainly due to low food prices, prices in some of the key consumer goods segments are rising at an alarming pace. The inflationary pressures will continue for producers, at least through the first quarter of 2022. The strength in August’s PPI was concentrated in mining and raw materials (Chart 1, top panel). Robust global demand and tight supply conditions supported high oil and base metals prices, while pushing up coal prices. Chart 1Chinese Mining And Manufacturing Goods Prices Accelerated To Record Highs Chart 2Commodity Prices Held Up Despite A Slowing China We do not expect China’s infrastructure investment growth to pick up and support industrial metal prices. However, this year’s unsynchronized recovery in global demand and severe supply shortages have delayed the global commodity market’s price reaction to slowing Chinese demand (Chart 2). Moreover, as China’s environmental policy remains stringent during the upcoming winter, supply-side constraints from production cuts will partially offset the slowdown in China’s demand for mining and raw materials (Chart 3A and 3B). Chart 3ASupply-Side Constraints And Chinese Production Cuts Likely To Continue Into Early 2022 Chart 3BSupply-Side Constraints And Chinese Production Cuts Likely To Continue Into Early 2022 Manufacturing goods inflation registered its topmost annual growth since data collection started in 1996 (Chart 1, bottom panel). Moreover, capacity utilization rates in the industrial and manufacturing sectors are at the highest levels since 2007, well above their means (Chart 4). Changes in manufacturing capacity are highly correlated with China’s export growth and tightly linked to PPI (Chart 5). Therefore, manufacturing goods prices will remain lofty as long as external demand stays robust and China’s manufacturers continue to produce near maximum output. Chart 4Chinese Manufacturers Are Producing Near Their Max Capacity Chart 5Robust Exports Have Been Supporting Strong Chinese Manufacturing Output The PPI’s weakest component has been consumer goods, which inched up by a mere 0.3% from a year ago (Chart 6). However, consumer goods only account for 25% of PPI, whereas industrial and manufacturing producer goods are 75%. In addition, the underlying data shows that among the four sub-components in the PPI’s consumer goods, only food prices have remained below their pre-pandemic levels (Chart 7, top panel). Prices in durable goods have rebounded strongly since March last year and clothing and daily sundry articles have recovered to their end-2019 rate of growth (Chart 7, mid and bottom panels).  Chart 6Producer Prices For Consumer Goods Remain Soft... Chart 7...But Food Prices Have Been The Main Drag The PPI’s price forces are consistent with the CPI, in which food has been the main drag. Core CPI, along with prices for consumer goods and services, have returned to pre-pandemic growth rates (Chart 8). Durable goods prices, such as home appliances, increased to a multiyear high in August. Fuel and utilities costs have also risen. This suggests that despite the soft CPI readings, inflation has flowed from producers to Chinese consumers through manufacturing goods. The passthrough will likely intensify into Q4 when domestic COVID-cases have been largely brought under control and the September – October holiday season will boost consumption for both goods and services. Chart 8Prices For Other Consumer Goods Categories Have Recovered Table 1A Look At China’s CPI Basket – Food Dominates We still expect that headline CPI will remain below the PBoC’s 3% inflation target for the year. Consumer durable goods prices are lightly weighted in China’s CPI, therefore, an acceleration in inflation passthroughs in this component is unlikely to significantly push up the CPI aggregates (Table 1). Chart 9Prices For Healthcare And Education Services On A Structural Downshift In addition, there are some structural headwinds that will affect prices in the education and healthcare and medical services components, which together account for about 15% of the CPI. Healthcare prices have been on a policy-driven structural downshift since late 2017 and recent regulatory changes in the education industry will depress pricing power in that sector (Chart 9). Despite sluggish aggregate consumer prices, climbing prices in consumer durable goods, services and particularly, fuel and utilities, will likely force China’s leadership to take action on policy. Bottom Line: Price pressures for Chinese producers remain intense and consumers will feel the heat of escalating prices in durable goods, fuel and utilities. Inflation is threatening domestic demand, which is already slowing from its peak earlier this year. Implications On Policy Response Inflation readings –even though they are lagging economic indicators –bear significant forward-looking market implications because changes in inflation dynamics herald various policy responses. Despite slower economic growth, higher inflation coupled with accommodative monetary and fiscal policies may indicate that the economy is in a “goldilocks” stage and corporate profits can still benefit (Chart 10). Chinese onshore stocks reached record high recently (Chart 11). Chart 10Are Chinese Corporates In A 'Sweet Spot'? Chart 11Accommodative Monetary Conditions Propelled Chinese Stock Prices To Highest Since 2015 However, underlying trends in China’s producer and consumer inflation prints raise the risks that policymakers may not deliver the ingredients needed for a “just right” scenario. Even though China has kept a loose monetary policy that we expect to extend into next year, inflationary pressures may force policymakers to either delay or reduce the magnitude of stimulus. Recent policy moves show that the authorities are focused on reducing input cost burdens and bumping up support for small- and medium-sized enterprises (SMEs), which are highly concentrated in mid- to downstream manufacturing and services sectors. In our view, the recent rhetoric from policymakers further reduces the odds of any broadly based stimulus to boost demand. Our view is based on the following observations: The elevated global input costs and limited price passthroughs to consumers are depressing Chinese manufacturers’ profit margins and incentives to expand production capacity. Despite strong exports and production, manufacturing investment has lagged that in infrastructure and real estate this year (Chart 12). Consumers, particularly lower-income households, are bearing most of the burdens; rising costs and slow wage growth are weakening their propensity to spend (Chart 13). Chart 12Slower Manufacturing Investment Recovery Than Infrastructure And Real Estate So Far This Year Chart 13Slow Wage Growth Limits The Pace Of Consumption Recovery The inflation prints came at the time when China’s top leadership shifted its structural policy goals to reduce income inequality and stabilize manufacturing share in the aggregate economy. The structural goals will likely be reflected in policy responses to the cyclical challenge.  Moreover, this year’s manufacturing production volume was growing twice as fast as producer prices, a reversal from 2017 when price increases outpaced production (Chart 14). Price changes are much more important to corporate profits than volume changes. A strong RMB and sharply escalating shipping costs have also reduced exporters’ pricing power and profits (Chart 15). In contrast, mounting prices across various commodities have allowed the upstream industrial sectors, which are dominated by SOEs, to deliver much stronger profits than the downstream and private sector (Chart 16). Chart 14Growth In Manufacturing Output And Prices Starting To Converge Chart 15Strong RMB And Rising Shipping Costs Have Reduced Chinese Exporters' Profitability   It is unsurprising that authorities are increasing support to the private sector in order to maintain manufacturing share in the economy and keep the export sector competitive (Chart 17). A boost in infrastructure investment, on the other hand, would exacerbate upward pressure on commodity prices and mostly benefit upstream SOEs. Chart 16Upstream Industries Disproportionally Benefited From Surging Commodity Prices Chart 17Private Sector: Lower Profit Margin, Higher Costs Furthermore, stimulating the traditional sectors would not revive household consumption. The subdued recovery in consumption and prices for consumer staple goods is due to slow growth in lower-income household wages and a disrupted recovery in the services sector. Ramping up infrastructure investment can support headline GDP growth, but will do little to provide jobs and wages since China’s private sector provides 80% of all jobs and 90% of annual job creations. Lower-income households have a higher marginal propensity to consume. We expect the government to accelerate fiscal support measures to fortify wages among lower-income households. Bottom Line: Ongoing inflationary pressures and the underlying forces will likely thwart policymakers from stepping up their efforts to stimulate the old economy sectors. Investment Conclusions Chart 18Rebound In Infrastructure Stocks Should Be Short-Lived Chinese onshore stocks in the infrastructure, materials, and industrial sectors recently advanced strongly in the expectation that policymakers will ramp up their fiscal support in the old economy sectors, particularly infrastructure. Although we agree that infrastructure investment will improve, we maintain our view that a sizable rebound is highly unlikely this year. Hence, we do not expect that the rally in infrastructure stocks will be long-lasting (Chart 18).  We are probably too late in the cycle to re-initiate our long material/broad market trade in the onshore and offshore equity markets (Chart 19). We closed the trade in December last year when Chinese policymakers started pulling back stimulus, and in expectations that raw material prices would tumble. However, we underestimated the intensity of China’s de-carbonization efforts and protracted global supply-side constraints. Although global commodity prices will remain elevated into 2022, the price rallies from this year are not sustainable on a cyclical (6- to 12-month) basis. Therefore, we do not recommend material stocks as a cyclical play.  Chart 19Price Rally In Materials Stocks Unlikely To Sustain Chart 20Industrial Stocks May Be On A Structural Upcycle Instead, we recommend a long industrial/broad A-share market trade (Chart 20). Even though China is in a late business cycle and the upcoming stimulus will be mediocre at best, we think that the industrial sector will benefit from policy support for investment in the manufacturing sector and a faster pace in the sector’s capacity expansion.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes Market/Sector Recommendations Cyclical Investment Stance

Highlights The US Climate Prediction Center gives ~ 70% odds another La Niña will form in the August – October interval and will continue through winter 2021-22. This will be a second-year La Niña if it forms, and will raise the odds of a repeat of last winter's cold weather in the Northern Hemisphere.1 Europe's natural-gas inventory build ahead of the coming winter remains erratic, particularly as Russian flows via Ukraine to the EU have been reduced this year. Russia's Nord Stream 2 could be online by November, but inventories will still be low. China, Japan, South Korea and India  – the four top LNG consumers in Asia  – took in 155 Bcf of the fuel in June. A colder-than-normal winter would boost demand. Higher prices are likely in Europe and Asia (Chart of the Week). US storage levels will be lower going into winter, as power generation demand remains stout, and the lingering effects from Hurricane Ida reduce supplies available for inventory injections. Despite spot prices trading ~ $1.30/MMBtu above last winter's highs – currently ~ $4.60/MMBtu – we are going long 1Q22 NYMEX $5.00/MMBtu natgas calls vs short NYMEX $5.50/MMBtu natgas calls expecting even higher prices. Feature Last winter's La Niña was a doozy. It brought extreme cold to Asia, North America and Europe, which pulled natural gas storage levels sharply lower and drove prices sharply higher as the Chart of the Week shows. Natgas storage in the US and Europe will be tight going into this winter (Chart 2). Europe's La Niña lingered a while into Spring, keeping temps low and space-heating demand high, which delayed the start of re-building inventory for the coming winter.  In the US, cold temps in the Midwest hampered production, boosted demand and caused inventory to draw hard. Chart of the WeekA Return Of La Niña Could Boost Global Natgas Prices Chart 2Europe, US Gas Stocks Will Be Tight This Winter Summer in the US also produced strong natgas demand, particularly out West, as power generators eschewed coal in favor of gas to meet stronger air-conditioning demand. This is partly due to the closing of coal-fired units, leaving more of the load to be picked up by gas-fired generation (Chart 3). The EIA estimates natgas consumption in July was up ~ 4 Bcf/d to just under 76 Bcf/d. Hurricane Ida took ~ 1 bcf/d of demand out of the market, which was less than the ~ 2 Bcf/d hit to US Gulf supply resulting from the storm.  As a result, prices were pushed higher at the margin. Chart 3Generators Prefer Gas To Coal US natgas exports (pipeline and LNG) also were strong, at 18.2 Bcf/d in July (Chart 4). We expect US LNG exports, in particular, to resume growth as the world recovers from the COVID-19 pandemic (Chart 5). This strong demand and exports, coupled with slightly lower supply from the Lower 48 states – estimated at ~ 98 Bcf/d by the EIA for July (Chart 6) – pushed prices up by 18% from June to July, "the largest month-on-month percentage change for June to July since 2012, when the price increased 20.3%" according to the EIA. Chart 4US Natgas Exports Remain Strong Chart 5US LNG Exports Will Resume Growth Chart 6US Lower 48 Natgas Production Recovering Elsewhere in the Americas, Brazil has been a strong bid for US LNG – accounting for 32.3 Bcf of demand in  June – as hydroelectric generation flags due to the prolonged drought in the country. In Asia, demand for LNG remains strong, with the four top consumers – China, Japan, South Korea, and India – taking in 155 Bcf in June, according to the EIA. Gas Infrastructure Ex-US Remains Challenged A combination of extreme cold weather in Northeast Asia, and a lack of gas storage infrastructure in Asia generally, along with shipping constraints and supply issues at LNG export facilities, led to the Asian natural gas price spike in mid-January.2 Very cold weather in Northeast Asia, drove up LNG demand during the winter months. In China, LNG imports for the month of January rose by ~ 53% y-o-y (Chart 7).3 The increase in imports from Asia coincided with issues at major export plants in Australia, Norway and Qatar during that period. Chart 7China's US LNG Exports Surged Last Winter, And Remain Stout Over The Summer Substantially higher JKM (Japan-Korea Marker) prices incentivized US exporters to divert LNG cargoes from Europe to Asia last winter. The longer roundtrip times to deliver LNG from the US to Asia – instead of Europe – resulted in a reduction of shipping capacity, which ended up compounding market tightness in Europe. Europe dealt with the switch by drawing ~ 18 bcm more from their storage vs. the previous year, across the November to January period. Countries in Asia - most notably Japan – however, do not have robust natural gas storage facilities, further contributing to price volatility, especially in extreme weather events. These storage constraints remain in place going into the coming winter. In addition, there is a high probability the global weather pattern responsible for the cold spells around the globe that triggered price spikes in key markets globally – i.e., a second La Niña event – will return. A Second-Year La Niña  Event The price spikes and logistical challenges of last winter were the result of atmospheric circulation anomalies that were bolstered by a La Niña event that began in mid-2020.4 The La Niña is characterized by colder sea-surface temperatures that develops over the Pacific equator, which displaces atmospheric and wind circulation and leads to colder temperatures in the Northern Hemisphere (Map 1). Map 1La Niña Raises The Odds Of Colder Temps The IEA notes last winter started off without any exceptional deviations from an average early winter, but as the new year opened "natural gas markets experienced severe supply-demand tensions in the opening weeks of 2021, with extremely cold temperature episodes sending spot prices to record levels."5 In its most recent ENSO update, the US Climate Prediction Center raised the odds of another La Niña event for this winter to 70% this month. If similar conditions to those of the 2020-21 winter emerge, US and European inventories could be stretched even thinner than last year, as space-heating demand competes with industrial and commercial demand resulting from the economic recovery. Global Natgas Supplies Will Stay Tight JKM prices and TTF (Dutch Title Transfer Facility) prices are likely to remain elevated going into winter, as seen in the Chart of the Week. Fundamentals have kept markets tight so far. Uncertain Russian supply to Europe will raise the price of the European gas index (TTF). This, along with strong Asian demand, particularly from China, will keep JKM prices high (Chart 8). The global economic recovery is the main short-term driver of higher natgas demand, with China leading the way. For the longer-term, natural gas is considered as the ideal transition fuel to green energy, as it emits less carbon than other fossil fuels. For this reason, demand is expected to grow by 3.4% per annum until 2035, and reach peak consumption later than other fossil fuels, according to McKinsey.6 Chart 8BCAs Brent Forecast Points To Higher JKM Prices Spillovers from the European natural gas market impact Asian markets, as was demonstrated last winter. Russian supply to Europe – where inventories are at their lowest level in a decade – has dropped over the last few months. This could either be the result of Russia's attempts to support its case for finishing Nord Stream 2 and getting it running as soon as possible, or because it is physically unable to supply natural gas.7 A fire at a condensate plant in Siberia at the beginning of August supports the latter conjecture. The reduced supply from Russia, comes at a time when EU carbon permit prices have been consistently breaking records, making the cost of natural gas competitive compared to more heavy carbon emitting fossil fuels – e.g., coal and oil – despite record breaking prices. With Europe beginning the winter season with significantly lower stock levels vs. previous years, TTF prices will remain volatile. This, and strong demand from China, will support JKM prices. Investment Implications Natural gas prices are elevated, with spot NYMEX futures trading ~ $1.30/MMBtu above last winter's highs – currently ~ $4.60/MMBtu. Our analysis indicates prices are justifiably high, and could – with the slightest unexpected news – move sharply higher. Because natgas is, at the end of the day, a weather market, we favor low-cost/low-risk exposures. In the current market, we recommend going long 1Q22 NYMEX $5.00/MMBtu natgas calls vs short NYMEX $5.50/MMBtu natgas calls expecting even higher prices. This is the trade we recommended on 8 April 2021, at a lower level, which was stopped out on 12 August 2021 with a gain of 188%.   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 Earlier this week, Saudi Aramco lowered its official selling price (OSP) by more than was expected – lowering its premium to the regional benchmark to $1.30/bbl from $1.70/bbl – in what media reports based on interviews with oil traders suggest is an attempt to win back customers electing not to take volumes under long-term contracts. This is a marginal adjustment by Aramco, but still significant, as it shows the company will continue to defend its market share. Pricing to Northwest Europe and the US markets is unchanged. Aramco's majority shareholder, the Kingdom of Saudi Arabia (KSA), is the putative leader of OPEC 2.0 (aka, OPEC+) along with Russia. The producer coalition is in the process of returning 400k b/d to the market every month until it has restored the 5.8mm b/d of production it took off the market to support prices during the COVID-19 pandemic. We expect Brent crude oil prices to average $70/bbl in 2H21, $73/bbl in 2022 and $80/bbl in 2023. Base Metals: Bullish Political uncertainty in Guinea caused aluminum prices to rise to more than a 10-year high this week (Chart 9). A coup in the world’s second largest exporter of bauxite – the main ore source for aluminum – began on Sunday, rattling aluminum markets. While iron ore prices rebounded primarily on the record value of Chinese imports in August, the coup in Guinea – which has the highest level of iron ore reserves – could have also raised questions about supply certainty. This will contribute to iron-ore price volatility. However, we do not believe the coup will impact the supply of commodities as much as markets are factoring, as coup leaders in commodity-exporting countries typically want to keep their source of income intact and functioning. Precious Metals: Bullish Gold settled at a one-month high last Friday, when the US Bureau of Labor Statistics released the August jobs report. The rise in payrolls data was well below analysts’ estimates, and was the lowest gain in seven months. The yellow metal rose on this news as the weak employment data eased fears about Fed tapering, and refocused markets on COVID-19 and the delta variant. Since then, however, the yellow metal has not been able to consolidate gains. After falling to a more than one-month low on Friday, the US dollar rose on Tuesday, weighing on gold prices (Chart 10). Chart 9 Chart 10       Footnotes 1      Please see the US Climate Prediction Center's ENSO: Recent Evolution, Current Status and Predictions report published on September 6, 2021. 2     Please see Asia LNG Price Spike: Perfect Storm or Structural Failure? Published by Oxford Institute for Energy Studies. 3     Since China LNG import data were reported as a combined January and February value in 2020, we halved the combined value to get the January 2020 amount. 4     Please see The 2020/21 Extremely Cold Winter in China Influenced by the Synergistic Effect of La Niña and Warm Arctic by Zheng, F., and Coauthors (2021), published in Advances in Atmospheric Sciences. 5     Please see the IEA's Gas Market Report, Q2-2021 published in April 2021. 6     Please see Global gas outlook to 2050 | McKinsey on February 26, 2021. 7     Please see ICIS Analyst View: Gazprom’s inability to supply or unwillingness to deliver? published on August 13, 2021.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades