Emerging Markets

Special Report

Executive Summary Iron Ore & Steel Prices: Facing Downward Pressure Global iron ore and steel supply is likely to grow faster than demand over the next six months. As a result, the prices of both metals will likely fall. Chinese steel output will likely rebound moderately in the absence of government-mandated steel production cutbacks. In the meantime, mainland steel demand will continue to contract because of its crumbling property sector. Global steel output excluding China will contract over the next six months on the back of weakening industrial demand for steel. Even though Chinese iron ore consumption may rise moderately over the next six months, its imports will not improve much because of robust growth in domestic iron ore production. Furthermore, global iron ore demand excluding China will decline as steel demand and output contract. In the intervening six months, global iron ore production growth will rise. This will lead to an oversupplied iron ore market.  Bottom Line: Both iron ore and steel prices will likely deflate over the next several months. Therefore, Chinese steel share prices as well as global mining and steel stocks have more downside.   China’s demand for iron ore and steel are key to their respective price outlooks because these metals account for about 70% of global iron ore imports and over 50% of global steel consumption. Considerable reduction in Chinese steel output (hence, demand for iron ore) and rising domestic iron ore supply have resulted in a contraction in Chinese iron ore imports since last June. In the meantime, domestic steel demand weakened sharply, primarily because of plunging property construction. The upshot has been lower domestic steel prices (Chart 1). This report evaluates the direction of iron ore and steel prices over the next six months. Chart 1Crumbling Property Sector: Lower Steel Demand Ahead Chart 2Iron Ore & Steel Prices: Facing Downward Pressure We expect Chinese steel output to rise in the absence of government-mandated production cuts and on positive profit margins. This will lift Chinese iron ore imports. In the meantime, Chinese steel demand will likely continue to contract. Thus, steel prices will continue falling over the next several months (Chart 2, top panel). For iron ore, an increase in Chinese imports will not be enough to offset contracting global demand. As a result, the price of iron ore will face downward pressure over the coming months (Chart 2, bottom panel). From The Chinese Steel Market… The Chinese steel market may experience an increasing oversupply over the next six months. Chinese Steel Supply Chinese steel production is likely to rise moderately in the next six months.  First, there are no government-mandated cuts in steel production currently in place. Chart 3Mandated Steel Output Cuts In 2021: Unlikely Repeat In 2022H2 Last June, Chinese authorities ordered steel mills to cut output from record levels in a bid to restrain carbon emissions. This resulted in a 15% year-on-year drop in Chinese crude steel1 output and a 10% year-on-year decline in Chinese steel products production during 2021H2 (Chart 3). In 2022Q1, to ensure smog-free skies in February as China hosted the 2022 Winter Olympic Games, some steel producers were again ordered to cut their production. As a result, the year-on-year decline of Chinese steel output and steel product output for 2022Q1 were at 10% and 5%, respectively. In 2022Q2, however, the picture is more of a mixed bad. While many small firms increased volumes, medium and large sized steel producers voluntarily chose to reduce their output. As a result, China’s steel output is remains in contraction. Further, tightness in electricity supply over the summer curbed any potential recovery in steel output. Over the next six months, we expect decreasing voluntary cuts and easing electricity supply will lift steel output moderately. Chart 4Steelmakers' Profit Margins: Low, Albeit Still Positive Second, overall profit margins for Chinese steel producers are still positive, albeit at a low level (Chart 4). Even at a very low profit margin, steel producers in China still tend to produce steel as much as they can to cover their very large fixed costs. In other words, if they do not produce, they will experience greater losses.  In addition, given deteriorating employment conditions in the broader economy, maintaining employment has become a major focus of local governments. The latter will guide state-owned enterprises (SOEs) – many steel mills are SOEs or government-affiliated – to raise output and employment. For now, the government has simply asked steel producers to cut their production voluntarily, rather than mandating cuts as authorities did last year and earlier this year. In brief, in the absence of government-mandated steel output reduction, some producers will opt to increase their output to cover their fixed costs and maintain/increase employment. Will the Chinese government demand mandated cuts again later this year? We believe the odds are low. Last year, the mandated cuts were the result of more aggressive emissions reduction targets, with a deadline at the end of 2025 for the Chinese steel sector. In February of this year, the authorities extended this deadline to 2030 to grant its steel sector the ability to reach peak emissions. This will allow a gradual output reduction instead of a sharp reduction in mills with high-emission steel-producing capacity. With such a deadline extension already in place, the government is unlikely to implement mandated steel output cuts again. Chinese Steel Demand Chinese steel consumption will likely continue to contract over the next six months. Chart 5 shows that 58% of Chinese steel consumption is from building and construction, which mainly comprises the property sector and the infrastructure sector. Based on our estimate, Chinese steel demand will decline about 3.8% over the next six months, mainly dragged down by the shattered property market (Table 1). Chart 5Chinese Steel Consumption Composition Table 1Chinese Steel Demand Growth Estimates Chart 6Property Market is in a Crisis The property sector is the largest steel consumer, accounting for about 35% of Chinese steel consumption. This sector is going through a crisis, and there are no signs of improvement yet. Property sales, new construction, and completion are all in a deep and unprecedented contraction (Chart 6, panels 1, 2, and 3). Even the commodity building floor space under construction entered contraction for the first time in at least the past two decades (Chart 6, bottom panel). Both central and local governments have implemented policies to revive the property sector since late last year. Following a wave of mortgage boycotts, the July 28 Central Politburo meeting demanded local governments to ensure those sold-but-unfinished housing projects to be completed. However, due to the extreme shortage of funding faced by real estate developers and the fragmented nature of this industry in China, it will take time to get the current property sector crisis resolved. Nonetheless, we expect supportive policies will work to some extent. We expect the year-on-year contraction in property construction to narrow to 10% over the next six months from about 13% in the past six months. Chart 7Infrastructure Sector: The Main Supportive Force for Chinese Steel Demand The infrastructure sector is another major source for Chinese steel demand (Chart 7). The sector contributes about 23% of Chinese steel consumption. Although the traditional infrastructure investment shows a solid 10% growth, we only assume 7% of growth in the sector’s steel demand. This is because, within the traditional infrastructure sector, two heavy steel consuming subsectors –railway and highway constructions – will register slower growth in their respective investments than overall infrastructure. Chart 8Steel Demand In the Machinery Sector: Likely to Remain In Contraction The 2016-2019 Boom: Only Sales Excavators And Cranes Hit A New High... Machinery production, the third largest steel consuming sector, will remain in contraction because of the depressed property market. Sales of major construction equipment – excavators, loaders, and cranes – have declined 36%, 23%, and 50% year-on-year in 2022H1 (Chart 8). With continuing weakness in the property market, we expect steel demand from machinery producers to be in a similar contraction (10%) over the next six months. Autos and electric appliances together account for about 7.3% of Chinese steel consumption. Weekly data shows Chinese auto sales are in a recovery phase (Chart 9). We expect the sector’s steel use to increase by 8% year-on-year over the next six months based on our projections from our research on the auto industry. Affected by the faltering domestic property market, the outlook for electric appliances is also dismal. The output of air conditioners, freezers, refrigerators, and washing machines is contracting (Chart 10). The expected contraction in global demand for consumer goods will ensure a continuous drop in their production in China, the largest world producer of white goods. We expect these sectors' steel consumption growth to improve from a 9% contraction in 2022H1 to a 5% contraction over the next six months. Chart 9Steel Demand From Auto Sales is Recovering Chart 10Steel Demand by Electric Appliances: Smaller Contraction Ahead Chart 11Steel Demand in Other Sectors: Will Likely Stay in Contraction Other sectors that consume steel include many industrial goods, such as civil steel ships and containers. The shipping industry has boomed during the past two years because of a global increase in goods demand. This also significantly increased demand for metal containers, and to a lesser extent, civil steel ships between 2020 and 2021 (Chart 11). As global trade volumes contract over the next six months, we expect steel consumption in these other sectors to contract by 3% over the same period. What about external demand for Chinese steel? Chinese steel products exports, which account for about 5% of the country’s steel products output, will grow moderately in the next six months. Historically, the Chinese government had provided a VAT rebate of around 13% to encourage steel exports. Last year, it removed such export tax rebates on various steel products in a bid to slow domestic carbon emissions. Chart 12Chinese Steel Exports: Moderate Growth Ahead However, this has not considerably reduced Chinese steel exports. Chinese exports of steel products only had a year-on-year contraction from January to April 2022, largely because of COVID-related shutdowns, and then experienced considerable growth during May-July of the same year (Chart 12). At the same time, Chinese imports of steel products have been contracting since last May. This pattern shows the strong global competitiveness of Chinese steel products. We expect moderate growth in Chinese steel products exports over the next six months, which will be much lower than last year’s growth. In 2021, Chinese steel products exports surged by 25% year-on-year, as steel exporters rushed to export their products to take advantage of the rebates before its removal. Bottom Line: Chinese steel supply is likely to exceed demand over the next six months. This will result in an oversupplied steel market in China, exerting downward pressure on steel prices. …To The Global Iron Ore Market Chart 13Chinese Steel Production: Largely Determines the Country's Iron Ore Imports Iron ore is mainly used in the steel-making process. Limited iron ore supplies within China mean that about 80% of the country’s iron ore demand are satisfied by imports. As a result, variations in Chinese steel production largely determine swings in Chinese iron ore imports (Chart 13). Based on our expectations of the Chinese steel market, we can provide our supply-demand analysis for the global iron ore market. Global Iron Ore Demand While rebounding Chinese steel output will lift the nation’s iron ore consumption, iron ore demand from the rest of the world will shrink materially. Net-net, global iron ore demand will weaken, albeit only marginally over the next six months. Steel production is declining in the world outside China. We expect such contraction will continue into early 2023, as the pandemic-triggered overspending on goods ex-autos reverses (Chart 14). In addition, in Europe, energy rationing and sky-high energy prices will likely lead to defunct mills as a response to reducing their output; hence, their iron ore consumption will tank. Given that Europe accounts for about 10% of world steel production and nearly 50% of its steel production is using electric furnaces,2 this will reduce global iron ore demand. Last year, global steel production excluding China increased by 13% year-on-year, the highest growth since 2011 (Chart 15). This is much higher than the average 2% growth during 2017-2019, reflecting the overconsumption of goods by advanced economies in 2021. Indeed, steel production has already declined for four consecutive months. We expect a year-on-year contraction of about 5% global steel production in the world excluding China over the next six months. Chart 14The World Outside China: Steel Output Will Continue Declining Chart 15Falling DM PMI Signals Weaker Steel Output in the World Outside China Scrap steel is one substitute for iron ore in the steel-making process, but, this time, there will be limited replacement from scrap steel in China. Tight supply of scrap steel and relatively high scrap steel prices will make iron ore more appealing than scrap steel as feedstock for Chinese steel producers over the next several months. Scrap prices are currently high relative to both steel product prices and imported iron ore prices (Chart 16). Chart 16Iron Ore Substitute in China: Limited Scrap Steel Demand in 2022H2 Chart 17China: Domestic Iron Ore Output is Rising Global Iron Ore Supply Global iron ore supply will rise slightly over the next six months. Chinese iron ore output is set to continue increasing as well (Chart 17, top panel). The authorities plan to boost domestic iron ore output by 6.5% per year until 2025. Profit margins for Chinese producers are currently at a multi-year high (Chart 17, bottom panel). This will encourage domestic iron ore production over the next six months.  Currencies in global major iron ore producing countries (Brazil, Australia and South Africa) have depreciated considerably. As a result, iron ore prices in these countries in local currency terms are currently still elevated. This will incentivize more iron ore production and exports by producers in these countries. Bottom Line: Global iron ore supply will increase slightly, while demand will contract slightly over the next six months. This will be negative for iron ore prices. Investment Implications Chart 18Global Mining Stocks and Steelmaker Stock Prices: More Downside Ahead Avoid Global Steel And Mining Stocks For Now Both iron ore and steel prices will likely deflate over the next six months. Hence, global mining stocks and steelmakers stock prices will experience more downside in the coming months (Chart 18). Global ex-China steel producers have benefited from strong steel demand in DM and from surging steel prices (Chart 15 above). As we expect that DM demand for consumer goods will contract over the next six months, steel prices will drop, weighing on global steelmakers’ share prices.  Concerning equity valuations, global mining and steel stocks trade at very low trailing P/E ratios. However, for highly cyclical stocks, such a low trailing P/E ratio is often a sign of peak profits. At peaks of cycles, share prices drop first, while EPS remains elevated, as it is a backward-looking variable. In fact, more often than not, buying these stocks when the P/E ratio is very high and selling them when the P/E ratio is very low has been a very profitable strategy. In short, a low P/E ratio for mining share prices and steel producers is not a reason to be long these stocks. The direction of both the global industrial cycle and steel and iron ore prices is what matters. On both counts, the outlook remains downbeat for now.   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com     Footnotes 1     According to the World Steel Association, crude steel is defined as steel in its first solid (or usable) form, including ingots, semi-finished products (billets, blooms, slabs), and liquid steel for castings. 2     The electric furnace is using electricity and scrap steel to produce crude steel. As Europe is facing energy constraint, this will likely affect European steel output greatly. Strategic Themes Cyclical Recommendations

Executive Summary China Copper Consumption Failed To Revive Post-Pandemic A greater-than-expected contraction in manufacturing and construction in China – evidenced by the latest PMI and home sales data – will keep pressure on copper prices. Higher inflation will continue to drive the cost of labor, fuels and materials higher. Lower copper prices and higher input costs will weaken margins, leading to reduced capex. This also will put pressure on the rate of spending on projects already sanctioned. Payouts to shareholders – buybacks and dividends – will fall, reducing the appeal of miners’ equities. Debt-service costs will rise as interest rates are pushed higher by central banks. Civil unrest in critically important metals-producing provinces is forcing some miners to suspend production guidance. This will be exacerbated in Chile by changing tax regimes, which likely will reduce capex as well. Bottom Line: As global demand for copper increases with the renewable-energy transition and higher arms spending in Europe, miners’ ability to expand supply is being seriously challenged. Falling prices and rising costs – along with higher tax burdens and civil unrest in key mining provinces – are forcing copper miners to lower production and capex guidance, which will redound to the detriment of supply growth. With demand expected to double by 2030-35, copper prices will have to move higher to keep capex flowing to support supply growth. We remain long the XME ETF as the best way to express our bullish, decade-long view. Feature Just as the world is scrambling to develop additional energy supplies in the wake of Russia’s invasion of Ukraine, copper supplies – the critical element of the renewable-energy buildout – are being squeezed by an unusual convergence of fundamental, financial and social factors. Chart 1China Copper Consumption Failed To Revive Post-Pandemic Firstly, copper demand is weak, which, all else equal, is suppressing prices. This is largely down to China’s zero-tolerance COVID-19 policy, and uncertainty over whether the EU will be pushed into a massive recession, following the cutoff of its natural gas supplies from Russia. These are two of the three major pillars of the global economy, and their economies are entwined via trade in goods. China’s COVID-19 policy is hammering its critically important property market – sales were down almost 40% y/y in July – and forcing a contraction in manufacturing. Construction represents ~ 30% of total copper demand in China. Manufacturing is contracting, based on China’s official July PMI report, which showed the index fell below 50 to 49.0 for July.1 Related Report  Commodity & Energy StrategyOne Hot Mess: EU Energy Policy China accounts for more than half of global copper demand, and, because of its zero-tolerance COVID-19 policy, was the only major economy to register a year-on-year contractions in copper demand throughout the pandemic up to the present (Chart 1). The EU accounts for ~ 12.5% of global copper demand, which we expect will continue to be supported by the bloc’s renewable-energy and defense buildouts.2 We noted in earlier research the odds of the EU going into recession remain high as the bloc scrambles to prepare for winter, in the wake of its attempts to replace its dependence on Russian natural gas supplies.3 We continue to expect the EU will avoid a major recession, and that it will be able to navigate this transition, leaving it on a better energy footing in subsequent years.4 Lower Copper Prices Will Hurt Capex Chart 2Copper Price Rally Fades After bottoming in March 2020 at $2.12/lb on the COMEX, copper prices staged a 125% rally that ended in March of this year. This was due to the post-pandemic reopening of most economies ex-China, which was accompanied by massive fiscal and monetary stimulus that super-charged consumer demand. Copper prices have since fallen ~33% from their March highs on the back of a substantial weakening of demand resulting from China’s zero-tolerance COVID policy and a concerted global effort to rein in the inflation caused by governments’ largess (Chart 2). Most year-end 2021 capex expectations for 2022 and into the future among copper miners were drawn up prior to the price collapse in June. After that, fear of central-bank policy mistakes – chiefly over-tightening of monetary policy that pushes the global economy into recession – and weak EM demand took prices from ~ $4.55/lb down to less than $3.20/lb by mid-July. A strong USD also pushed demand lower during this time. Chart 3DRC Offsets Chile, Peru Weakness Following the copper-price rout, miners are re-thinking production goals, dividend policy and capex. Social and governance issues also are contributing to weaker copper output. Rio Tinto, for example, notified markets it would shave $500mm from its $8 billion 2022 capex budget. For 1H22, Rio cut its dividend to $2.67/share from $5.61/share in 1H21. Elsewhere, Glencore said copper output from its Katanga mine in the DRC now is expected to come in 15% lower this year, at 1.06mm MT, owing to geological difficulties. Separately, output guidance for Chinese miner MMG Ltd’s Las Bambas mine in Peru has been suspended, following a 60% drop in production. The company expected it would be producing up to 320k tons this year. Civil unrest at Las Bambas has been ongoing since production started in 2016, according to Reuters. Big producers like Chile and Peru – accounting for ~ 35% of global ore production – along with the DRC face multiple challenges. Chile accounts for ~ 25% of global copper ore production. Its output fell ~ 6% in 2Q22 vs year-earlier output due to falling ore quality, water-supply constraints, and rising input costs (Chart 3). Chile’s government expects copper ore output to decline 3.4% y/y in 2022, with many of the country’s premier mines faltering (Chart 4). Chart 4Chile Expecting Lower Copper Output Chile also is proposing to increase taxes and royalties, to raise money for its budget. However, this may have the effect of driving away investment in the country’s copper mining industry. Fitch notes, “Increased costs will decrease mining cash flows and discourage new mining investments in Chile, favoring the migration of investors to other copper mining districts.”5 BHP Billiton, on que, said it will reconsider further investment in Chile, if the new legislation is approved. Renewables Buildout Will Widen Copper Deficit Markets appear to be trading without regard for the huge increase in copper supply that will be required for the global renewable-energy transition, to say nothing of the upcoming re-arming of the EU and continued military spending by the US and China. In our modeling of supply-demand balances, we move beyond our usual real GDP-based estimates of demand, which estimates the cyclical copper demand, and include assumptions for the demand the green-energy transition will contribute. Hence, this additional copper demand for green energy needs to be added to the copper demand forecast generated by the model. Using projections for global supply taken from the Resource and Energy Quarterly published by the Australian Government’s Department of Industry, Science and Resources, we estimate there will be a physical refined copper deficit of 224k tons in 2022 and 135K tons next year (Chart 5). Among other things, we are assuming refined copper demand will double by 2030 and reach 50mm tons/yr by then. This is a somewhat more aggressive assumption than S&P Global’s estimate of demand doubling by 2035. If we assume refined copper production is 2% lower than the REQ’s estimate, we expect the physical deficit in the refined copper market rise to a ~ 532k-ton deficit in 2022 and ~ 677k-ton deficit in 2023. These results including renewables demand highlight the need to not only account for cyclical demand but also the new demand that will be apparent as the EU, the US and China kick their renewables investments into high gear. Importantly, this kick-off is occurring with global commodity-exchange inventories still more than ~ 35% below year-ago levels (Chart 6). Chart 5Coppers Deficit Will Narrow On Lower Demand​​​​​​ Chart 6Exchange Inventories Remain Exceptionally Low​​​​​​ Investment Implications Copper prices will have to move higher to keep capex flowing to support supply growth normal cyclical demand and renewable-energy demand will require over coming decades. Falling prices and rising costs – along with higher tax burdens and civil unrest in key mining provinces – are forcing copper miners to lower production and capex guidance, which will redound to the detriment of supply growth. This situation cannot persist unless governments call off their renewable-energy transition, and, in the case of the EU, their efforts to re-arm Europe’s militaries following the invasion of Ukraine by Russia. We remain bullish base metals, particularly copper. We remain long the XME ETF as the best way to express this decade-long view. Commodities Round-Up Energy: Bullish OPEC 2.0 agreed a token increase in oil production Wednesday of 100k b/d, partly as a sop to the US following President Biden’s visit to the Kingdom last month. KSA will be producing close to 11mm b/d in 2H22. We have argued this is about all KSA will be willing to put on the market, in order to maintain some spare capacity in the event of another exogenous shock. OPEC 2.0 spare capacity likely falls close to 1.5mm b/d in 2023 vs. an average of 3mm b/d this year, which will limit the capacity of core OPEC 2.0 – KSA and the UAE – to backstop unforeseen production losses. Separately, the US EIA reported total US stocks of crude oil and refined products rose 3.5mm barrels (ex SPR inventory). Demand for refined products in the US was down 28mm barrels in the week ended 29 July, or 4mm b/d. We continue to expect prices to average $110/bbl this year and $117/bbl next year (Chart 7). Base Metals: Bullish China flipped from a net importer of refined zinc in 2021 to a net exporter for the first half of 2022, despite a high export tax on the metal. This is indicative of the premium Western zinc prices are commanding over the domestic price. Chinese zinc demand has fallen, following reduced manufacturing activity and an ailing property sector. Thursday’s Politburo meeting did little to encourage markets of a Chinese rebound later this year. A subdued Chinese recovery, along with European zinc smelters operating at reduced capacity, if at all, could see this reversal in trade flow perpetuate for the rest of the year. Precious Metals: Bullish As BCA’s Geopolitical Strategy highlighted, US House Speaker Nancy Pelosi’s visit to Taiwan will increase tensions between the US and China but will not lead to war. For now. Increased uncertainty normally is good for gold and its rival, the USD. While geopolitical uncertainty from Russia’s invasion of Ukraine initially buoyed the yellow metal, gold has since dropped below the USD 1800/oz level. The greenback was the main beneficiary from the war (Chart 8). It is yet to be seen how this round of geopolitical risk will impact gold and USD, with the backdrop of increasing odds of a US recession and a hawkish Fed. Chart 7 Chart 8   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   Footnotes 1      Please see China’s factory activity contracts unexpectedly in July as Covid flares up published by cnbc.com on July 31, 2022. The PMI summary noted contractions in oil, coal and metals smelting industries led the index’s decline. 2     Please see One Hot Mess: EU Energy Policy, which we published on May 26, 2022, for additional discussion. 3     Please see Copper Prices Decouple From Fundamentals, which we published on July 7, 2022. It is available at ces.bcaresearch.com. 4     Please see Energy Security Rolls Over EU's ESG Agenda published on July 28, 2022. It is available at ces.bcaresearch.com. 5     Please see Proposed Tax Reform Weakens Cost Positions for Chilean Miners (fitchratings.com), published by Fitch Ratings on July 7, 2022.   Investment Views and Themes Strategic Recommendations Trades Closed in 2022

Executive Summary The US economy is experiencing a period of stagflation: booming nominal economic growth amid a lack of volume expansion. Very strong nominal growth (due to high inflation), a tight labor market, and more evidence of a wage-price spiral will cause the Fed to err on the side of hawkishness. Global trade volumes will contract and commodity prices will drop further. The former is bearish for Emerging Asian financial markets and the latter is negative for Latin American markets. Equities are currently rallying from very oversold levels and the rebound could continue in the coming weeks. However, if we are correct about our outlook on US inflation, Fed policy and global trade, then risk assets will resume their decline and the US dollar will rally. Strong Nominal, Weak Real Growth = Stagflation Bottom Line: Stay defensive and continue underweighting EM in global equity and credit portfolios. The greenback will resume its uptrend sooner rather than later. This will depress EM share prices and fixed-income markets.     Financial markets interpreted Fed chairman Powell’s comments in last Wednesday’s (July 27) FOMC press conference as a dovish pivot, catalyzing a sharp rebound in the S&P500. Is the bear market over? Should investors buy risk assets, including EM ones? Chart 1No Strong Rebound In EM Share Prices We are hesitant to declare an end to the bear market and to recommend higher exposure to EM risk assets and currencies. In fact, the rebound in EM stocks has been feeble (Chart 1, top panel). As a result, the relative performance of EM equities versus their DM peers has fallen back to its lows of earlier this year (Chart 1, bottom panel). Overall, we reiterate what we wrote two weeks ago “…our macro themes of Fed tightening amid slowing global growth, the US dollar overshooting, and China’s disappointing recovery remain intact. These factors still warrant a defensive investment strategy, despite a possible near-term rebound in the S&P 500. EMs will lag and underperform in this rebound.” Can The Fed Afford To Pivot? With entrenched and persistent inflation in the US running well above the Fed’s target, the Fed cannot afford to – and will not – pivot for now. A simple rollover in inflation that reflects falling commodity and goods prices will not be sufficient for the Fed to make a policy U-turn and cut rates by 50 basis points next year (as fixed-income markets expect). We have been arguing that the US is already experiencing broad-based genuine inflation and has developed a wage-price spiral. Chart 2US Wage Growth Is At Its Fastest Rate In 40 years US wage growth has surged to a 40-year high of 5.7% (Chart 2). Even though the labor market is set to soften on the margin, its tightness will keep wage growth elevated. Importantly, real wages have fallen significantly, and employees will be demanding higher wages to offset lost purchasing power. US companies have been raising their prices at the fastest rate in decades. Prices charged by non-farm businesses rose at an annual rate of 8-9% in Q2, the highest in the past 40 years (Chart 3). Chart 3US Companies Are Raising Their Prices At Their Fastest Rate In 40 years Chart 4Strong Nominal, Weak Real Growth = Stagflation Even though volumes have stagnated, corporate profits have been holding up because companies have been able to raise prices. Final sales to domestic purchasers in real terms registered zero growth in Q2 from Q1(Chart 4). This entails that the US economy is currency experiencing stagflation. Given that companies are able to raise prices (generating strong nominal sales) and are facing very tight labor market conditions, they might be willing to raise wages further. In brief, a wage-price spiral is unfolding in the US. US core inflation is running well above the Fed’s 2% target. The average of seven core PCE and CPI measures – our “super core” gauge of consumer price inflation − stands at 5.5% (Chart 5). Although falling commodity and goods prices (Chart 6) could cap the upside in core inflation, they are unlikely to bring it down below 4%. Hence, core inflation will remain well above the Fed’s target of 2%. This will lead the Fed to keep tightening monetary policy. Chart 5US Super Core Inflation Is At 5.5% and Rising Chart 6US Import Prices From Asia Will Fall Finally, in our opinion, financial markets are underappreciating how entrenched and persistent US inflation has become and are overlooking the unfolding wage-price spiral. The latest easing in US financial conditions will cause the Fed to refocus on inflation rather than growth. That is why we maintain our theme that the Fed and US equity markets remain on a collision course.  We are open to the idea that the Fed could ultimately pivot earlier than required and eventually cut rates. However, odds are that the Fed has not yet pivoted and will ramp up its hawkishness in the coming months. The bar for the Fed to turn dovish is currently much higher than at any other time in the past 35 years, as inflation is much more entrenched and higher today. In our view, Powell would not like to be remembered as the chairman under whose watch inflation became enduring. He would prefer to be remembered as Paul Volcker, and not as Arthur Burns. Under the latter’s watch in the 1970s, the US experienced a devastating era of high and persistent inflation. Global equities, credit markets and US Treasurys were very oversold a few weeks ago. That is why even a minor hint from the Fed of a possible end to the hiking cycle produced such a strong rebound in stocks and fixed-income markets. This rally could persist in the coming weeks. However, if we are correct about the outlook on US inflation, Fed policy and global trade (see the section below), then risk assets will resume their decline and the US dollar will rally. Bottom Line: The US economy is experiencing a period of stagflation: booming nominal economic growth amid a lack of volume expansion. Very strong nominal growth (due to high inflation) a tight labor market, and more evidence of a wage-price spiral will cause the Fed to err on the side of hawkishness. As a result, the current rally in risk assets is unsustainable. Global Manufacturing / Trade Contraction Global manufacturing and trade are entering a period of contraction: According to manufacturing PMI data for July, Taiwanese new export orders for overall manufacturing and the semiconductor industry have plunged to 37 and 34, respectively (Chart 7). Meanwhile, their customer inventories have surged to a 10-year high (Chart 8). Taiwan is a major supplier of semiconductors and other inputs to many industries around the world. Hence, these data suggest that industrial companies globally have stopped ordering chips and other inputs. This development is a sign of broad-based industrial weakness. Therefore, we believe that global trade volumes are set to shrink in H2 this year. Chart 7Taiwan: Overall And Semiconductor New Orders Have Plunged... Chart 8...And Customer Inventories Have Surged A similar situation is unfolding in the Korean semiconductor sector. The DRAM DXI index (revenue proxy) is falling, and DRAM and NAND spot prices are deflating (Chart 9). Notably, Korea’s overall export sector is also reeling. Business confidence among Korean exporters is plunging – this includes the latest datapoint from August (Chart 10, top panel). The nation’s export volume growth is already close to zero and export value growth is only holding up because of higher prices (Chart 10, bottom panel). Chart 9Korea: Semiconductor Prices Are Deflating Chart 10Downside Risks For Korean Exports Chart 11US Goods Imports Are Set To Contract US import volumes are set to shrink in the coming months. This will deepen the global trade slump. Chart 11 illustrates that US consumption of goods-ex autos has been contracting and retail inventory of goods ex-autos has skyrocketed. Together, these developments foreshadow a major contraction in US imports and global trade volumes. Commodity prices are heading south. Chinese commodity consumption will remain in the doldrums, and US/EU demand for commodities will weaken as global manufacturing contracts.  The sanctions imposed on Russia initially led buyers to increase their precautionary and speculative purchases of various commodities, creating a tailwind for prices earlier this year. However, these precautionary and speculative purchases have since been halted or reversed, causing commodity prices to plunge. We made the case for falling oil prices in our July 21 report, and BCA’s China Investment Strategy’s Special Report on copper from July 27 concludes that  copper prices will decline further. Chart 12China: Has The Post-Reopening Bounce Ran Its Course? Finally, the Chinese manufacturing PMI rolled over in July following the rebound in May and June. New orders, backlog orders and import subcomponents have relapsed anew (Chart 12). The Chinese economy is facing considerable headwinds from the property market, rolling lockdowns resulting from the dynamic zero-COVID policy and a contraction in exports. As we argued in our July 13 report, policy stimulus has so far been insufficient. Bottom Line: Global trade volumes will contract and commodity prices will drop further. The former is bearish for Emerging Asian financial markets and the latter is negative for Latin American markets. Investment Strategy Although the rebound in global risk assets could persist for several weeks, their risk-reward profile is not attractive. Stay defensive and continue underweighting EM in global equity and credit portfolios. The Fed’s hawkish bias as well as contracting global trade are bullish for the US dollar. As a result, the greenback will resume its uptrend sooner rather than later. This will cap the upside in EM stocks and fixed-income markets. We continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN, PHP, and IDR. In addition, we recommend shorting HUF vs. CZK, KRW vs. JPY, and BRL vs. MXN. Although we find good value in many EM local yields, we do not yet recommend buying them aggressively. The basis is our view on EM currencies versus the US dollar. For now, we prefer to bet on flattening yield curves. Our current favorite markets for flatteners are Mexico and Colombia. 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)

Special Report

Executive Summary Non-Commodity Enterprises: No Profit Expansion For 12 Years The past decade has seen a deterioration in the financial performance metrics of industrial Chinese companies. Declining efficiency of investments, rising labor compensation and slowing productivity growth will constitute formidable headwinds to the long-term profitability of China’s industrial sector. Potential deleveraging by local governments, companies and households will cap revenue growth for enterprises and, hence, weigh on their profitability. High commodity prices in the past 18 months have improved profitability and financial metrics for commodity producers. These strengths will reverse as commodity prices sink in the coming months. Corporate earnings are set to disappoint in 2H. Bottom Line: We maintain a neutral stance on Chinese onshore stocks and an underweight stance on investable stocks in a global equity portfolio. In absolute terms, risks to Chinese shares prices are to the downside. ​​​​Among Chinese industrial companies, underweight commodity producers and overweight food & beverage, autos and utilities.   The data for this report for industrial enterprises, which are sourced from China’s National Bureau of Statistics (NBS), encompass state-owned and holding enterprises (SOEs) and other forms of ownership, including private ones. It covers both listed and non-listed companies. The sectors included are construction materials, steel, non-ferrous metals, energy, coal, machinery, auto, tech hardware, food & beverage and utilities. An analysis based on this dataset shows that China’s corporate profitability and efficiency ratios have experienced a prolonged structural downturn since the early 2010s (Chart 1 and 2). Chart 1Chinese Industrial Companies: Structural Deterioration in Productivity... Chart 2… And Operational Efficiency Chart 3Cyclical Improvements Within Structural Downtrend In the past 10 years, these measures improved only modestly during recovery periods and stumbled during downturns (Chart 3). The structural deterioration in corporate profitability from 2011 onward has followed structural improvements from the late 1990s to 2010. Beyond cyclical upswings, China's corporate profitability will likely continue to face structural headwinds. Declining efficiency of investments, rising labor compensation and slowing productivity growth will constitute formidable headwinds to the long run profitability of China’s industrial sector. Furthermore, potential deleveraging by local governments, companies and households will curtail revenue growth for enterprises and, hence, weigh on profitability. Investigating The Financial Performance Of Industrial Enterprises Our analysis of corporates’ financial ratios shows the following: Corporate leverage: The total liabilities (debt)-to-sales ratio rose sharply from 2011 until 2021. However, the leverage ratio has declined in the past 18 months. A close examination suggests that the descent in the debt-to-sales ratio has been due to surging revenues of resource producing companies propelled by rising commodity prices. Chart 4 illustrates that the debt-to-sales ratio has dropped substantially for commodity producers, but much less so for other industrial companies. In the case of non-commodity industrial enterprises, the leverage ratio has not declined much because nominal sales have been lackluster. As resource prices continue to drop, revenues of commodity companies will be devastated, and their debt-to-sales ratios will spike. The thesis that corporate leverage has not yet dropped in China is corroborated by data on all companies. The country’s corporate leverage remains the highest worldwide (Chart 5). Chart 4The Decline In Debt-To-Sales Ratio For Commodity Producers Was Largely Due to Surging Commodity Prices Chart 5China's Corporate Leverage Remains The Highest In the World Chart 6Corporates' Debt servicing Ability Has Been propelled by falling interest rates Debt servicing: Even though debt levels of industrial companies remain elevated, their interest coverage ratios – operating profits-to-interest expense – have improved since late 2020. For all industries, interest expenses have dropped substantially because of falling interest rates (Chart 6). On the margin, this has also helped industrials’ profit margins.   Efficiency: Asset turnover (sales/assets), inventory turnover (sales/inventory) and receivables turnover (sales/receivables), have all have sunk in the past 10 years, as shown in Chart 2. Lower turnover indicates falling efficiency. Coal, steel and non-ferrous metals have been the only sectors experiencing an improvement in inventory turnover due to China’s capacity reduction campaign. Meanwhile, there has been no improvement in inventory turnover for non-commodity enterprises.   Profit margins: Net profit margins for industrial corporates have recently risen slightly. However, the entire improvement in industrial profit margins is attributable to commodity producers. With the exception of commodity producing sectors, there has not been any upturn in operating profit margins and/or net profit margins (Chart 7). Rising corporate income taxes from 2011 to 2020 were one of the reasons worsening profitability (Chart 8). Chart 7Improvement In Industrial Profit Margins Is Attributable To Commodity Producers Chart 8Rising Corporate Income Taxes Have Contributed The Divergency Between GPM And Net Profit Margin Profitability: The return on assets (RoA) and the return on equity (RoE) for industrial corporates have dwindled during the past decade (Chart 1 above). The spike in commodity prices in the past two years has helped profitability of commodity producers, but this is about to reverse. A DuPont analysis1 illustrates that the downturn in corporate profitability was driven by poor operating efficiency and a lack of improvement in net profit margins. Chart 9 shows that the profitability of non-commodity producers has worsened dramatically during the past 10 years. After more than a decade-long structural downturn, the RoA and RoE for commodity producers have recently strengthened along with asset turnovers and net profit margins (Chart 10). However, the commodity bonanza is over for now and profitability measures of resource companies are set to worsen significantly.2 Chart 9A DuPont Analysis: Non-Commodity Enterprises Chart 10A DuPont Analysis: Commodity Enterprises Bottom Line: The past decade has seen a deterioration in the financial performance metrics of industrial companies. The profitability of corporates has undergone a structural decline along with a prolonged slump in operating efficiency.  High commodity prices in the past 18 months have ameliorated profitability and efficiency parameters for commodity producers. Nevertheless, these improvements will vanish as commodity prices fall materially in the coming months. Structural Headwinds To Corporate Profitability The following factors will weigh on China’s corporate profitability in the long term: 1. Demographics and rising labor costs: A shrinking workforce since mid-2010s has led to higher wages that have weighed on the corporate sector’s profitability (Chart 11). This dynamic is also confirmed by rising labor compensation as a share of non-financial corporates’ value added, as illustrated in Chart 12. Chart 11China: Shrinking Labor Force Chart 12Labor Compensation As A Share Of Corporate Revenues In China, blue-collar labor shortages and upward pressures on wages will likely intensify in the coming decade. A rapid decline in the population’s natural growth rate with the third lowest fertility rate in the world (below Japan) foreshadows a decline in China’s working age population which started in 2015.  2. Common prosperity policies: The share of labor compensation in GDP has risen since 2011 at the expense of the share of corporate profits (Chart 13). China’s common prosperity policies will only reinforce this trend. These policies will encourage enterprises to assume more social duties, distributing a larger share of profits to society at the expense of shareholders. Chart 13Labor's Share Will Continue Rising In China's National Income Chart 14Output Per Unit Of Capex Is Falling 3. Declining efficiency of investments: A deteriorating output-to-capital ratio  indicates capital misallocation or falling efficiency (Chart 14). When a nation attempts to invest substantially for a long time, capital will likely be misallocated and the return on new investment will be low. This will drag down the overall return on capital. Falling efficiency ultimately entails lower productivity. 4. Slowing productivity growth: China’s productivity growth has downshifted, and total factor productivity growth slipped again recently. Notably, total factor productivity – a measure of productivity calculated by dividing economy-wide total production by the weighted average of inputs – has contributed less and less to China’s real GDP growth in the past decade. It is unrealistic to expect that China will reverse the downward trend in productivity growth in the next few years. 5. Deleveraging by companies and households: China’s corporate sector continues to face deleveraging pressures. Although some industrial enterprises underwent deleveraging in recent years, the country’s overall corporate debt is still very elevated. Remarkably, Chinese corporate debt as a share of nominal GDP is the highest in the world, as shown in Chart 5. China’s households are reducing debt. Depressed household income growth and deflating home prices have curbed borrowing. Deleveraging by households heralds weaker consumption, which is negative for corporates revenues. Bottom Line: Rising labor compensation and declining efficiency of investments constitute formidable headwinds to the profitability of China’s industrial sector. Moreover, the secular outlook of corporates’ profitability is also vulnerable to lower productivity growth and weaker top-line growth due deleveraging among companies and households. The Cyclical Outlook In our report two weeks ago, we discussed how China’s business cycle recovery in the second half of this year will be more U rather than V shaped. Both sluggish domestic demand and contracting external demand for Chinese exports will curb the rebound of the industrial sector in 2H. Industrial earnings are set to disappoint.  Chart 15Non-Commodity Enterprises: No Profit Expansion For 12 Years Manufacturing producers have not been able to fully pass on higher input prices to consumers given weak demand. This weakness together with elevated commodity prices has led to a substantial profit divergence between upstream and mid- and downstream industries since late 2020 (Chart 15).  However, upstream commodity producers face the headwind of commodity price deflation. At the margin, weakening resource prices will benefit mid- and downstream industries that use commodities. However, their revenue growth will remain fragile due to subdued domestic and external demand and a lack of pricing power. The tight correlation between industrial profits and raw material prices reinforces the importance of commodity prices as a driver of China’s industrial profit cycles Therefore, if commodity prices drop meaningfully in the second half of this year, then overall industrial profits in China will suffer markedly. Chart 16The share of loss-making industrial enterprise ventures has Rocketed Furthermore, overcapacity and operational inefficiencies persist despite supply-side reforms and a capacity reduction campaign implemented by China’s authorities. Chart 16 demonstrates that the share of loss-making industrial enterprise ventures has soared to 24%, implying capital misallocation.  With a further rising share of enterprises making losses as commodity prices plunge, the ability of companies to service debt will deteriorate and hence banks will experience climbing non-performing loans. Bottom Line: China’s recovery in the second half of this year will be more U than V shaped. Corporate earnings are set to disappoint in 2H. Investment Strategy The gloomy outlook for corporate profitability does not bode well for the performance of Chinese stocks. Chinese A-shares are struggling to bottom on the back of shaky economic fundamentals, while investable stocks are cheap for a reason. We maintain a neutral stance on Chinese onshore stocks and an underweight stance on investable stocks in a global equity portfolio. Lower profitability and return on equity have ramifications for the valuations of China’s industrial companies. Remarkably, China’s industrial profits have been flat in the past 12 years (Chart 15 above). That is a reason why many Chinese stocks have been de-rated. Among A-share industrial companies, sectors with higher profitability are coal, non-ferrous metals, auto, construction materials and food & beverage. However, coal, non-ferrous metals and construction materials are pro-cyclical sectors, and their profit growth is positively correlated with economic growth, which is facing downward pressure at least through the end of this year. In addition, resources and commodity plays are vulnerable in the next 6 to 12 months. We recommend to underweight these sectors.  Within the Chinese equity universe, we recommend overweighting autos, food & beverage, and utilities sectors. Food & beverage and utilities are interest rate-sensitive sectors, which will continue to benefit from lower onshore bond yields. In addition, utilities sector’s profit margin and earnings will improve as coal prices decline. The auto sector will gain an advantage from China’s stimulus for auto purchases, especially for new energy vehicles.   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 The DuPont analysis breaks down return on equity in three distinct elements: net profit margin, operational efficiency, and leverage. This analysis enables to identify how various drivers impact return on equity. 2Please see China Investment Strategy Special Report "Global Copper Market: No Bottom Yet," dated July 27, 2022, and Emerging Markets Strategy Report "A Cocktail Of Falling Oil Prices And Surging US Wages," dated July 21, 2022, available at bcaresearch.com Strategic Themes Cyclical Recommendations