Economy

Executive Summary Global risk assets are oversold, and investor sentiment is downbeat. In this context, a technical equity rebound cannot be ruled out. However, we do not think it will be the beginning of a major cyclical rally. The Fed and the stock market remain on a collision course. An equity rally and easing financial conditions would make the Fed even more resolute to continue hiking interest rates. There are many similarities between dynamics that prevailed in US tech stocks and in previous bubbles. While it is not our baseline view, the odds of a protracted bear market are nontrivial. Resource prices and commodity plays have more downside. The History Of Financial Bubbles: Is This Time Different? Bottom Line: The decline in commodity prices and the relentless US dollar rally will ensure that EM currencies, bonds and stocks continue to sell off even if the US equity market rebounds in the near term. Feature Among the most frequently discussed topics in recent client calls are the upside and downside risks to our baseline view. We elaborate on these risks in this report. To recap, our baseline view is as follows: EM and DM stocks have another 15% downside in USD terms, the US dollar will continue overshooting and commodity prices will fall. Global yields are topping out, and the US yield curve will soon invert. Hence, defensive positioning for absolute-return investors is still warranted, and global equity and fixed-income portfolios should continue to underweight EM. The rationale is that US and EU demand for goods ex-autos, and hence global trade, is about to contract while the Fed is straightjacketed by high and broad-based inflation. China’s economy will be struggling to recover. In EM ex-China, domestic demand will relapse. Chart 1Will The S&P 500's Technical Support Hold? If one believes that the US equity bull market that began in 2009 is still alive (i.e. the March 2020 selloff is a short-lived red herring), odds are that the S&P 500 drawdown is over. The reasoning is that the S&P 500 is already down 23% from its 2021 peak, on par with the selloffs that occurred in 2011, 2015-16 and 2018 (Chart 1). However, if one believes that the structural bull market is over, the magnitude of the current equity selloff is likely to exceed the ones in 2011, 2015-16 and 2018. Hence, a bearish stance is still warranted. As we argue below, after a 12-year bull run, the excesses in the US equity market in general, and US tech stocks in particular, have become extreme. There are many signs of a bubble, or at least of a major top. Even though we risk overstaying in our negative view, our bias is that the global equity market rout is not yet over. A Bullish Scenario A (hypothetical) bullish case would look something like this: Weakening global and US growth and falling commodity prices bring down US inflation and Treasury yields. As US bond yields drop further, the S&P 500 rallies given their negative correlation of the past 18 months or so. As US inflation declines rapidly, the Fed makes a dovish pivot, reinforcing the risk asset rally and reversing the US dollar’s uptrend. Finally, Chinese stimulus produces a robust business cycle recovery in China that propels commodity prices higher and lifts the rest of EM out of the abyss. Chart 2Keep An Eye On Rising US Trimmed-Mean Inflation In our opinion, this scenario has no more than a 25% chance of playing out. Even if there are apparent signs of a US/global slowdown, elevated US core inflation and accelerating wages and unit labor costs would keep the Fed from dialing down its hawkishness Critically, even though US core PCE inflation has rolled over and will likely decline further, its trimmed-mean PCE inflation is rising (Chart 2). The latter means that inflation is broadening even as some volatile items like food, energy and used-auto prices deflate. As we have written extensively, wages and inflation are lagging variables. Despite the ongoing slowdown in the US economy, it will take many months before the underlying core inflation rate drops below 3%. We maintain that the Fed and the stock market remain on a collision course. An equity rally and easing financial conditions would make the Fed even more resolute to hike interest rates. The basis is that even if core inflation falls in the coming months, it would still be well above the Fed’s target of 2%. Notably, the Fed has recently communicated that its commitment to bring down inflation to 2% is unconditional. Chart 3The Anatomy Of The US Equity Bear Market In 2000-2002 This policy stance represents a major departure from the past several decades when the Fed was very sensitive to any tightening in financial conditions and often eased preemptively. In short, with inflation still well above its target, the Fed will, for now, err on the side of hawkishness if financial conditions ease. Importantly, US corporate profits will likely contract even if US real GDP does not shrink. As US corporate top-line growth slows and unit labor costs accelerate, profit margins will shrink. For example, the 2001-2002 recession was very mild – consumer spending did not contract at all, and housing boomed (Chart 3, top two panels). Yet, the S&P 500 operating earnings dropped by 30%, and the S&P 500 fell by 50% (Chart 3, bottom two panels). In brief, a devastating bear market does not necessarily require a hard landing. Concerning China, the recovery will likely be U-shaped rather than V-shaped with risks skewed to the downside. Finally, contracting global trade and falling commodity prices will continue, which are negative for EM currencies and assets. Notably, industry data from Taiwan’s manufacturing PMI suggest that the slowdown in the Asian and global economies is widespread. Taiwan’s substantial trade linkages with mainland China signify that the slowdown is not limited to the US and the EU but includes China too. Taiwanese PMI export orders of both semiconductor and basic material producers have plunged to 40 and 30, respectively (Chart 4). Barring a quick turnaround, global semiconductor and basic materials stocks have more downside. Even as US Treasury yields drop, the dollar will continue firming versus EM currencies, including those of Emerging Asian countries. In such a scenario, EM stocks and bonds will weaken further (Chart 5).  Chart 4A Broad-Based Contraction In Global Trade Is In The Cards Chart 5A Free Fall In EM Ex-China Stocks And Currencies   Bottom Line: The S&P 500 is oversold, and investor sentiment is downbeat. In this context, a technical equity rebound can occur at any moment. However, we do not think it will be the beginning of a major cyclical rally. A Bearish Case: Are US TMT Stocks A Bubble? What is a more bearish scenario than our baseline case? The bursting of bubbles or the unwinding of excesses would entail a more protracted and devastating bear market than the 15% drop in global share prices we currently expect. We can identify two major excesses in the global economy and financial system: In US TMT (Technology, Media & Entertainment and Internet & Catalog Retail) stocks and private equity In Chinese real estate. We have written extensively about property market excesses in China. Below we discuss the recent sharp selloff in commodities, which is partially linked to Chinese property construction. We also present the case for major excesses in US stocks. Chart 6 illustrates the history of bubbles of the past several decades: The Nifty-fifty (involving the 50 US large-cap stocks) bubble occurred in the 1960s and burst in the 1970s (not shown in the chart). The commodity bubble took place in the 1970s and burst in the 1980s. Japanese equity and property prices rose exponentially in the 1980s and deflated in the 1990s. The Nasdaq bubble occurred in the 1990s and was shattered in the early 2000s. Commodities/EM/China were the leaders of the 2000s, and they were devastated in the 2010s. We use iron ore in this chart because its price surged the most in the 2000s. FAANGM stocks, the Nasdaq 100 index and private equity were by far the biggest beneficiaries of the 2010s. No one can be certain about bubbles in real time because there are always superior fundamentals or persuasive stories that justify exponential price appreciation. That said, there are a lot of similarities between dynamics prevailing in US tech and private equity and in previous bubbles: In the past decade, FAANGM stocks, the Nasdaq 100 index and private equity companies registered gains comparable to the bubbles of the previous 60 years. Furthermore, as Chart 6 illustrates, the equal-weighted FAANGM index in inflation-adjusted terms rose 30-fold, much more than the bubbles of the previous decades. The Nasdaq 100 index and share prices of Blackstone, the largest private equity company, have risen by nearly 10-fold in real (inflation-adjusted terms) between 2010 and the end of 2021. Chart 6The History Of Financial Bubbles: Is This Time Different? The final phase of bubbles is often characterized by growing retail investor participation. This is exactly what happened with US tech/new economy stocks. Chart 7US TMT Stocks: Exponential Growth Rarely Ends Well Toward the end of the decade, not only retail but also institutional capital stampedes into the winners of the decade. This played out with US large-cap tech stocks as well as in private equity and private debt spaces. Inflows into private equity and private debt have been enormous. As a result of these inflows into US large-cap stocks, the market cap share of US TMT stocks as a percentage of total US market cap has surpassed 40%, its peak in 2000 (Chart 7). Bubbles often thrive during periods of low interest rates and crash when the cost of capital rises. This is exactly what has been happening in global financial markets since early 2019. The parameters of the overall US equity market were also excessive prior to this bear market. As of last year, the S&P 500 stock prices in real (inflation-adjusted) terms became as elevated relative to their long-term time trend as they were in the late 1960s and the late 1990s − the peaks of previous secular bull markets (Chart 8, top panel).   Chart 8The S&P 500 and Operating Profits: A Long-Term Perspective Chart 9Equity Issuance Marks Market Tops The S&P 500’s operating earnings in real terms have surpassed two standard deviations above its time trend (Chart 8, bottom panel). Some sort of mean reversion to its long-term trend is in the cards. US corporate profits have benefited from fiscal/monetary stimulus, low labor costs and pricing power. All of these are now working against profits.   Finally, new share issuance in the US mushroomed in 2021, another sign of a major top (Chart 9). Bottom Line: We are not entirely convinced that US TMT stocks are a bubble waiting to burst. Yet, the odds of this happening are nontrivial. This time might not be different. A Word On Commodities The selloff in the commodity space has been broad-based. Odds are that it will continue for the following reasons: A global business cycle downtrend is always bearish for commodity prices. In fact, oil prices are often lagging and are typically the last shoe to drop during global slowdowns. US sales of gasoline have started to contract. Besides, Saudi Arabia will likely increase its oil output and shipments following President Biden’s visit to the Kingdom next week. Chart 10Investors Have Been Long Commodity Futures As we have argued in recent months, China’s demand for commodities was contracting and, in our opinion, the rally in resource prices over the past 12 months was supported by investment demand for commodities, i.e., financial inflows into the commodity space. Many portfolios have bought commodities as an inflation hedge. When a hedge becomes a consensus trade and crowded, it stops being a hedge. Chart 10 demonstrates that net long positions in 17 commodities have been very elevated. The speed at which liquidation is taking place corroborates our thesis that it is investors not producers or consumers who have been caught being long commodities. China’s business cycle recovery will be U-shaped at best. Domestic orders point to weaker import volumes in the months ahead (Chart 11, top panel). ​​​​​​​Corporate loan demand has plunged suggesting that liquidity provisions by the PBoC might fail to produce a meaningful recovery in credit growth (Chart 11, bottom panel). Finally, technicals bode ill for commodity prices. As Chart 12 illustrates, copper prices and global material stocks have probably formed medium-term tops, and risks are skewed to the downside.  Chart 11China: The Economy Is Struggling To Gain Traction Chart 12A Major Top In Commodity Prices?   Bottom Line: Commodity prices and their plays have more downside. Investment Strategy The decline in commodity prices and the relentless US dollar rally will ensure that EM currencies, bonds and stocks continue to sell off even if the US equity market rebounds in the near term driven by lower Treasury yields. Global equity and fixed-income portfolios should continue underweighting EM. We also continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN, PHP and IDR; as well as HUF vs. CZK, and KRW vs. JPY. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)

Executive Summary Caught In Risk-Off Selling Weak Chinese and European economies are suppressing copper demand and helping to temper prices in a market that remains fundamentally tight. Weaker US GDP growth could put the three largest economies in the world in or close to recession in 2H22/1H23, which would contribute to demand-side weakness in copper markets. The odds manufacturing and base-metals refining will be curtailed in Europe are rising. Although a strike in Norway has been averted by government intervention, maintenance on Russia’s Nord Stream 1 pipeline scheduled to begin next week likely will serve as a pretext for longer and deeper natgas supply cuts to the EU. Bottom Line: Despite fundamental tightness in global copper markets, prices are being restrained by fears weaker Chinese and European economic performance will lead to a global recession. Early reads of US GDP pointing to negative growth in 2Q22 stoke these fears. Heightened economic policy uncertainty globally exacerbates them. We remain fundamentally bullish copper and will re-establish our long SPDR S&P Metals & Mining ETF (XME) – down ~ 40% from its highs in April – at tonight’s close. In addition, we went long the XOP oil and gas ETF at Tuesday’s close, after prompt Brent breached the buy-trigger we set last week of $105/bbl during this week’s crude-oil sell-off.   Feature   Lower GDP growth expectations in China and the EU – along with a wobbly US economy being flagged by an Atlanta Fed GDPNow forecast pointing to negative growth in 2Q22 – are stoking fears of a global manufacturing and industrial recession. This prompted a rout in industrial commodities – base metals and oil – this week, which still has markets on edge. This slow-down in the world’s three largest economies – accounting for almost 50% of global GDP expressed in purchasing-power terms – is the only thing keeping the level of global copper demand close to supply at present (Chart 1).1 At least for the time being, this is keeping the threat of sharply higher copper prices, which would be more in line with the low levels of supplies and inventories globally, at bay (Chart 2). As of the week ended May 27th, global copper stocks stood at just above 562k tons, which is ~ 31% lower y/y. Chart 1World’s Biggest Economies Slowing Chart 2Copper Prices Disconnect From Fundamentals   Uncertainty Weakens Copper Prices Energy and metals markets remain extremely tight on a fundamental supply-demand basis.2 The sharp sell-off this week in oil and metals prices is, in our view, evidence industrial-commodity prices have decoupled from fundamentals.  This makes traders – hedgers and speculators – extremely risk-averse, which reduces liquidity and increases volatility. On the back of these concerns, markets exhibit the sort of volatility associated with economic collapse, despite still-strong underlying fundamentals. Chart 3Rising Global Policy Uncertainty Volatility is on the rise due to increasing economic uncertainty in these markets. This makes it extremely difficult to assign probabilities to different price outcomes (i.e., true uncertainty). The BBD Global Economic Policy Uncertainty is approaching levels seen during the early pandemic (Chart 3).  We put this rising uncertainty down to poor policy and communication from central banks and governments; a pig’s breakfast of energy policy globally that increasingly adds nothing but confusion to markets; and a muddled public-health policy in China, which produces random shut-downs in global supply chains as covid infections randomly crop up in important port cities.  Lastly, the East and West are moving toward a new Cold War, which already is having profound effects on all markets, trade flows and capital availability in the short- and medium-term. This keeps markets on edge and forces them to parse every geopolitical development that hits the tape.3 Re-forging supply chains, re-building basic industrial infrastructure as the West moves away from outsourcing to China and other EM states will be costly and volatile, especially as embargoes and sanctions increase between these blocs.    This political and economic evolution will require increased investment in base metals production and exploration, along with similar commitments to oil and gas. Low and volatile prices will not support this, as they disincentivize investment, and set markets up for continued shortage and scarcity going forward. In the metals markets, years of underinvestment by major mining companies will keep copper supplies and inventories tight going forward (Chart 4). This will hinder and delay the global renewable-energy transition, which cannot be realized without higher base-metals supplies.  Chart 4Structural Underinvestment In Mining Fundamentally Bullish Copper Recession Fears Haunt Metals Globally … The proximate causes of the persistent weakening of copper prices is the demand destruction arising from the lockdown in China, and an increasing concern over the economic prospects of the EU as it prepares for a possible shut-off of Russian natgas exports. Should Russian supplies be cut off, the EU will be pushed into recession as natural-gas rationing – and the attendant prioritization of human needs going into winter – will constrict economic activity, particularly in manufacturing.  This leaves two of the three largest economies in the world either in recession or not growing at all. Added to this is the fear of a wobbly US economy, which has been slowed by higher energy prices and the Fed’s hawkish tightening of monetary policy. The Atlanta Fed’s GDPNow forecast for 2Q22 estimates a 2.1% contraction in US GDP. This would be the second consecutive quarter of negative growth and would meet a widely held rule-of-thumb indicator or recession.4  In our modelling, we estimate the income elasticity of copper demand in DM economies like the EU and US (1.39) and EM-ex-China (0.87) states is higher than that of China (0.37). This means that a 1% contraction in p.a. Chinese real GDP would translate to a 0.37% p.a. fall in copper demand, all else equal. A contraction of real incomes – i.e., real GDP – in the EU and EM-ex-China will cause a larger relative adjustment in copper demand than in China, even though the level of copper demand in China is far greater in absolute terms (Chart 5).  A recession in the EU will reduce import demand for China’s manufactured output in these markets (Chart 6). As China’s trade volumes fall, Chinese manufacturing PMIs will contract. Similarly, exports to China from the EU will weaken as manufacturing weakens and real GDP moves lower. We believe this will put more pressure on the Chinese government to provide fiscal and monetary stimulus to counter such a downdraft.  Chart 5Copper Demand Sensitive to Real GDP (Income) Chart 6Trade Channel Effects Follow GDP Weakness … But China Worries Dominate The Chinese economy is showing signs of further slowing.5 Weakness in credit levels, infrastructure investment, manufacturing, the property sector, and exports all indicate the covid-policy lockdowns, high commodity prices, and parsimonious credit and fiscal policies have produced a dramatic slowing in economic activity. In our modelling, we find evidence that each of these components exhibits a long-run inverse relationship with Chinese copper inventories, which in turn exhibits a long-run inverse relationship with COMEX copper prices.  Roughly 10 days after the initial Shanghai lockdown, copper prices went into contango (Chart 7). This occurred despite continuous declines in Chinese copper inventories during the lockdown months (Chart 8). Such anomalous behavior – i.e., as inventories fall markets become more backwardated – makes it difficult to connect prices and supply-demand-inventory fundamentals. Chart 7Copper In Contango For Most Of China’s Lockdown Chart 8Chinese Copper Inventories Continue To Draw In Lockdown BCA’s China Investment Strategy expects a muted 2H22 recovery for the Chinese economy. Rolling lockdowns due to China’s COVID policy will reduce the potency of fiscal and monetary stimulus. The stop-start nature of economic activity will stymie growth in disposable income and job creation, which in turn will translate to weaker aggregate demand. The knock-on effect of weaker business activity due to the lockdown earlier this year has been a higher propensity to save by households (Chart 9). Household surveys conducted by the PBoC show that, since 2017, household savings have been increasing, suggesting a precautionary sentiment (Chart 10). Chart 9Chinese Economic Slowdown Reduced Credit Demand Chart 10Rising Precautionary Savings... Chart 11...Will Impact Domestic Property Market We do not expect the property market to recover in a manner similar to what occurred following China’s re-opening after the first wave of the COVID-19 pandemic. Depressed household purchasing power will keep housing demand subdued, while the “three red lines” policy, which limits the amount property developers can borrow, will keep supply low (Chart 11).6 Housing accounts for ~ 30% of copper consumption in China, which means weak property markets will remain a drag on copper demand. Investment Implications Continued weakness in China’s economy and a potentially deep recession in the EU will continue to restrain demand for copper globally. In addition, with the US economy looking wobbly, the third global pillar of economic strength also will be weakening going into 2H22. These fundamental demand-side effects will lower pressure on tight copper inventories and keep prices subdued, in our view. This does not, however, signal an all-clear for copper supply or inventory tightness. Weaker demand is the only thing keeping prices from rising sharply, given the tight supply and inventory position of global copper markets. On the supply side, governance issues in copper-rich Latin American states, which are in the process of revising their social contracts with copper producers and consumers, will increase mining costs for companies, disincentivizing long-term and large-scale investments in new mines.7 These costs ultimately will be borne by consumers as supply shortages mount and the need to increase capex grows. Ultimately, this will feed into longer-term inflation and inflation expectations. Chart 12Caught In Risk-Off Selling We remain long-term bullish copper, as fundamentals remain tight and will get tighter. That said, over the short term, aggregate-demand weakness in the three major economic pillars in the world makes us leery of getting long copper futures, particularly as prompt COMEX prices test support (Chart 12).  Persistently weak copper prices will disincentivize the needed investment in new supply the world will need to effect a transition to renewable energy in coming decades. For this reason, we are comfortable re-establishing our long XME metals and mining ETF at tonight’s close, as copper prices are down 40% from their April highs. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodity Round-Up Energy: Bullish. A strike by Norwegian energy-sector workers that would have hit the natural gas market in Europe particularly hard was averted earlier this week.8 This still leaves the EU and UK (Europe) at risk of additional losses of Russian natgas exports beginning next week when Nord Stream 1 (NS1) maintenance is due to start. These threats have pushed Dutch Title Transfer Facility (TTF) natural gas prices up close to 93% since 1 June, and close to 400% y/y as of Tuesday. For the first five months of this year, Europe’s been importing just under 15 Bcf/d of LNG, with ~ 8.5 Bcf/d of those volumes coming from the US, based on EIA data. The EIA expects US LNG exports to average ~ 11.9 Bcf/d this year and 12 Bcf/d in 2023. Europe accounted for just under 75% of US exports in January – April of this year, and we expect that to continue going forward. The IEA expects Russia to supply 25% of EU demand this year, the lowest in 20 years. Last year, Russian imports covered ~ 40% (~ 7 TCF) of EU demand. Base Metals: Zinc stocks are depleted but prices are dropping on recession fears (Chart 13). Smelting operations were hit last year following the power-supply crunches in China and Europe. While China has recovered its energy security, Europe, which accounts for ~15% of global refined zinc supply, has not. Reduced natgas supply from Russia will make the smelting shortage in Europe even more acute, especially if power and fuel rationing occur. In April, China was a net exporter of zinc for the first time since 2014, as low demand in the state and low European zinc supply incentivized Chinese smelters to ship metal to the West despite high outbound tariffs. Precious Metals: Markets switched from inflation to growth fears, as central banks, notably the Fed began hiking interest rates aggressively to curb inflation. Investors have been flocking to the USD, which hit a 20-year high on recession fears this week (Chart 14). This has happened at the expense of the yellow metal, which, since breaking through the USD 1800/oz mark last week, has continued to drop, hitting an 8-month low as of yesterday's close. Chart 13Global Copper Inventories Remain Tight Chart 14   Footnotes 1     Please see China, US and EU are the largest economies in the world, which was published by Eurostat 19 May 2020. 2     For additional discussion of oil-market fundamentals, please see Recession Unlikely To Batter Oil Prices, which covers our expectation for global oil balances and prices. It was published 16 June 2022. 3    Please see Hypo-Globalization (A GeoRisk Update) published by BCA Research’s Geopolitical Strategy 30 July 2021. See also Commodities' Watershed Moment, which we published 22 March 2022.  4    Please see GDPNow, published by the Federal Reserve Bank of Atlanta 1 July 2022. 5    Please see Third Quarter Geopolitical Outlook: Thunder And Lightning, published by BCA’s Geopolitical Strategy 24 June 2022. This report notes, “China’s political crackdown, struggle with Covid-19, waning exports, and deflating property market have led to an abrupt slowdown this year. The government is responding by easing monetary, fiscal, and regulatory policy, though so far with limited effect … . Economic policy will not be decisive in the third quarter unless a crash forces the administration to stimulate aggressively.” 6    In August 2020, the Ministry of Housing and Urban-Rural Development and the People’s Bank of China proposed to implement a policy which kept a ceiling on companies’ asset to liability ratio at 70%, net debt to equity ratio at 100%, and cash to short-term borrowings ratio at 1. Developers whose liabilities are within these requirements may increase their liabilities by less than 15%. These were known as the “three red lines.” Per that policy, if one or more of these ceilings are surpassed, maximum liabilities growth is capped at a lower percentage. 7     Please see Add Local Politics To Copper Supply Risks, which we published 25 November 2021. It is available at ces.bcaresearch.com. See also Chile sticks to plan for new mining profit tax up to 32% linked to copper price, published by reuters.com via mining.com 1 July 2022. 8    Please see Norway’s government halts oil and gas strike published by ft.com 5 July 2022. Investment Views and Themes Strategic Recommendations Tactical Trades Trades Closed In 2022

Executive Summary Our recommended model bond portfolio outperformed its custom benchmark index by +24bps in Q2/2022, improving the year-to-date outperformance to a solid +72bps. The Q2 outperformance came entirely from the credit side of the portfolio (+35bps), led by underweights to US investment grade corporates (+28bps) and EM hard currency debt (+24bps). The rates side of the portfolio was down slightly (-11bps), with gains from underweights in US and UK inflation-linked bonds (a combined +24bps) helping offset the hit from overweights to German and French government bonds (a combined -30bps). Looking ahead, we continue to see more defensive positioning in growth-sensitive credit sectors like US investment grade corporate bonds and EM hard currency debt, rather than duration management, as providing the better opportunity to generate alpha in bond portfolios over the latter half of 2022. GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months Bottom Line: In our model bond portfolio, we are maintaining an overall neutral duration stance and a moderate underweight of spread product versus developed market sovereign bonds. We are, however, reducing the recommended tilts in inflation-linked bonds by upgrading US TIPS to neutral and downgrading Canadian linkers to neutral. Feature Dear Client, We are about to take a mid-summer publishing break, as this humble bond strategist moves his family into a new home in a new city. Next week, you will be receiving a report written by BCA Research’s Chief US Bond Strategist, Ryan Swift. The following week, there will be no Global Fixed Income Strategy report published. Our next report will be published on July 26, 2022. Regards, Rob Robis Bond investors are running out of places to hide to avoid losses in 2022. The total return on the Bloomberg Global Aggregate index (hedged into USD) in the second quarter of this year was -4%, nearly matching the -6% loss seen in Q1. No sector, from government bonds to corporate debt to emerging market credit, could avoid the damage caused by hawkish central bankers belated responding to the worst bout of global inflation since the 1970s. Related Report  Global Fixed Income StrategyGFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Global inflation rates will soon peak, led by slowing growth of goods prices and commodity prices. However, inflation will remain well above central bank targets across the bulk of the developed world, supported by more domestic sources like services prices, housing costs and wages. This will limit the ability for important central banks like the Fed and ECB to quickly pivot in a more dovish direction to support weakening growth – and bail out foundering bond markets. With that backdrop in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio for the second quarter of 2022. We also present our recommended positioning for the portfolio for the next six months, as well as portfolio return expectations for our base case and alternative investment scenarios. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q2/2022 Model Bond Portfolio Performance: All About Credit Chart 1Q2/2022 Performance: Gains From Defensive Credit Positioning The total return for the GFIS model portfolio (hedged into US dollars) in the second quarter was -4.3%, outperforming the custom benchmark index by +24bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -11bps of underperformance versus our custom benchmark index while the latter outperformed by +35bps. In our previous quarterly portfolio performance review in April, we noted that the greater opportunities to generate outperformance for fixed income investors would come from more defensive allocations to spread product, rather than big directional moves in government bond yields. That forecast largely panned out, as global credit markets moved to price in the growing risk of a deep economic downturn. Declining nominal government bond yields provided some modest relief at the end of June, with markets modestly pricing out some of the rate hikes discounted over the next year amid deepening global recession fears. While we maintained a neutral stance on overall portfolio duration during the quarter, we did benefit from the fact that the decline in global bond yields in late June was concentrated more in lower inflation expectations than falling real yields. Thus, our underweight positioning in inflation-linked bonds, focused on the US and UK, helped add a combined +25bps of outperformance versus the benchmark (Table 1). Table 1GFIS Model Bond Portfolio Q2/2022 Overall Return Attribution The bar charts showing the total and relative returns for each individual government bond market and spread product sector in our model portfolio are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q2/2022 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q2/2022 Spread Product Performance Attribution By Sector Biggest Outperformers: Underweight US investment grade Industrials (+19bps) Underweight UK index-linked Gilts (+15bps) Underweight US TIPS (+9bps) Underweight US investment grade Financials (+7bps) Underweight US MBS (+6bps) Underweight US Treasuries with maturities beyond ten years (+6bps) Biggest Underperformers: Overweight euro area investment grade corporates (-19bps) Overweight German government bonds with maturities beyond ten years (-14bps) Overweight French government bonds with maturities beyond ten years (-8bps) Overweight UK Gilts with maturities beyond ten years (-6bps) Overweight US CMBS (-4bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q2/2022. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q2 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q2/2022 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. That pattern largely held true in Q2/2022, especially at the tail ends of the chart. During a quarter where all the major asset classes in our portfolio lost money on a hedged and duration-matched basis, we outperformed by selectively underweighting the worst performers within the credit side of the benchmark portfolio universe. Notably, we were underweight EM USD-denominated Sovereigns (-1099bps), EM USD-denominated corporates (-816bps) and US investment grade corporates (-686bps) on the extreme right side of the chart. Some of our key overweight positions did relatively well, led by overweights in US CMBS (-148bps), Australian government bonds (-288bps) and euro area investment grade corporates (-378bps), all of which were on the left side of Chart 4. One of our key recommendations throughout the first half of 2022 - overweighting German government bonds (-517bps) and French government bonds (-657bps) versus underweighting US Treasuries (-283bps) - performed poorly in Q2. This was due to investors rapidly pricing in a far more aggressive series of ECB rate hikes than we expected, resulting in some convergence of US-European bond yield differentials. Importantly, core European bond yields have pulled back substantially over the last month, and by much more than US yields have declined. Most notably, the 2-year German yield, which began Q2 at minus-7bps and hit a peak of 1.2% on June 14, has now fallen all the way back to 0.4% as this report went to press. The 2-year US-Germany yield differential has already widened by 35bps in the first week of July, suggesting that our overweight core Europe/underweight US allocation is already contributing positively to the model bond portfolio returns for Q3. Bottom Line: Our model bond portfolio outperformed its benchmark index in the second quarter of the year by +24bps – a positive result coming largely from underweight positions in US corporate bonds, EM spread product and inflation-linked bonds in the US and UK. Future Drivers Of Model Bond Portfolio Returns Just as in Q2/2022, the performance of the model bond portfolio in Q3/2022 will be driven more by relative allocations between countries and spread product sectors, rather than big directional moves in bond yields or credit spreads. Overall Duration Exposure Chart 5A More Stable Backdrop For Global Bond Yields In terms of portfolio duration, we still see a stronger case for global bond yields to be more rangebound than trending, especially in the US. There has already been a major downward adjustment to global bond yields via lower inflation expectations and reduced rate hike expectations. A GDP-weighted average of major developed market 10-year inflation breakevens has already fallen from an April 2022 peak of 281bps to 216bps (Chart 5). That aggregate breakeven is now back to the levels that began 2022, before the Russian invasion of Ukraine that triggered a surge in global energy prices. We anticipate that additional declines in global inflation expectations – and the associated reductions in central bank rate hike expectations – will be harder to achieve over the latter half of 2022. “Stickier” inflation from services, housing costs and wages will remain strong enough to keep overall inflation rates above central bank targets, even as decelerating goods and commodity price inflation act to slow headline inflation rates. Our Global Duration Indicator, which is comprised of growth indicators like the ZEW expectations index for the US and Europe as well as our own global leading economic indicator, has fallen substantially and is signaling a decline in global bond yield momentum once realized inflation rates peak (Chart 6). Chart 6Our Duration Indicator Calling For Slowing Global Yield Momentum​​​​​​ Chart 7Overall Portfolio Duration: Stay Neutral We see that as signaling more of a sideways action in bond yields over the next six months, rather than a big downward move, especially in the US. Thus, we are keeping the duration of the model bond portfolio close to that of the benchmark index (Chart 7). Government Bond Country Allocation We are sticking with our view that, for countries with active central banks (i.e. everyone but Japan), favoring markets where interest rate expectations are above plausible estimates of neutral policy rates should lead to outperformance from country allocation. In Chart 8, we show 10-year bond yields and 2-years-forward 1-month Overnight Index Swap (OIS) rates for the US, euro area, UK, Canada and Australia. The shaded regions in the chart represent estimates of the range of neutral policy rates. In the case of the US, rate expectations and Treasury yields are now below the upper level of the range of neutral fed funds rates estimates, between 2-3%, taken from the latest set of FOMC economic projections. Hence, we are sticking with an underweight stance on US Treasuries with yields offering less protection against the Fed following through on its current guidance and lifting the funds rate into restrictive territory above 3%. In the other countries, rate expectations are above the range of neutral rate estimates, which suggests that bond yields have a bit more protection against hawkish central bank actions. That leads us to stay overweight core Europe, the UK and Australia in the government bond portion of the model bond portfolio. We are only keeping Canada at neutral, however, as we suspect that the Bank of Canada is more willing than other central banks to follow the Fed’s lead on taking rates to a restrictive level to help bring down elevated Canadian inflation. For other countries, we are staying neutral on Italian government bond exposure, for now, and underweight Japan (Chart 9). Chart 8Favor Countries Where Markets Expect Above-Neutral Rates​​​​​​ Chart 9Underweight JGBs, Stay Neutral Italy (For Now)​​​​​​ For Italy, we await news from the July 21 ECB meeting on the details of a proposal to help support Italian bond markets in the event of additional yield increases or spread widening versus Germany. It is clear from the history of the past decade that Italian bond returns suffer when the ECB is either hiking rates or slowing the growth of its balance sheet (top panel). In other words, it is difficult to recommend overweighting Italian bonds without the support of easy ECB monetary policy. Chart 10Our Inflation-Linked Bond Country Allocations For Japan, our recommendation is strictly related to our view on the move in overall global bond yields. The Bank of Japan is bucking the worldwide trend to tighten monetary policy because core Japanese inflation remains weak. This makes Japanese government bonds (JGBs) a good place for bond investors to “hide out” in when global bond yields are rising. Given our view that global bond yield momentum will slow – in line with the signal from our Global Duration Indicator – we do not see a strong cyclical case for overweighting low-yielding JGBs. On inflation-linked bonds, we are maintaining a cautious overall stance, with commodity prices decelerating, realized inflation momentum set to soon peak and central banks signaling more tightening ahead (Chart 10). This week, we are closing out our lone overweight recommendation on inflation-linked bonds in Canada, where we downgrading to neutral (3 out of 5, see the model bond portfolio table on page 24).2 At the same time, we are neutralizing our underweight stance on US TIPS, moving the allocation to neutral. We still see shorter-term TIPS breakevens as having downside from here, but longer-maturity breakevens have already made enough of a downward adjustment, in our view. Global Spread Product Turning to credit markets, we are maintaining our moderately cautious view on the overall allocation to credit versus government bonds. Slowing global growth momentum and tightening global monetary policy is not an environment where credit spreads can narrow, especially for growth-sensitive credit like corporate bonds and high-yield (Chart 11). Having said that – the spread widening seen in US and European corporate bond markets has introduced a better valuation cushion into spreads. Our preferred measure of spread product valuation – the historical percentile ranking of the 12-month breakeven spread – shows that investment grade spreads in the euro area are now in the top quartile (85%) of its history on a risk-adjusted basis (Chart 12). US investment grade spreads are now up into the second quartile (64%), which is a big improvement from the start of 2022 but not as much as seen in Europe. Chart 11Global Monetary Backdrop Turning More Negative For Credit​​​​​ Chart 12Corporate Spread Valuations Have Improved In The US & Europe​​​​​ European credit spreads likely need to be wide as a risk premium against the numerous risks the region is facing right now – slowing growth, an increasingly hawkish ECB, soaring energy prices and the lingering uncertainties stemming from the Ukraine war. However, a lot of bad news is now discounted in European spreads and, as a result, we are maintaining our overweight stance on European investment grade corporates, especially versus US investment grade where we remain underweight. High-yield spreads on both sides of the Atlantic look more attractive on a 12-month breakeven spread basis, but also on a default-adjusted spread basis (Chart 13). Assuming a moderate increase in the high-yield default rates in the US and Europe - consistent with a sharp slowing of economic growth but no deep recession - the current level of high-yield spreads net of expected default losses over the next year is above long-run averages. It is too soon to move to an overweight stance on high-yield, with the Fed and ECB set to tighten more amid ongoing growth uncertainty, but given the improved valuation cushion we see a neutral allocation to junk in both the US and Europe as appropriate in our model portfolio. Chart 13Junk Spreads Offer Value If Recession Can Be Avoided Finally, we remain comfortably underweight emerging market USD-denominated sovereign and corporate debt. The backdrop is poor for emerging market bond returns, given slowing global growth, softening commodity prices, a tightening Fed and a strengthening US dollar (Chart 14). Chart 14Staying Cautious On EM Debt Exposure​​​​​​ Summing It All Up The full list of our recommended portfolio allocations can be seen in Table 2. The portfolio enters the second half of 2022 with the following high-level characteristics: Table 2GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months Chart 15Overall Portfolio Allocation: Underweight Spread Product Vs Governments the overall duration exposure remains at-benchmark (i.e. neutral) the portfolio has an underweight allocation to overall spread products versus government bonds, equal to four percentage points of the portfolio (Chart 15) the tracking error of the portfolio, or its expected volatility in excess of that of the benchmark, is 77bps – below our self-imposed 100bps tracking error limit (Chart 16) the portfolio now has a yield below that of the custom benchmark index, equal to -31bps on a currency-unhedged basis but a more modest “carry gap” of -10bps on a USD-hedged basis given the gains from hedging into USD (Chart 17). Chart 16Overall Portfolio Risk: Moderate​​​​​​ Chart 17Overall Portfolio Yield: Below-Benchmark​​​​​​ Bottom Line: Looking ahead, our model bond portfolio performance will continue to be driven by the same factors in Q3/2022 as in the previous quarter: the relative performance of US bonds versus European equivalents for both government debt and corporate bonds, and the path for emerging market credit spreads. Portfolio Scenario Analysis For The Next Six Months After making the modest changes to our inflation-linked bond allocations in the US and Canada, which can be seen in the tables on pages 23-24, we now turn to our regularly quarterly scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 3A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 3B). Table 3AFactor Regressions Used To Estimate Spread Product Yield Changes Table 3BEstimated Government Bond Yield Betas To US Treasuries For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. In the current environment, our scenarios center around the pace of global growth. Base Case (Slow Global Growth) Global growth momentum slows substantially, with firms cutting back on hiring and investing activity due to slowing corporate profit growth. An outright recession is avoided because softening energy prices help ease the drag on real spending power for consumers. China introduces more monetary and fiscal stimulus measures to boost growth. Global inflation peaks and eases on the back of slowing growth of goods prices and commodity prices, but the floor on inflation in the US and other developed markets is higher than central bank inflation targets due to sticky domestic price pressures. The Fed continues to hike at every policy meeting in H2/2022. There is a very mild bear flattening of the US Treasury curve, but with longer-term yields remain broadly unchanged over the full six month scenario period with the Fed not hiking by more than currently discounted. The Brent oil price retreats by -10%, the US dollar modestly appreciates by 2%, the VIX stays close to current levels at 28 and the fed funds rate reaches 3.25% by year-end. Resilient Growth Scenario Consumer spending surprises to the upside in the US and even Europe, as softer momentum of energy prices eases the relentless downward pressure on real incomes. Labor demand remains sold across the developed world, particularly with firms reluctant to do mass layoffs because of a perceived scarcity of quality labor. China enacts more policy stimulus with growth likely to fall below 2022 government targets. The Fed is forced to be more aggressive on rate hikes, given resilient US growth and inflation staying well above the Fed’s 2% target. The US Treasury curve bear-flattens into outright inversion, but with Treasury yields rising across the curve. The Brent oil price rises +20%, the VIX index climbs to 30, the US dollar appreciates by +3% thanks to a more aggressive Fed that lifts the funds rate to 3.75% by year-end. Recession Scenario A toxic combination of contracting corporate profits and negative real income growth drags the major developed economies into outright recession. Global inflation rates slow rapidly from current elevated levels, fueled by a rapid decline in commodity prices, but remain above central bank targets making it hard for the Fed and other major central banks to pivot dovishly to support growth. Chinese policymakers belatedly act to ease monetary and fiscal policy, but not by enough to offset the slow response from developed market policymakers. The Treasury curve moderately bull-steepens, although the absolute decline in nominal Treasury yields is relatively modest as the Fed will not pivot quickly to signaling policy easing with inflation still likely to remain above 2%. The Brent oil price falls -20%, the VIX index soars to 35, the US dollar depreciates by -3% (as lower US rates win out over slowing global growth) and the Fed pushes the funds rate to 2.75% before pausing after September. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 4A. The US Treasury yield assumptions are shown in Table 4B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 18 and Chart 19, respectively. Table 4AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months Table 4BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis Chart 18Risk Factor Assumptions For The Scenario Analysis​​​​​ Chart 19US Treasury Yield Assumptions For The Scenario Analysis​​​​​​ Given our neutral overall duration stance, the return scenarios will be driven by mostly by the credit side of the portfolio. In the recession scenario where Treasury yields decline, there is a modest projected outperformance from the rates side of the portfolio coming through the underweight to low-beta JGBs. In all scenarios, financial market volatility is expected to stay at, or above, current levels as central banks will be unable to ease policy, even in the event of an actual recession, because of lingering high inflation. Thus, the return on the credit side of the model portfolio will be the main driver of performance, delivering a range of excess return outcomes between +47bps and +60bps. Bottom Line: The model bond portfolio should benefit in H2/2022 from the ongoing cautious stance on global spread product, focused on underweights to US investment grade corporates and EM hard currency debt.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2     We are also closing out our Canadian breakeven widening trade in our Tactical Overlay portfolio. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations*

Special Report

Executive Summary Rebounding Chinese Auto Sales China’s stimulus for auto purchases and an easing global auto chip shortage will lead to about a 10% recovery in domestic auto sales in 2022H2 from a year ago. Next year, we expect Chinese auto sales to grow only modestly (under 5%).  The share of new energy vehicles (NEVs) in auto sales is rising rapidly in China, crowding out internal combustion engine vehicles (ICEVs) at a fast rate. China is becoming more competitive in global auto manufacturing given its edge in NEV battery technologies and autonomous driving. Production of NEVs and the installation of NEV charging poles will expand rapidly. Yet, given the still-high valuation of these stocks, we will look to buy into these sectors at a better price entry point. Bottom Line: Chinese onshore and offshore automobile stock prices have risen sharply in the past couple of months on the expectation of improving car sales. Our bias is that the rally has been too fast and gone too far. Investors should wait for a pullback before they buy. Feature Chinese total auto sales contracted by 12% year on year in the first five months of this year due to a deep 24% contraction in non-NEV sales. In stark contrast, Chinese NEV sales have more than doubled during the same period. However, the 1-million-unit increase in NEV sales failed to counteract the 2.4-million-unit loss in non-NEV demand. This raises two questions. Why have NEV sales skyrocketed at a time when non-NEV sales have tanked? Will Chinese auto sales recover in 2022H2 and 2023? If so, then how strongly will the recovery be? The answer to the first question lies in a major auto chip allocation strategy that many Chinese auto producers adopted last year. Under limited semiconductor supplies, auto producers in China prioritized the use of chips in their production of NEV models – which have higher profit margins –over traditional vehicles. The greater availability of NEVs than ICEVs has meant an increase in sales of the former and a deep contraction in the latter in 2022H1. Chart 1Chinese Auto Sales: A Recovery Ahead? For the second question, we believe that China’s stimulus package to boost auto sales and an easing global auto chip shortage will lead to about a 10% recovery in auto sales in 2022H2 from a year ago. On the other hand, growth in 2023 will be very modest (under 5%). Accordingly, the daily data of Chinese retail auto sales have already shown a strong rebound in the total sales of NEVs and ICEVs in the last three weeks of June (Chart 1). Auto Sales In China: A Gradual Recovery     China’s auto sales are set to have a gradual recovery in 2022H2. We expect auto sales to reach 26.2-26.8 million units by the end of this year, with NEV and non-NEVs rising to 5-5.3 million units and 21.2-21.5 million units, respectively1 (Chart 2). The reasons for our positive estimates include policy stimulus, improving technological advancement of NEVs, as well as an easing in the global auto chip shortage. First, the government has issued a flurry of policies since late May attempting to boost domestic auto demand. As Chart 1 shows, these policies have proved effective, at least for now. In previous episodes of stimulus aimed at boosting auto sales in 2009-2010, 2016-2017, and 2019-2021, authorities had implemented similar supportive measures. While the stimulus worked well in the first two episodes, it was not effective in 2019-2021 (Chart 3).   Chart 2Auto Demand In China: A Gradual And Moderate Rebound Chart 3Policy Stimulus Will Help Lift Chinese Auto Demand Box 1 shows our summary of those auto stimulus and a comparison of these episodes. Of all these policies, we believe that a sales tax reduction2 on certain vehicles has proved to be the most effective policy as it directly reduced the prices of these vehicles. In 2022H2, this policy will mainly benefit ICEVs sales as NEVs will continue to enjoy a full exemption from the 10% vehicle purchase tax. The government is also considering an extension of the exemption for NEVs to the end of next year.  Box 1China’s Stimulus Package For The Domestic Auto Industry​​​​​​​ This year’s stimulus is more comparable to the 2009 and 2016 episodes as they share the same reduction in the sales tax rate from 10% to 5%. The main difference is that this time the policy targets cars with 2-liter engines or smaller, while back in 2009 and 2016 this policy only applied to vehicles with capacity no bigger than 1.6-liters. This means a larger range of vehicles will benefit from the reduction. In short, the current policy will allow an additional 23% share of total vehicles sold to benefit from the stimulus. Please note that for the period of 2019-2021 there was no sales tax reduction. This may be one of the reasons for the lack of recovery in vehicle sales in this episode; Chinese auto sales contracted in both 2019 and 2020. Second, Chinese NEVs buyers have been enjoying government subsidies, albeit on a sliding scale since 2019. The amount of subsidy has been dropping by 10%, 20% and 30% in 2020, 2021 and 2022, respectively (Table 1). We expect NEV sales to rise as the subsidy is set to expire by the end of this year. This may induce some buyers to buy NEVs before the subsidy ends. Table 1Government Subsidy For NEV Purchase in China Chart 4NEVs Become More Appealing To Chinese Consumers In addition, NEVs are becoming increasingly appealing for auto buyers. This is due to longer travel mileage per battery charge, constant improvement in NEV related technologies, and an expanded charging/battery swap framework (Chart 4). Further, in comparison to traditional ICEVs, NEVs have become increasingly more equipped with functions such as autonomous driving, intelligent interconnection, and other software application-based services. NEVs will also become more integrated with intelligent and interactive networks. All these features will make NEVs more attractive to automobile buyers as well.  According to the McKinsey China Auto Consumer Insights 2021 report, Chinese consumers are more interested than ever in smart vehicle technologies, and they are willing to pay a premium for innovative features. 80% of consumers report that autonomous driving will be a key factor in their decision-making when they buy their next car. Meanwhile, 69% of consumers consider that over-the-air update technology (OTA) is an important feature, and 62% of those are willing to pay for it. Chart 5NEV Sales In China Are Not Very Sensitive To Gasoline Prices Rising oil and gasoline prices have also encouraged NEV sales in the past six-to-nine months. But we believe high fuel prices are relatively less important factors to NEV demand in China than in the US and EU. For example, in 2020H2, when oil prices were only around US$40-50 and domestic gasoline price were low, Chinese NEV sales still rose strongly during the same period (Chart 5). Third, the deep contraction in non-NEV sales in China in 2021 was partially caused by the global auto chip shortage. Global semiconductor chip shortages are likely to continue easing in 2022H2 as demand-supply gaps decrease across most components. Demand for consumer electronics is set to contract in the US and the EU in the next six-to-nine months. Hence, some capacity for PC and smartphone chips could be used to produce auto chips in the months ahead. Bottom Line: Government initiatives to boost auto sales, improving technological advancement of NEVs, and an easing of the global auto chip shortage will lift Chinese auto sales to some extent. Structural Auto Demand: A New Normal? Auto sales peaked in 2017 and are since down by 13%. Even if auto sales registered a modest recovery as we expect in 2022 and 2023, they will still be about 6% below their 2017 peak. The reasons why we do not expect a brisk auto sales recovery are as follows: Household (HH) income growth is very weak and the unemployment rate has been rising (Chart 6). HHs have considerable debt (Chart 7). With house prices not rising, and potentially deflating, HH willingness to take on more debt has declined. Chart 6Falling HH Income Growth And Rising Unemployment Chart 7HH Debt Burden Is Already High​​​​​​ Wage/income growth has downshifted and narrowed its gap with interest rates on consumer loans. The cost HH debt has therefore risen relative to their income growth, making consumers less willing to take on more debt.   Reflecting downbeat consumer sentiment, the HH marginal propensity to consume has fallen to very low levels and has not shown signs of improvement (Chart 8). With the mediocre structural auto demand outlook in China, NEV sales will rapidly gain market share from non-NEVs (Chart 9). NEVs currently account for about 18% of total auto sales in China, still much lower than the country’s goal of 40% in 2030. Chart 8HH Willingness To Spend Is Low Chinese Consumers: Falling Willingness To Consume Chart 9Accelerating NEV Penetration In China Last week the EU passed a plan of a 2035 phase-out of new fossil fuel car sales. This is also a trend for China. Chinese auto makers such as Changan, BAIC Motor and Haima have already announced that they will stop ICEV production in 2025. Chart 10Decelerating Growth In Chinese Oil Demand Declining ICEV sales will lead to lower growth of these vehicles on the road (Chart 10). Consequently, gasoline and diesel demand growth from passenger and commercial autos will be decelerating in China in the coming years. Bottom Line: Passenger car demand in China will be settled in low single digit growth rates. The market share of NEVs will rise very fast at the expense of ICEVs. In turn, falling ICEV sales will result in slower growth in domestic petroleum demand.  China: Increasing Competitiveness Chart 11Increasing Competitiveness Of Chinese Auto Manufacturers China has become increasingly competitive in global auto manufacturing. This is a strong tailwind for the country’s auto exports. In fact, the country’s net exports of autos have been rising (Chart 11). China is the world’s largest auto producer and consumer, accounting for 32.5% and 32% of global auto production and sales, respectively. The country is also the world’s largest NEV producer. Chart 12China: The World’s Leading And Largest EV Battery Producer ​​​​​​​​​​​​​​The battery is the most important component of an NEV, and its technological progress holds the key to the speed of NEV penetration. China is the world leader in this battery technology. China’s CATL is currently the world's largest battery manufacturer, with a market share of 32.5%. CATL ranked first in the world for five consecutive years from 2017 to 2021. In addition, four out of the top ten global EV battery players are Chinese companies, with a total market share of 44%, up from 41% last year (Chart 12). Moreover, in late June, CATL launched its cell-to-pack (CTP 3.0) battery. With a record-breaking volume utilization efficiency of 72% and an energy density of up to 255 Wh/kg, it achieves the highest integration level worldwide so far, capable of delivering a range of over 1,000 km on a single charge. The CTP 3.0 batteries are expected to be mass produced and come onto the market in 2023. The development of charging/battery-swapping infrastructure will continue to be faster in China than in other countries/regions due to the country’s competitive advantage in NEV production, including batteries, as well as related policy support. For example, the number of total public & private charging poles rose at a compound annual growth rate of 50% in the past five years. This allows China to collect more NEV charging-related data, which could be used to improve the country’s NEV manufacturing process, charging pole production, and the country’s charging infrastructure development. This will help reduce the charging anxiety of Chinese NEV users. In terms of autonomous driving, five Chinese companies have been included in the world’s 10 best autonomous driving companies based on their technological edge, according to the global autonomous driving report released by the California Department of Motor Vehicles (DMV). In addition to test drives in the US, major Chinese NEV makers have also carried out test drives in China with long distances and more complicated driving conditions. For example, as of mid-March, Baidu Apollo’s autonomous driving has already exceeded 25 million kilometers. In comparison, the total test distance of autonomous driving of all autonomous driving test cars in California were only 6.4 million kilometers. Chart 13China: Faster NEV Penetration Versus Other Countries At 13.4%, the share of NEVs in total auto sales in China was high last year compared with other countries (Chart 13). The ratio has already risen to 21% in the first five months of this year. Bottom Line: China will become more competitive in global auto manufacturing given its edge in NEV battery technologies and autonomous driving. Investment Implications Chinese onshore and offshore automobile stock prices have risen sharply in the past couple of months, expecting improving car sales in the short-to-medium term (Chart 14). Our bias is that the rally has been too fast and gone too far. Investors should wait for a pullback before they buy. A shakeout in broader Chinese offshore and onshore stocks is likely due to the following (Chart 15): Chart 14Chinese Automobile Stock Prices: A Lot Of Good News Already Priced In... Chart 15...A Pullback Is Due Chart 16Look To Buy Chinese NEV-related Stocks China’s economy is still facing downward pressure due to a faltering property market, sluggish household income growth and consumption, falling export demand, as well as heightened risks of further COVID-induced lockdowns. Global equities have probably not completed their downtrend. It will be hard for Chinese stocks to continue rallying if global share prices continue to fall. That said, we have a bullish bias towards Chinese NEV producers. China’s NEV sector enjoys tailwinds from structurally strong demand and its technological edge, especially in batteries. Hence, we will look to buy Chinese NEV and battery stocks at a better price entry point (Chart 16).   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Footnotes 1     China Association of Automobile Manufacturers (CAAM) predicted Chinese auto sales to rise to 27.5 million units for the full year. We are a little bit less optimistic on that front. 2     The State Council of China is enacting 60-billion-yuan (US$9 billion) worth of tax cuts between June and December. The purchase tax on certain passenger vehicles will be reduced by half to 5% of the sticker price. The tax cuts target cars with 2-liter engines or smaller, priced at 300,000 yuan (US$ 44,800) or less. Strategic Themes Cyclical Recommendations