Economy

Executive Summary The Fed will continue to hike rates at a time when global trade is contracting. Earlier this week, Fed Chairman Jerome Powell reiterated that the Fed will not hesitate to hike rates until core consumer price inflation gets closer to 2%. Given that US core consumer price inflation is currently at around 5-6%, a mere rollover in core inflation from current levels will not be enough for the Fed to tone down its hawkishness. Besides, according to Powell, US financial conditions are not yet at a level that is consistent with inflation coming down substantially. China will stick to its dynamic zero-COVID policy this year. The economy will continue to underwhelm as the magnitude and nature of stimulus measures announced thus far are not adequate to produce a recovery. Industrial metal prices and global material stocks are at risk of gapping down. Play these markets on the short side. Commodity Currencies Are Signaling Lower Commodity Prices Bottom Line: It is still dangerous to bottom fish in global equities and risk assets in general. The US dollar has more upside. Continue underweighting EM stocks and credit within global equity and credit portfolios, respectively. Feature The risks to global and EM risk assets are still skewed to the downside. Although investor sentiment on global equities has soured of late, we do not think global or EM equities have made a bottom, and the US dollar has not yet reached an apex. Consequently, absolute-return investors should stay defensive, and global equity portfolios should continue to underweight EM stocks. The Fed and Equities Are Still On A Collision Course Earlier this week, Fed Chairman Jerome Powell reiterated the Fed’s commitment to hiking interest rates until core consumer price inflation gets closer to 2%. Notably, in his speech at a WSJ event on May 17, Powell noted: “This is not a time for tremendously nuanced readings of inflation”… “We need to see inflation coming down in a convincing way. Until we do, we’ll keep going.” Given that US core consumer price inflation is currently at around 5-6%, a mere rollover in core inflation from current levels will not be enough for the Fed to tone down its hawkishness. Chart 1US Core Inflation Will Roll Over But Stay Above 3.5-4% For Now Chart 1 shows the average of core median CPI, core trimmed-mean CPI and core sticky CPI, which are better indicators of genuine inflationary pressures because they are less affected by outliers. Even though core CPI inflation ticked down in April, other core measures such as core median CPI, core trimmed-mean CPI and core sticky CPI continued to rise. These core inflation measures are not likely to ease back to 2% unless economic growth falls below its potential. In his same speech, Chairman Powell also asserted: “We will go until we feel like we are at a place where we can say, ‘Yes, financial conditions are at an appropriate place. We see inflation coming down.’ We will go to that point, and there will not be any hesitation about that.” This means that US financial conditions have not yet tightened enough for the Fed to back down on its hawkishness. Finally, we have been arguing that a wage-price spiral has developed in the US as the labor market has become very tight (Chart 2, top panel). Wages and unit labor costs have been surging. Unit labor costs are the most important driver of US core CPI (Chart 2, bottom panel). Therefore, it will be impossible for the Fed to bring down core inflation toward 2% without a retrenchment in the labor market, i.e., layoffs. Rising unemployment will in turn weigh on household income growth and consumption. Chart 2The US Labor Market Is Very Tight And Wage Growth Is Accelerating The cost of borrowing for companies is rising globally, and these periods often coincide with equity selloffs. Notably, surging US high-yield ex-energy corporate bond yields herald lower US share prices ahead (Chart 3, top panel). Similarly, rising EM corporate bond yields foreshadow a further decline in EM ex-TMT share prices (Chart 3, bottom panel). Chart 3Rising Corporate Bond Yields Are Bearish For Stocks On the whole, the Fed and many other central banks will be hiking interest rates at a time when global trade volumes are contracting in H2 2022. As discussed in our report A Whiff Of Stagflation? US and EU imports of consumer goods are set to shrink following the pandemic boom. Chart 4Global Export/Manufacturing Are Heading Into Contraction Meantime, rolling lockdowns and extremely weak income growth are depressing domestic demand in China. High food and energy prices as well as rising interest rates are weighing on EM ex-China consumption. The sharp underperformance of global cyclicals equities versus global defensive sectors corroborates our expectation that global manufacturing activity will contract (Chart 4). The trade-weighted US dollar typically benefits from both Fed hikes and a global trade slump. As long as the Fed is hawkish and global exports are contracting, the greenback will continue to appreciate. For now, the US dollar remains in a strong position for further appreciation, especially versus EM currencies (Chart 5). Consistently, the selloff in broad EM risk assets is not yet over.  Chart 5EM Currencies: More Downside A major reversal in the trade-weighted dollar will be a signal that the global macro backdrop is improving and that global share prices and EM risk assets are bottoming. Bottom Line: Although equities have become oversold and investor sentiment is depressed, any rebound will prove to be short lived. The Fed will continue to hike rates at a time when global trade is about to shrink. The global/EM equity selloff has further to run. China: Ordinary Stimulus Despite Extraordinary Conditions Only one thing is currently certain in China: authorities are committed to the dynamic zero-COVID policy. However, most experts outside China believe that it will be very difficult to wholly limit the spread of the easily transmissible Omicron variants, even with such stringent mainland containment policies. As a result, rolling lockdowns are the most likely scenario for China’s regions and cities in 2022. These lockdowns will depress household income, confidence and consumption. Private business investment and hiring will also tank. Have authorities provided enough stimulus to support a recovery in H2 2022? We do not think so. Chinese stimulus has so far been ordinary in nature and in magnitude. Policy easing will likely prove to be insufficient to lift the economy out of the current extraordinary slump. First, Chinese exports are set to shrink in H2 as US and EU consumption of consumer goods revert to their pre-pandemic trend. Demand from EM will remain weak. Second, rising unemployment and under-employment is hindering household income. Generous cash transfers are needed to offset this hit to income. Not only did aggregate retail sales collapse in April, but online sales of goods and service also plunged (Chart 6). It is hard to imagine that private businesses will be investing when consumer spending and exports are weak. Our proxies for the marginal propensity to spend for households and enterprises continue to fall (Chart 7). Chart 6China: Even Online Retail Sales Are Shrinking Chart 7China: Household And Enterprise Propensity To Spend Have Been Declining   Critically, China’s credit impulse, excluding government bond issuance, remains in negative territory (Chart 8). Third, China’s property market is frail. Despite modest policy easing for the real estate market, sentiment among home buyers and developers remains downbeat. Given that the housing sector faces structural headwinds, odds are that buyers and developers might not react to the modest property market easing that authorities have so far provided. It is worth noting that Chinese property stocks seem to have had a structural breakdown, and offshore corporate bonds of real estate developers remain in a bear market (Chart 9). These market patterns corroborate that China's housing market has experienced a structural breakdown. Chart 8Chinese Stimulus Has So Far Been Tame Chart 9Chinese Property Market Has Experienced A Structural Breakdown   Finally, even though infrastructure spending is being ramped up, it will prove to be insufficient for the economy to recover from a deep slump. Local governments are facing a major financing shortfall. Land sales – which make up about 40% of local government revenues – have dried up. This will hinder local governments’ ability to finance infrastructure projects. As to Chinese equities, internet/platform stocks have become oversold. However, their long-term outlook remains dismal. As we have been arguing since late 2020, the fundamental case for their de-rating remains intact. This week’s meeting between government officials and technology companies has not produced any positive news. Although the tone from authorities was more balanced, they did not offer any relief from already imposed regulations. Chart 10Implications Of China's Common Prosperity Policies Looking forward, implementing common prosperity policies will be the primary objective of the Communist Party in the coming years. These policies will assure that labor’s share of income will rise further at the expense of corporate profits. Chart 10 demonstrates that the share of labor in national income has been rising since 2011. Conversely, the share operating profits peaked in 2011 and has dropped to a 30-year low. These dynamics will persist as income will continue to be redistributed from shareholders to labor in the majority of industries/companies in China. This is an unfriendly outlook for shareholders, especially foreign ones. Bottom Line: Chinese policy stimulus has so far been insufficient. The economy is in a deep slump, and share prices remain at risk of further decline. Short Industrial Metals And Material Stocks Chart 11Chinese Imports Of Metals Was Shrinking In 2021 Industrial metals’ resilience last year in the face of shrinking Chinese import volumes was unusual (Chart 11). This resilience was probably due to robust DM demand for goods, supply bottlenecks and investors buying commodities as an inflation hedge. As we elaborated in the April 28 report, risks to industrial metals are skewed to the downside. This is despite the fact that agriculture prices will likely rise further, and energy prices will remain volatile due to the geopolitical situation. We continue to recommend investors underweight/short materials stocks and industrial metals for the following reasons: It is ill-advised to play the US inflation story by being long industrial metals and materials stocks. As shown in Chart 2 above, US unit labor costs are driving core inflation, not industrial metals. China accounts for 50-55% of global industrial metal consumption, and since early 2021 the key risk in China has been decelerating demand/deflation not inflation. In fact, commodities have become a crowded hedge against inflation and a global growth slowdown poses a substantial risk to industrial metals. Chart 12 demonstrates that Chinese materials stocks have plunged. We read this as a warning sign for global materials because China is by far the largest consumer of raw materials (excluding energy). Chart 12Chinese Material Stocks Are Signaling Trouble For Global Materials When share prices of customers are falling, equity prices of suppliers will likely follow. Chart 13 shows that over the past 200 years raw material prices in real US dollar terms (deflated by US headline CPI) have oscillated around a well-defined downtrend. The pandemic surge in commodity prices has pushed raw material prices to two standard deviations above this long-term trend. Chart 13Raw Material Prices (In Real Terms) Are At The Upper End Of A 200-Year Downtrend Historically, commodity rallies (and even their secular bull markets) ended when prices reached this threshold. Hence, odds are that industrial commodities might hit a soft spot. Energy prices remain a wild card due to geopolitics. It is critical to note that the raw materials price index shown in Chart 13 does not include energy, gold and semi-precious metals. Finally, shrinking global trade volumes are also negative for raw materials. The average of AUD, NZD and CAD points to lower industrial metal prices (Chart 14). Chart 14Commodity Currencies Are Signaling Lower Commodity Prices Chart 15Bearish Technical Patterns: BHP Share Price And Copper The share price of BHP, the world’s largest mining company, has put in a major top and is now gapping down (Chart 15, top panel). Copper prices have broken below their 200-day moving average that served as a support in the past 12 months (Chart 15, bottom panel). These market profiles point to more downside. We continue to recommend that investors play this theme in the following ways: Short copper or short copper / long gold; Short global materials / long global industrials; Short ZAR / long USD. Also, we downgraded Brazil early this week  partly due to expectations of lower iron ore prices and souring investor attitude toward commodity plays in general. Investment Conclusions Global and EM equities have entered a capitulation phase. It is still dangerous to bottom fish in global equities and risk assets in general. Continue underweighting EM stocks and credit within global equity and credit portfolios, respectively. The US dollar has more upside. Continue shorting the following EM currencies versus the USD: ZAR, PLN, HUF, COP, PEN, PHP and IDR. As we discussed in a recent report, we are approaching a major buying opportunity in EM local currency bonds. However, the US dollar needs to peak for that to transpire. 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)

Next Thursday May 26, we will hold the BCA Debate – High Inflation: Here To Stay,Or Soon In The Rear-View Mirror? – a Webcast in which I will debate my colleague, Chief Commodity & Energy Strategist, Bob Ryan on the outlook for inflation, and take the side that inflationary fears will soon recede. I do hope you can join us. As such, the debate will replace the weekly report, though we will renew the fractal trading watchlist on our website. Dhaval Joshi Executive Summary The second quarter’s synchronised sell-off in stocks, bonds, inflation protected bonds, industrial metals and gold is an extremely rare star alignment. The last time that the ‘everything sell-off’ star alignment happened was in early 1981 when the Paul Volcker Fed ‘broke the back’ of inflation and turned stagflation into an outright recession. In 2022, the Jay Powell Fed risks doing the same. If history repeats itself, then the template of 1981-82 could provide a useful guide for 2022-23. In which case, bond prices are now entering a bottoming process.  Stocks would bottom next. While the near term outlook is cloudy, we expect stock prices to be higher on a 12-month horizon, especially long-duration stocks that are most sensitive to bond yields. But just as in 1981-82, the biggest casualty will be industrial metals, which are likely to suffer at least double-digit losses over the coming year. Fractal trading watchlist: FTSE 100 versus Stoxx Europe 600, Czech Republic versus Poland, Food and Beverages, US REITS versus Utilities, CNY/USD. 2022-23 Could Be An Echo Of 1981-82 Bottom Line: The 1981-82 template for 2022-23 suggests that bonds will bottom first, followed by stocks. But steer clear of gold and industrial metals. Feature Investors have had a torrid time in the second quarter, with no place to hide.1  Stocks are down -10 percent. Bonds are down -6 percent. Inflation protected bonds are down -6 percent. Industrial metals are down -13 percent. Gold is down -6 percent. To add insult to injury, even cash is down in real terms, because the interest rate is well below the inflation rate! (Chart I-1) Chart I-1The 'Everything Sell-Off' In 2022 Last Happened In 1981, When Stagflation Morphed Into Recession Such a star alignment of asset returns, in which stocks, bonds, inflation protected bonds, industrial metals, and gold all sell off together, is unprecedented. In the eighty calendar quarters since the inflation protected bond market data became available in the early 2000s there has never been a quarter with an ‘everything sell-off’. Everything Has Sold Off, But Does That Make Sense? The rarity of an ‘everything sell-off’ is because there are virtually no economic or financial scenarios in which all five asset-classes should fall together (Chart I-2 and Chart I-3). Chart I-2An 'Everything Sell-Off' Is Extremely Rare Chart I-3An 'Everything Sell-Off' Is Extremely Rare A scenario dominated by rising inflation is bad for bonds, but good for inflation protected bonds, especially relative to conventional bonds. Yet inflation protected bonds have not outperformed either in absolute or relative terms. A scenario of rising inflation should also support the value of stocks, industrial metals and certainly gold, given that all three are, to varying degrees, ‘inflation hedges.’ Yet the prices of stocks, industrial metals, and gold have all plummeted. The rarity of an ‘everything sell-off’ is because there are virtually no economic or financial scenarios in which all asset classes should fall together. Conversely, a scenario dominated by slowing growth is bad for industrial metal prices, but good for conventional bond prices – as bond yields decline on diminished expectations for rate hikes. Yet conventional bonds have sold off. What about a scenario dominated by both rising inflation and slowing growth – which is to say, stagflation? In this case, we would expect inflation protected bonds to perform especially well. Meanwhile, with the economy still growing, the prices of industrial metals should not be collapsing, as they have been recently.  In a final scenario of an imminent recession we would expect stocks, industrial metals and even gold to sell off, but conventional bonds to perform especially well. The upshot is there are virtually no economic scenarios in which stocks, bonds, inflation protected bonds, industrial metals, and gold plummet together, as they have recently. So, what’s going on? To answer, we need to take a trip back to the 1980s. 1981 Was The Last Time We Had An ‘Everything Sell-Off’ Inflation protected bonds did not exist before the late 1990s. But considering the other four asset-classes – stocks, bonds, industrial metals, and gold – to find the last time that they all fell together we must travel back to 1981, the time of Margaret Thatcher, Ronald Reagan, and the Paul Volcker Fed. And suddenly, we discover spooky similarities with the current Zeitgeist. Just like today, the world’s central banks were obsessed with ‘breaking the back’ of inflation, which, like a monster in a horror movie, kept appearing to die before coming back with second and third winds (Chart I-4). Chart I-4In 1981, Just As In 2022, Central Banks Would 'Do Whatever It Takes' To Kill Inflation Just like today, the central banks were desperate to repair their badly damaged credibility in managing the economy. As the biography “Volcker: The Triumph of Persistence” puts it: “He restored credibility to the Federal Reserve at a time it had been greatly diminished.” And just like today, central bankers hoped that they could pilot the economy to a ‘soft landing’, though whether they genuinely believed that is another story. Asked at a press conference if higher interest rates would cause a recession, Volcker replied coyly “Well, you get varying opinions about that.” 2022 has spooky similarities with 1981. In fact, in its single-minded aim ‘to do whatever it takes’ to kill inflation, the Volcker Fed hiked the interest rate to near 20 percent, thereby triggering what was then the deepest economic recession since the Depression of the 1930s (Chart I-5 and Chart I-6). With hindsight, it was a price worth paying because the economy then began a quarter century of low inflation, steady growth, and mild recessions – a halcyon period for which the Volcker Fed’s aggressive tightening in the early 1980s have been lauded. Chart I-5In 1981, The Fed Hiked Rates To Near 20 Percent... Chart I-6...And Thereby Morphed Stagflation Into Recession Granted, the problems of 2022 are a much scaled down version of those in 1981, yet there are spooky similarities – a point which will not have gone unnoticed by the current crop of central bankers. It is no secret that Jay Powell is a big fan of Paul Volcker.   The Echoes Of 1981-82 In 2022-23 The answer to why everything sold off in early 1981 is that central banks took their economies from stagflation to outright recession, and the risk is that the same happens again in 2022-23 (Chart I-7). Chart I-7The Echoes Of 1981-82: Aggressive Rate Hikes In 2022-23 Will Morph Stagflation Into Recession In the transition from stagflation fears to recession fears, everything sells off because first the stagflation casualties get hammered, and then the recession plays get hammered. This leaves investors with no place to hide, as no mainstream asset is left unscathed. Just as in 1981, a transition from stagflation fears to recession fears likely explains the recent ‘everything sell-off’ because the sell-off in April was most painful for the stagflation casualties – bonds. Whereas, the sell-off in May has been most painful for the recession casualties – industrial metals and stocks.  In a stagflation that morphs to recession, everything sells off. What happens next? The template of 1981-82 could provide a useful guide. Bond prices bottomed first, in the late summer of 1981, as it became clear that the economy was entering a downturn which would exorcise inflation. Of the three other asset classes – all recession casualties – stocks continued to remain under pressure for the next few months but were higher 12 months later. Gold fell another 30 percent, though rebounded sharply in 1982. But the greatest pain was in the industrial metals, which fell another 30 percent and did not recover their highs for several years (Chart I-8). Chart I-82022-23 Could Be An Echo Of 1981-82 2022-23 could be an echo of 1981-82, with bond prices now entering a bottoming process.  Stocks would bottom next, with one difference being a quicker recovery than in 1981-82 because of their higher sensitivity to bond yields. While the near term outlook is cloudy, we expect stock prices to be higher on a 12 month horizon, especially long-duration stocks that are most sensitive to bond yields. But just as in 1981-82, the biggest casualty of a stagflation that morphs into a recession will be the overvalued industrial metals, which are likely to suffer at least double-digit losses over the coming year. Fractal Trading Watchlist This week’s new additions are Czech Republic versus Poland, and Food and Beverages versus the market, which appear overbought. And US REITS versus Utilities, and CNY/USD, which appear oversold. Finally, our new trade recommendation is to underweight the FTSE 100 versus the Stoxx Europe 600. The resource heavy FTSE 100 is especially vulnerable to our anticipated sell-off in commodities, and its recent outperformance is at a point of fragility that has marked previous turning points (Chart I-9). Set the profit target and symmetrical stop-loss at 5 percent. Chart I-9FTSE 100 Outperformance Is Near Exhaustion Fractal Trading Watchlist: New Additions Chart I-10Czech Outperformance Near Exhaustion Chart I-11Food And Beverage Outperformance Near Exhaustion CHART 1 Chart I-12US REITS Are Oversold Versus Utilities CHART 12 Chart I-13CNY/USD At A Support Level Chart 1The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 2The Strong Trend In The 3 Year T-Bond Is Fragile Chart 3AUD/KRW Is Vulnerable To Reversal Chart 4Canada Versus Japan Is Reversing Chart 5Canada's TSX-60's Outperformance Might Be Over Chart 6US Healthcare Providers Vs. Software At Risk of Reversal Chart 7A Potential Switching Point From Tobacco Into Cannabis Chart 8Biotech Is A Major Buy Chart 9CAD/SEK Reversal Has Started Chart 10Financials Versus Industrials To Reverse Chart 11Norway's Outperformance Could End Chart 12Greece's Brief Outperformance To End Chart 13BRL/NZD At A Resistance Point Chart 14The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 15The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 16Cotton's Outperformance Is Vulnerable To Reversal Chart 17Homebuilders Versus Healthcare Services Has Turned Chart 18Switzerland's Outperformance Vs. Germany Has Started To End Chart 19The Rally In USD/EUR Could End Chart 20The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 21A Potential New Entry Point Into Petcare Chart 22FTSE100 Outperformance Vs. Euro Stoxx 50 Vulnerable To Reversal Chart 23Netherlands Underperformance Vs. Switzerland Close To Exhaustion Chart 24The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 25The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 26Czech Outperformance Near Exhaustion Chart 27Food And Beverage Outperformance Near Exhaustion CHART 1 Chart 28US REITS Are Oversold Versus Utilities CHART 12 Chart 29CNY/USD At A Support Level   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The returns are based on the S&P 500, the 10-year T-bond, the 10-year Treasury Inflation Protected Security (TIPS), the LMEX index, and gold.   Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Executive Summary Increase In Chinese Ag Prices Has Been Much More Muted Than Globally China’s food price inflation accelerated in April. The rising cost of global agricultural goods and domestic COVID-related disruptions in the supply-chain contributed to a sharp bump in food prices last month. China is not overly reliant on food imports. The country is also well stocked with grain reserves and should weather ongoing global food supply shortages, particularly wheat, better than most emerging economies.  However, China will still be impacted by escalating prices of global agricultural products and energy. Some imported goods (e.g. soybeans and related products) that China relies on, coupled with higher energy costs and a bottoming in China’s pork prices, will continue to push up food prices and headline inflation. Higher reading in headline inflation will not change the direction of the PBoC’s monetary policy. However, more expensive food will dampen Chinese households’ spending power on non-food consumer goods, especially as income growth slows. The food and beverage sector in China’s onshore stocks will benefit from higher food costs. We are initiating a new trade: long domestic consumer staples/broad A-share market. CYCLICAL RECOMMENDATIONS (6 - 18 MONTHS) INITIATION DATE RETURN SINCE INCEPTION (%) COMMENT LONG DOMESTIC CONSUMER STAPLES/BROAD A-SHARE MARKET 05/18/2022     Bottom Line: Despite China’s solid self-sufficiency in food supplies, its food price inflation is not immune from the mounting prices of global agricultural products.   Is China’s Food Price Inflation Transitory? The food component of China’s consumer price index (CPI) increased by 0.9% in April compared with the previous month, a sharp reversal from a 1.2% month-over-month decline in March. Higher food and energy prices pushed headline CPI to 2.1% in April, the fastest year-on-year growth since August 2020. China is not overly reliant on food imports and has abundant grain reserves.  The country is in a better position to weather ongoing global supply shortages in grain compared with other emerging economies, such as the Middle East and North Africa. Moreover, agricultural product prices in China have been structurally higher than those traded in the global commodity market. Large margins in China’s bulk agricultural pricing provide a cushion from escalating global food prices. Nonetheless, China remains at risk for higher food prices this year. Elevated oil prices and the war in Ukraine will further lift the price of fertilizers, adding to input costs for agricultural products. A strong USD will add to the price of USD-denominated commodity imports, particularly soybeans. In addition, China’s domestic pork price may have reached its hog cycle bottom and will pick up in the second half of this year. Food Prices Are Driving Up Inflation China’s headline CPI accelerated to 2.1% in April, on a year-on-year basis, from 1.5% in the previous month. Even though pork prices plunged by 33% in April from a year ago, food prices grew by 1.9% and have been boosted by a jump in the cost of fresh food, such as vegetables (+24% year-on-year), fruit (+14%) and eggs (+12%). Prices in other food categories, such as grains and edible oil, also rose, albeit more modestly (Chart 1A and 1B). Chart 1ALarge Jump In Fresh Food Prices In April Chart 1BOther Food Prices Also Picked Up, But More Modestly China’s strict COVID-19 containment measures have had a broad-based impact on food supplies. Mobility restrictions, roadblocks and risk-averse truck drivers introduced significant challenges in food supplies and transportation. Lockdowns in some large urban areas also led to panic buying and stockpiling among consumers, pushing up demand. Chart 2Increase In Chinese Ag Prices Has Been Much More Muted Than Globally Meanwhile, higher global food and energy prices have likely both directly and indirectly contributed to food price inflation in China. The UN Food and Agriculture Organization (FAO) Food Price Index in April this year leapt to its highest level since its inception in 1990; it is 30% higher than last year and nearly double from its trough in mid-2020. Although price increases in China’s domestic agricultural products have been more moderate, the country’s agricultural wholesale prices have jumped by 10% from a year ago (Chart 2). Bottom Line: Food accounts for about 20% of China’s CPI basket (Chart 3).  Climbing food, along with energy, prices are driving up China’s headline inflation. Chart 3Food Accounts For 20% Of Chinese Household Budgets China Is In A Good Position To Weather Global Food Supply Shocks … Chart 4Ex-China Food Inventories Haven’t Been Built China is well stocked with food reserves and does not rely on imports for most of its agricultural supplies. Thus, the country should weather ongoing global shortages in the food supply better than most emerging economies (Chart 4).  China’s food inventories are significantly higher than levels in the 2006-2008 and 2010-2012 global food price hikes (Chart 5). The nation’s inventories have been steadily building up in the past decade to avert potential food supply shortages. Corn and rice stocks are sufficient to cover consumption for nearly three quarters of a year and wheat stocks are at nearly a year’s worth of consumption. Chart 5China Has Been Building Up Inventories To Buffer Against Supply Shortfalls Chart 6China Is Not Overly Dependent On Ag Imports Furthermore, with the exception of soybeans, China is not overly dependent on imports for agricultural supplies (Chart 6). The country is self-sufficient in supplying rice, wheat, and corn, three major staples in China’s grain consumption basket. Less than 5% of China’s total consumption of the three staple grains comes from imports. Bottom Line:  China is well stocked with agriculture products and is not overly dependent on imports for its food supplies. … But Not Immune To Food Price Hikes Worldwide Chart 7Ag Products Are Traded At Higher Prices In China Than In The Global Market Rising global agricultural and energy prices could still push up the country’s food price inflation. In USD terms, prices of China’s domestic agricultural products have been structurally higher than those traded on global commodity markets (Chart 7). The government heavily regulates and subsidizes its agricultural procurement prices as an encouragement to domestic farmers.  When global food supply shocks sharply pushed up agricultural prices worldwide, China’s domestic agricultural prices, with their large buffer versus global food prices, rose more moderately.  Nonetheless, China’s domestic food prices are not insulated from worldwide price hikes. China is facing higher inflation in food prices this year for the following reasons: Pork prices, which account for 13% of China’s CPI food basket, have likely bottomed. Although pork prices remain in a deep contraction year-over-year, they rebounded sharply in April on a month-on-month basis (Chart 8). The number of sows peaked in mid-2021 and has been declining for the past 10 consecutive months. Falling sow numbers have historically led to rising pork prices (Chart 9).   Chart 8Pork Prices May Have Bottomed Chart 9Pork Prices Will Likely Increase In 2H22 Nearly 90% of China’s soybean consumption relies on imports, making the country vulnerable to external price fluctuations. Soybean prices have jumped sharply this year. A stronger USD will also add to the price of USD-denominated commodity imports. About 80% of Chinese soybeans are crushed to produce meal to feed China’s massive pork industry, which means higher soybean prices will indirectly lead to rising pork prices by boosting input costs. Given that pig output is approaching its cyclical bottom, an increase in pig livestock would mean more demand for soybeans.  Chart 10Edible Oil Prices Reached Their Highest In Decades Growing prices in soybeans and corn will lift the cost of cooking oil, which represents about 8% of China’s food CPI basket (Chart 10). Ukraine supplies 30% of China’s corn imports, and Russia and Ukraine together account for nearly 20% of China’s soybean oil imports. China ramped up corn imports from Ukraine through March despite the war and snapped up large volumes of US corn in April after supplies from Ukraine were cut off. Nonetheless, prices of soybeans and corn will likely remain elevated with no end in sight to the Russia-Ukraine war and supply shortages globally. In addition, as global travel becomes more popular and oil prices remain elevated, the demand for corn-based ethanol, which is blended with gasoline, will also expand. Wheat prices will continue to experience upward pressure in the global market, mainly due to reduced production and exports from Ukraine and Russia (these countries account for 30% of world’s wheat exports). The World Bank forecasts that wheat will be 40% more expensive this year, reaching an all-time high in nominal terms.1 Although China is about 96% self-sufficient in wheat, the upsurge in global prices has boosted China’s domestic cost for wheat; it climbed by 15% in May from a year ago (Chart 11). Higher shipping and input costs, especially for fertilizers, will exacerbate the upside price pressures on agricultural goods. China is the world’s largest exporter of phosphate fertilizer, but its domestic fertilizer prices are heavily subsidized and much cheaper than exported ones (Chart 12). However, the domestic cost of fertilizer will likely follow the lead of rising global prices for fertilizers and agricultural products. Chart 11Chinese Wheat Prices Jumped Against The Backdrop Of Global Supply Shortages Chart 12China's Domestic Fertilizer Prices Will Likely Trend Up The relationship between agricultural prices and the dollar broke down early last year (Chart 13). Historically, a strong USD would weigh down agricultural prices by encouraging ex-US producers to raise exports and boost global supplies. However, the COVID pandemic and war in Ukraine have triggered a global surge in government controls on food exports. Such broad enforcement of protectionist measures will continue to exacerbate worldwide inflationary pressures on food. Chart 13The Inverse Relationship Between Global Ag Prices And The Dollar Has Broken Down Bottom Line: China’s food prices face upward pressure. Strengthening global prices in a wide range of agricultural products, coupled with higher energy costs and a bottoming in China’s pork prices, will all contribute to higher food price inflation in the country. Investment Conclusions Chart 14Core CPI Remains Subdued Food price inflation should not constrain the PBoC from further easing monetary policy. As mentioned in previous reports, China’s monetary policy framework has shifted away from headline CPI and has been anchored in core CPI, which has remained subdued  (Chart 14). However, China’s accelerating food and energy prices, as household income growth is slowing, will lower households’ purchasing power and curb their demand for non-food consumer goods and services.  While China’s overall consumption and economy will suffer from higher food price inflation, soaring food prices will help to widen the profit margins among food processing firms (Chart 15).  Furthermore, food and beverage companies in China’s onshore equity market have one of the highest ROAs and the lowest financial leverages (Chart 16). We are initiating a new trade: long Chinese onshore consumer staples/short broad A-share market. Chart 15Long Chinese Onshore Consumer Staples... Chart 16...As The Sector Will Benefit From Rising Food Prices   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1     The World Bank’s Commodity Markets Outlook Report, April 2022.     Strategic Themes Cyclical Recommendations