Asia

Dear Client, In lieu of our weekly report next week, I will be hosting two webcasts with my colleague Arthur Budaghyan, Chief Emerging Market Strategist: Time To Buy EM/China? June 23, 2022 9:00 AM EDT (2:00 PM BST, 3:00 PM CEST) and June 24, 2022 9:00 AM HKT (11:00 AM AEST). We will discuss the implications of the global macro environment on EM economies and assets, and whether it is time to buy EM/Chinese equities. I look forward to answering any questions you might have. Kind regards, Jing Sima China Strategist Executive Summary Chinese Households Leverage Ratio Fell The Most Since The GFC China’s households may be entering a deleveraging mode.  The level of newly increased household medium- to long-term loans declined in two out of the first five months of this year. The household leverage ratio has also been falling. The deleveraging is driven by both cyclical and structural forces. Depressed economic growth, home prices as well as jobs and incomes, have all curbed borrowing. Structurally, China’s demographic shift and a decline in the working-age population will lead to a steady decrease in the demand for housing and mortgages. The experience in Japan and the US suggests that when households start deleveraging, the trend will likely progress into a decade-long cycle.  The household deleveraging cycle may lead to a structural downshift in real estate investment, consumption of durable goods and money supply in China. As an offset, interest rates in China will shift down. A low interest rate environment may be positive for China’s financial asset valuations. Bottom Line: Both cyclical and structural forces are prompting Chinese households to reduce debt. A prolonged deleveraging cycle will lead to a slump in the demand for housing and consumer durable goods. However, a deleveraging cycle, coupled with a decline in total population, may lead to a structurally lower interest rate environment, which may be positive for Chinese equity valuations in the long run. Feature China’s newly increased consumer medium- to long-term (ML) loans turned negative in February and April this year, the first negative readings since data collection started in 2007. The reading indicates that households are paying off more ML loans than borrowing (Chart 1).  Chart 1Chinese Household New ML Loans Dropped Below Zero Twice This Year In the near term, a slowing economy and uncertainties surrounding job and income prospects, coupled with stagnating housing prices, will curb households’ propensity to take on debt. In the longer term, China’s working-age population peaked in 2015 and its total population is set to decline beginning in 2025. This unfavorable demographic trend will drive down the demand for housing and ML loans. Japan's experience shows that when the working-age population falls along with the household leverage ratio, the growth in real estate investment, consumption of consumer durable goods and money supply M2 will structurally shift to a lower range. Although a weakening demographic profile and deleveraging households are negative factors for economic growth, interest rates in China will likely move down structurally. Lower borrowing costs will make corporate debt-servicing cheaper and increase corporate profitability, thus providing tailwinds to Chinese stocks and government bonds in the long run. An Inflection Point In Chinese Households’ Leverage? Chart 2Chinese Households Leverage Ratio Fell The Most Since The GFC Several signs suggest that Chinese household debt, after more than a decade of rapid expansion, may have reached an inflection point. Newly increased household ML loans, which are mostly mortgage debt, turned negative this year. Although household ML loans were slightly positive in May, the number was one of the weakest in the past 15 years. China’s household leverage ratio (measured by household debt versus disposable income) rolled over, the first such plunge since the 2008/09 Global Financial Crisis (Chart 2). Chinese households’ reluctance to take on debt reflects current dire economic conditions, which have been damaged by the pandemic and collapse in the housing market. Furthermore, structural forces, such as the nation’s unfavorable demographic shifts, will likely drive the ongoing cyclical deleveraging into a sustained secular trend. Related Report  Emerging Markets StrategyA Whiff Of Stagflation? The pandemic and frequent city lockdowns in the past two years in China have significantly reduced households’ income growth, which has increased debt repayment burdens on families. Even though the central bank and more than 100 cities in China recently slashed mortgage rates, the average cost of mortgage loans remains higher than income growth per capita.  In other words, the current mortgage rates in China are not low enough to reverse the downward trend in households’ ML loans (Chart 3). The investment appeal of real estate has also diminished. Prior to 2018, home prices often appreciated faster than the prevailing mortgage rates. Since late 2019, however, the rate of housing price appreciation in China’s 70 medium and large cities has been falling below the average interest rate on mortgage loans (Chart 4). Home price appreciation has stalled since the second half of last year, whereas mortgage rates are currently about 5.5%. As such, housing’s carry has become negative, discouraging investment purchases of residential properties. Chart 3Mortgage Rates Have Dropped But Still Higher Than Income Growth Chart 4Returns On Leveraged Property Investment Have Diminished In order for consumer ML loans to pick up strongly in the next 6 to 12 months, either the household income growth must significantly improve and/or mortgage rates will have to drop well below home price appreciation. Recent surveys suggest that both will probably not happen in the near term (Chart 5). Chart 5Chinese Households' Income And Investment Outlooks Are Dim Chart 6Demand For Housing Will Dwindle Along With Smaller Labor Force In a previous report we indicated that China’s falling birthrate and working-age population will lead to less demand for housing from a structural point of view. Home sales have fluctuated in a downward trend in the past five years along with a peak in the working-age population in 2015 (Chart 6). Moreover, the sharp deterioration in China’s birthrate will reduce the demand for housing even more significantly in the next 15-20 years. This unfavorable demographic trend will exert powerful downward pressures on the country’s household credit demand. Bottom Line: While the ongoing economic slowdown and housing market slump are curbing ML loans, China’s household loan demand may be entering a structural downturn due to the country’s demographic headwinds. The Economic Impact Of Household Deleveraging The experience in both Japan and the US suggests that when households begin to reduce their debt, the trend may spiral into a secular cycle that lasts up to a decade (Chart 7). A prolonged deleveraging cycle can push the growth in residential real estate investment, consumption of durable goods and money supply to much lower levels.  In Japan’s case, the household debt-to-income ratio rolled over in the late 1990s when the country’s working-age population peaked and began a nose-dive in the early 2000s.  The country’s growth in residential investment fell along with households’ debt reduction, from a 13% average annual rate (nominal) in the 1980s to about 3% in the 2000s (Chart 8). Chart 7Deleveraging Can Spiral Into A Decade##br## Long Cycle Chart 8Japan's Real Estate Investment Growth Slowed Along With Falling Household Leverage... Consumption growth, particularly in consumer durable goods, also dropped from more than 10% in the 1980s to around 0-2% in the late 1990s. It subsequently fell into a prolonged contraction in the 2000s when the household leverage ratio declined (Chart 9). Real estate credit is a major source for China’s money origination. Therefore, a lack of household loan demand will depress the country’s overall credit and money growth. Japan’s money supply grew by less than 4% in the 2000s in nominal terms, compared with a nearly 10% increase in the years prior to the household deleveraging cycle (Chart 10). Chart 9...So Did Demand For Consumer Durable Goods Chart 10Money Supply Growth Also Slowed Bottom Line: Without an imminent and significant improvement in the economy, household deleveraging can progress into a secular trend. A prolonged household deleveraging cycle will drive down the growth in residential property investment, consumption and money supply. Investment Conclusions The combination of declining household debt and total population will weigh on the demand for housing, consumption and investment growth, generating deflationary headwinds for China’s economy. Thus, China’s interest rate regime will likely follow Japan’s example and downshift structurally (Chart 11). A lower interest rate environment will at margin be positive for China’s financial asset valuations in the long run. Related Report  China Investment StrategyExpect A Much Weaker Economy In Q2 Weaker prices on capital will make corporate debt-servicing cheaper and increase corporate profitability. China will likely maintain a very accommodative fiscal policy in the next decade to offset less demand from households and to help implement industrial policies aimed at achieving self-sufficiency in technology and energy. Furthermore, Chinese households may bump up their savings while reducing debt. As returns on residential property investment diminish and yields on risk-free assets shift lower, Chinese households may be increasingly willing to invest in financial assets. This trend could provide tailwinds to Chinese equities in the long term (Chart 12). Chart 11Interest Rates In China Will Likely ##br##Structurally Downshift Chart 12Chinese Households May Shift Their Investment Preference From Properties To Financial Assets   Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations

Special Report

Executive Summary Autocracy Hurts Productivity Over the next six-to-18 months, the Xi Jinping administration will “let 100 flowers bloom” – i.e., relax a range of government policies to secure China’s economic recovery from the pandemic. The first signs of this policy are already apparent via monetary and fiscal easing and looser regulation of Big Tech. However, investors should treat any risk-on rally in Chinese stocks with skepticism over the long run. Political risk and policy uncertainty will remain high until after Xi consolidates power this fall. Xi is highly likely to remain in office but uncertainty over other personnel – and future national policy – will be substantial. Next year China’s policy trajectory will become clearer. But global investors should avoid mistaking temporary improvements for a change of Xi’s strategy or China’s grand strategy. Beijing is driven by instability and insecurity to challenge the US-led world order. The result will be continued economic divorce and potentially military conflicts in the coming decade. Russia’s reversion to autocracy led to falling productivity and poor equity returns. China is also reverting to autocratic government as a solution to its domestic challenges. Western investors should limit long-term exposure to China and prefer markets that benefit from China’s recovery, such as in Southeast Asia and Latin America. Bottom Line: The geopolitical risk premium in Chinese equities will stay high in 2022, fall in 2023, but then rise again as global investors learn that China in the Xi Jinping era is fundamentally unstable and insecure. Feature Chart 1Market Cheers China's Hints At Policy Easing In 1957, after nearly a decade at the helm of the People’s Republic of China, Chairman Mao Zedong initiated the “Hundred Flowers Campaign.” The campaign allowed a degree of political freedom to try to encourage new ideas and debate among China’s intellectuals. The country’s innovative forces had suffered from decades of foreign invasion, civil war, and repression. Within three years, Mao reversed course, reimposed ideological discipline, and punished those who had criticized the party.  It turned out that the new communist regime could not maintain political control while allowing liberalization in the social and economic spheres.1 This episode is useful to bear in mind in 2022 as General Secretary Xi Jinping restores autocratic government in China. In the coming year, Xi will ease a range of policies to promote economic growth and innovation. Already his administration is relaxing some regulatory pressure on Big Tech. Global financial markets are cheering this apparent policy improvement (Chart 1). In effect, Xi is preparing to let 100 flowers bloom. However, China’s economic trajectory remains gloomy over the long run – not least because the US and China lack a strategic basis for re-engagement. Chinese Leaders Fear Foreign Encroachments Mao’s predicament was not only one of ideology and historical circumstance. It was also one of China’s geopolitics. Chinese governments have always struggled to establish domestic control, extend that control over far-flung buffer territories, and impose limits on foreign encroachments. Mao reversed his brief attempt at liberalization because he could not feel secure in his person or his regime. In 1959, the Chinese economy remained backward. The state faced challenges in administration and in buffer spaces like Tibet and Taiwan. The American military loomed large, despite the stalemate and ceasefire on the Korean peninsula in 1952. Russia was turning against Stalinism, while Hungary was revolting against the Soviet Union. Mao feared that the free exchange of ideas would do more to undermine national unity than it would to promote industrialization and technological progress. The 100 flowers that bloomed – intellectuals criticizing government policy – revealed themselves to be insufficiently loyal. They could be culled, strengthening the regime. However, what followed was a failed economic program and nationwide famine. Fast forward to today, when circumstances have changed but the Chinese state faces the same geopolitical insecurities. Xi Jinping, like all Chinese rulers, is struggling to maintain domestic stability and territorial integrity while regulating foreign influence. Although the People’s Republic is not as vulnerable as it was in Mao’s time, it is increasingly vulnerable – namely, to a historic downshift in potential economic growth and a rise in international tensions (Chart 2). The Xi administration has repeatedly shown that it views the US alliance system, US-led global monetary and financial system, and western liberal ideology as threats that need to be counteracted. Chart 2China: Less Stable, Less Secure In addition, Russia’s difficulties invading Ukraine suggest that China faces an enormous challenge in attempting to carve out its own sphere of influence without shattering its economic stability. Hence Beijing needs to slow the pace of confrontation with the West while pursuing the same strategic aims. Xi Stays, But Policy Uncertainty Still High In 2022  2022 is a critical political juncture for China. Xi was supposed to step down and hand the baton to a successor chosen by his predecessor Hu Jintao. Instead he has spent the past decade arranging to remain in power until at least 2032. He took a big stride toward this goal at the nineteenth national party congress in 2017, when he assumed the title of “core leader” of the Communist Party and removed term limits from its constitution. This year’s Omicron outbreak and abrupt economic slowdown have raised speculation about whether Xi’s position is secure. Some of this speculation is wild – but China is far less stable than it appears. Structurally, inequality is high, social mobility is low, and growth is slowing, forcing the new middle class to compromise its aspirations. Cyclically, unemployment is rising and the Misery Index is higher than it appears if one focuses on youth employment and fuel inflation (Chart 3). The risk of sociopolitical upheaval is underrated among global investors. Chart 3AStructurally China Is Vulnerable To Social Unrest Chart 3BCyclically China Is Vulnerable To Social Unrest Yet even assuming that social unrest and political dissent flare up, Xi is highly likely to clinch another five-to-ten years in power. Consider the following points: The top leaders control personnel decisions. The national party congress is often called an “election,” but that is a misnomer. The Communist Party’s top posts will be ratified, not elected. The Politburo and Politburo Standing Committee select the members of the Central Committee; the national party congress convenes to ratify these new members. The Central Committee then ratifies the line-up of the new Politburo and Politburo Standing Committee, which is orchestrated by Xi along with the existing Politburo Standing Committee (Diagram 1). Xi is the most important figure in deciding the new leadership. Diagram 1Mechanics Of The Chinese Communist Party’s National Congress There is no history of surprise votes. The party congress ratifies approximately 90% of the candidates put forward. Outcomes closely conform to predictions of external analysts, meaning that the leadership selection is not a spontaneous, grassroots process but rather a mechanical, elite-driven process with minimal influence from low-level party members, not to mention the population at large.2  The party and state control the levers of power: The Communist Party has control over the military, state bureaucracy, and “commanding heights” of the economy. This includes domestic security forces, energy, communications, transportation, and the financial system. Whoever controls the Communist Party and central government exerts heavy influence over provincial governments and non-government institutions. The state bureaucracy is not in a position to oppose the party leadership. Xi has conducted a decade-long political purge (“anti-corruption campaign”). Upon coming to power in 2012, Xi initiated a neo-Maoist campaign to re-centralize power in his own person, in the Communist Party, and in the central government. He has purged foreign influence along with rivals in the party, state, military, business, civil society, and Big Tech. He personally controls the military, the police, the paramilitary forces, the intelligence and security agencies, and the top Communist Party organs. There may be opposition but it is not organized or capable. Chart 4China: Big Tech Gets Relief ... For Now There are no serious alternatives to Xi’s leadership. Xi is widely recognized within China as the “core” of the fifth generation of Chinese leaders. The other leaders and their factions have been repressed. Xi imprisoned his top rivals, Bo Xilai and Zhou Yongkang, a decade ago. He has since neutralized their followers and the factions of previous leaders Hu Jintao and Jiang Zemin. Premier Li Keqiang has never exercised any influence and will retire at the end of this year. None of the ousted figures have reemerged to challenge Xi, but potential rivals have been imprisoned or disciplined, as have prominent figures that pose no direct political threat, such as tech entrepreneur Jack Ma (Chart 4).  Additional high-level sackings are likely before the party congress. China’s reversion to autocracy grew from Communist Party elites, not Xi alone. China’s slowing potential GDP growth and changing economic model raise an existential threat to the Communist Party over the long run. The party recognized its potential loss of legitimacy back in 2012, the year Xi was slated to take the helm. The solution was to concentrate power in the center, promoting Maoist nostalgia and strongman rule. In essence, the party needed a new Mao; Xi was all too willing to play the part. Hence Xi’s current position does not rest on his personal maneuvers alone. The party has invested heavily in Xi and will continue to do so. Characteristics of the political elite underpin the autocratic shift. Statistics on the evolving character traits of Politburo members show the trend toward leaders that are more rural, more bureaucratic, and more ideologically orthodox, i.e. more nationalist and communist (Chart 5). This trend underpins the party’s behavior and Xi’s personal rule. Chart 5China: From Technocracy To Autocracy Chart 6China: De-Industrialization Undermines Stability Xi has guarded his left flank. By cornering the hard left of the political spectrum Xi has positioned himself as the champion of poor people, workers, farmers, soldiers, and common folk. This is the political base of the Communist Party, as opposed to the rich coastal elites and westernizing capitalists, who stand to suffer from Xi’s policies. Ultimately de-industrialization – e.g. the sharp decline in manufacturing and construction sectors (Chart 6) – poses a major challenge to this narrative. But social unrest will be repressed and will not overturn Xi or the regime anytime soon. Xi still retains political capital. After centuries of instability, Chinese households are averse to upheaval, civil war, and chaos. They support the current regime because it has stabilized China and made it prosperous. Of course, relative to the Hu Jintao era, Xi’s policies have produced slower growth and productivity and a tarnished international image (Chart 7). But they have not yet led to massive instability that would alienate the people in general. If Chinese citizens look abroad, they see that Xi has already outlasted US Presidents Obama and Trump, is likely to outlast Biden, and that US politics are in turmoil. The same goes for Europe, Japan, and Russia – Xi’s leadership does not suffer by comparison.  Chart 7China’s Declining International Image External actors are neither willing nor able to topple Xi. Any outside attempt to interfere with China’s leadership or political system would be unwarranted and would provoke an aggressive response. The US is internally divided and has not developed a consistent China policy. This year the Biden administration has its hands full with midterm elections, Russia, and Iran, where it must also accept the current leadership as a fact of life. It has no ability to prevent Xi’s power consolidation, though it will impose punitive economic measures. Japan and other US allies have an interest in undermining Xi’s administration, but they follow the US’s lead in foreign policy. They also lack influence over the political rotation within the Communist Party. The Europeans will keep their distance but will not try to antagonize China given their more pressing conflict with Russia. Russia needs China more than ever and will lend material support in the form of cheaper and more secure natural resources. North Korean and Iranian nuclear provocations will help Xi stay under the radar.  There is no reason to expect a new leader to take over in China. The Xi administration’s strategy, revealed over the past ten years, will remain intact for another five-to-ten years at least. The real question at the party congress is whether Xi will be forced to name a successor or compromise with the opposing faction on the personnel of the Politburo and Politburo Standing Committee. But even that remains to be seen – and either way he will remain the paramount leader. Bottom Line: Xi Jinping has the political capability to cement another five-to-ten years in power. Opposing factions have been weakened over the past decade by Xi’s domestic political purge and clash with the United States. China is ripe for social unrest and political dissent but these will be repressed as China goes further down the path of autocracy. Foreign powers have little influence over the process. Policy Uncertainty Falls In 2023 … Only To Rise Again What will Xi Jinping do once he consolidates power? Xi’s administration has weighed heavily on China’s economy, foreign relations, and financial markets. The situation has worsened dramatically this year as the economy struggles with “A Trifecta Of Economic Woes” – namely a rampant pandemic, waning demand for exports, and a faltering housing market (Chart 8). In response the administration is now easing a range of policies to stabilize expectations and try to meet the 5.5% annual growth target. The money impulse, and potentially the credit impulse, is turning less negative, heralding an eventual upturn in industrial activity and import volumes in 2023. These measures will give a boost to Chinese and global growth, although stimulus measures are losing effectiveness over time (Chart 9).  Chart 8China's Trifecta Of Economic Woes Chart 9More Stimulus, But Less Effectiveness This pro-growth policy pivot will continue through the year and into next year. After all, if Xi is going to stay in power, he does not want to bequeath himself a financial crisis or recession at the start of his third term. Still, investors should treat any rally in Chinese equity markets with skepticism. First, political risk and uncertainty will remain elevated until Xi completes his power grab, as China is highly susceptible to surprises and negative political incidents this year (Chart 10). For example, if social unrest emerges and is repressed, then the West will impose sanctions. If China increases its support of Russia, Iran, or North Korea, then the US will impose sanctions.     Chart 10China: Policy Uncertainty And Geopolitical Risk To Stay High In 2022, Might Improve In 2023 Chart 11China Needs To Court Europe The regime will be extremely vigilant and overreact to any threats this year, real or perceived. Political objectives will remain paramount, above the economy and financial markets, and that means new economic policy initiatives will not be reliable. Investors cannot be confident about the country’s policy direction until the leadership rotation is complete and new policy guidance is revealed, particularly in December 2022 and March 2023. Second, after consolidating power, investors should interpret Xi’s policy shift as “letting 100 flowers bloom,” i.e., a temporary relaxation that aims to reboot the economy but does not change the country’s long-term policy trajectory. Economic reopening is inevitable after the pandemic response is downgraded – which is a political determination. Xi will also be forced to reduce foreign tensions for the sake of the economy, particularly by courting Europe, which is three times larger than Russia as a market (Chart 11). However, China’s declining labor force and high debt levels prevent its periodic credit stimulus from generating as much economic output as in the past. And the administration will not ultimately pursue liberal structural reforms and a more open economy. That is the path toward foreign encroachment – and regime insecurity. The US’s sanctions on Russia have shown the consequences of deep dependency on the West. China will continue diversifying away from the US. And, as we will see, the US cannot provide credible promises that it will reduce tensions. US-China: Re-Engagement Will Fail The Biden administration is focused on fighting inflation ahead of the midterm elections. But its confrontation with Russia – and likely failure to freeze Iran’s nuclear program – increases rather than decreases oil supply constraints. Hence some administration officials and outside observers argue that the administration should pursue a strategic re-engagement with China.3  Theoretically a US-China détente would buy both countries time to deal with their domestic politics by providing some international stability. Improved US-China relations could also isolate Russia and hasten a resolution to the war in Ukraine, potentially reducing commodity price pressures. In essence, a US-China détente would reprise President Richard Nixon’s outreach to China in 1972, benefiting both countries at the expense of Russia.4  This kind of Kissinger 2.0 maneuver could happen but there are good reasons to think it will not, or if it does that it will fall apart in one or two years. In 1972, China had nowhere near the capacity to deny the US access to the Asia Pacific region, expel US influence from neighboring countries, reconquer Taiwan, or project power elsewhere. Today, China is increasingly gaining these abilities. In fact it is the only power in the world capable of rivaling the US in both economic and military terms over the long run (Chart 12). Secretary of State Antony Blinken recently outlined the Biden administration’s China policy and declared that China poses “the most serious long-term challenge” to the US despite Russian aggression.5  Chart 12US-China Competition Sows Distrust, Drives Economic Divorce While another decade of US engagement with China would benefit the US economy, it would be far more beneficial to China. Crucially, it would be beneficial in a strategic sense, not just an economic one. It could provide just the room for maneuver that China needs – at this critical juncture in its development – to achieve technological and productivity breakthroughs and escape the middle-income trap. Another ten-year reprieve from direct American competition would set China up to challenge the US on the global stage. That would be far too high of a strategic price for America to pay for a ceasefire in Ukraine. Ukraine has limited strategic value for the US and it does not steer US grand strategy, which aims to prevent regional empires from taking shape. In fact Washington is deliberately escalating and prolonging the war in Ukraine to drain Russia’s resources. Ending the war would do Russia a strategic favor, while re-engaging with China would do China a strategic favor. So why would the defense and intelligence community advise the Biden administration to pursue Kissinger 2.0? Chart 13US Unlikely To Revoke Trump Tariffs Biden could still pursue some degree of détente with China, namely by repealing President Trump’s trade tariffs, in order to relieve price pressures ahead of the midterm election. Yet even here the case is deeply flawed. Trump’s tariffs on China did not trigger the current inflationary bout. That was the combined Trump-Biden fiscal stimulus and Covid-era supply constraints. US import prices are rising faster from the rest of the world than they are from China (Chart 13). Tariff relief would not change China’s Zero Covid policy, which is the current driver of price spikes from China. And while lifting tariffs on China would not reduce inflation enough to attract voters, it would cost Biden some political credit among voters in swing states like Pennsylvania, and across the US, where China’s image has plummeted in the wake of Covid-19 (Chart 14).   Chart 14US Political Consensus Remains Hawkish On China If Biden did pursue détente, would China be able to reciprocate and offer trade concessions? Xi has the authority to do so but he is unlikely to make major trade concessions prior to the party congress. Economic self-sufficiency and resistance to American pressure have become pillars of his support. Promises will not ease inflation for US voters in November and Xi has no incentive to make binding concessions because the next US administration could intensify the trade war regardless.  Bottom Line: The US has no long-term interest, and a limited short-term interest, in easing pressure on China’s economy. Continued US pressure, combined with China’s internal difficulties, will reinforce Xi Jinping’s shift toward nationalism and hawkish foreign policy. Hence there is little basis for a substantial US-China re-engagement that improves the global macroeconomic environment over the coming years. Investment Takeaways Chart 15Autocracy Hurts Productivity Xi Jinping will clinch another five-to-ten years in power this fall. To stabilize the economy, he will “let 100 flowers bloom” and ease monetary, fiscal, regulatory, and social policy at home. He will also court the West, especially Europe, for the sake of economic growth. However, he will not go so far as to compromise his ultimate aims: self-sufficiency at home and a sphere of influence abroad. The result will be a relapse into conflict with the West within a year or two. Ultimately a closed Chinese economy in conflict with the West will result in lower productivity, a weaker currency, a high geopolitical risk premium, and low equity returns – just as it did for Russia (Chart 15). Any short-term improvement in China’s low equity multiples will ultimately be capped. Over the long run, western investors should hedge against Chinese geopolitical risk by preferring markets that benefit from China’s periodic stimulus yet do not suffer from the break-up of the US-China and EU-Russia economic relationships, such as key markets in Latin America and Southeast Asia (Charts 16 & 17). Chart 16China Stimulus Creates Opportunity For … Latin America Chart 17China Stimulus Creates Opportunity For … Southeast Asia     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1     Modern scholarship has shown that Mao intended to entrap the opposition through the 100 Flowers Campaign. For a harrowing account of this episode, see Jung Chang and Jon Halliday, Mao: The Unknown Story (New York: Anchor Books, 2006), pp. 409-17. 2     “At least 8% of CPC Central Committee nominees voted off,” Xinhua, October 24, 2017, english.www.gov.cn. 3    Christopher Condon, “Yellen Says Biden Team Is Looking To ‘Reconfigure’ China Tariffs,” June 8, 2022, www.bloomberg.com. 4       Niall Ferguson, “Dust Off That Dirty Word Détente And Engage With China,” Bloomberg, June 5, 2022, www.bloomberg.com. 5    See Antony J Blinken, Secretary of State, “The Administration’s Approach to the People’s Republic of China,” George Washington University, Washington D.C., May 26, 2022, state.gov. Additionally, see President Joe Biden’s third assertion of US willingness to defend Taiwan against China, in a joint press conference with Japan’s Prime Minister Kishida Fumio, “Remarks by President Biden and Prime Minister Kishida Fumio of Japan in Joint Press Conference,” Akasaka Palace, Tokyo, Japan, May 23, 2022, whitehouse.gov.

Executive Summary Natural Gas Markets Eerily Quiet An eerie calm in European natural gas markets belies the state of war in Ukraine that already is producing a cutoff of Russian natgas supplies in retaliation for the EU’s oil embargo. Such cutoffs will accelerate, and send natgas prices in Europe and Asia sharply higher if they occur sooner – as we expect – rather than later. The US will continue to send most of its LNG exports to Europe. These exports are expected to average 12 Bcf/d this year, up 22% from last year’s level. Planners in Europe and Asia will want to secure as much natgas supply as possible by the end of October to refill storage for the November-March withdrawal season, which is beginning to look like another La Niña winter. The US Climate Prediction Center makes the odds of such an event, which is associated with colder-than-normal winters in the Northern Hemisphere, just over 60%. Bottom Line: European governments are preparing their citizens for natgas rationing, in the event of a cutoff of Russian gas. This will occur sooner rather than later. In its wake, EU GDP will fall, and inflation will rise as knock-on effects constrict base metals, fertilizer and food supplies. At tonight’s close, we will be getting long 1Q23 TTF futures on the ICE, expecting prices to again exceed €225/MWh. Feature Related Report  Commodity & Energy StrategyHigher Gasoline, Diesel Prices Ahead Russia is at war with Ukraine. NATO military support for Ukraine – with the EU at the forefront – is being maintained at a high level, and Ukrainian forces are vigorously defending their homeland.1 The EU embargoed Russian oil imports to sharply reduce funding for Russia’s war machine. Russia will be compelled to follow through on its threat to cut off pipeline gas shipments to Europe, following the embargo.2 It is highly doubtful Russia will countenance the timetable envisioned in the EU embargo, which calls for a phase-out of oil imports by yearend that removes close to 3mm b/d, or 90% of Russia’s sales into its largest market (Chart 1). Equally doubtful is the notion the EU will countenance funding Russia’s war on Ukraine over the course of such a phase-out. Our colleague Matt Gertken, who runs BCA’s Geopolitical Strategy, demonstrated that while such a phase-out schedule may be optimal for both sides – i.e., it prolongs revenue flows to Russia and gas flows to the EU – it almost surely is not an equilibrium.3 An equilibrium in this prisoners’ dilemma obtains when both sides act immediately to end their vulnerability to the other unilaterally upsetting the optimal state – i.e., endure short-term pain for long-term gain (Diagram 1). For this reason, we believe Russia’s cutoff of natgas shipments to the EU will occur sooner rather than later, to inflict maximum pain on the EU going into the coming winter season. The EU knows this, and is preparing its citizens for rationing of natgas. Chart 1EU’s Russian Oil Embargo Cuts Sales By 90% By Year-end Diagram 1The EU, Russia Prisoners’ Dilemma Russian Natgas Cutoff To The EU Underway Russia already has begun reducing natural gas supplies to the EU (Chart 2). Russian gas flows to Finland, Poland, Bulgaria, Netherlands, and Denmark were embargoed after these states refused to pay for gas in rubles (Chart 3). Russia reduced gas shipments to Germany – albeit marginally – after Shell refused to pay for natgas supplied to Germany in rubles. While this only disrupted 1.3% of total natgas consumption in Germany, it showed Russia will quickly act against what it views as “unfriendly” customers.4 Ukraine was forced to shut a gas transit point through which 8% of total Russian gas flows reach Europe, after Russian occupying forces were found to be siphoning gas, according to Gas Transmission System Operator of Ukraine (GTSOU). As a result, gas flows from Russia have taken a further hit and have not recovered (Chart 4). EU member states whose supply of Russian gas has been disrupted will need to search for alternatives. Orsted, an energy company supplying natgas to Denmark, stated it will source gas from the EU market. Given supply constraints in Europe, an increase in the number of bids on the single EU market will raise the Dutch Title Transfer Facility (TTF), all else equal. Chart 2Russia Starts Cutting Gas Flows Chart 3Russian Gas Flows To EU Falling Overall... Chart 4...Particularly Via Ukraine Higher TTF prices will direct gas flows from the US to Europe, reducing gas available for domestic consumption. LNG gas exports to Europe have maintained their upward trend since 2016 and were up by 87% (674 BCF) in 1Q22 vs the same period in 2019 (Chart 5). Chart 5US LNG Exports To Europe Surge Simultaneously, the US witnessed its largest inventory withdrawal this winter in the last four years (Chart 6). Warmer-than-normal temperatures and drought conditions in the US also are increasing domestic demand, as electricity companies are forced to substitute hydroelectric power with natgas-fired generation. Increased exports and weather phenomena have combined to push the Henry Hub contract above $9.50/MMBtu this week, the highest level since 2008. Chart 6US Natgas Inventories Slowly Filling US LNG Exports To Europe Surge Higher European prices for US natgas have disincentivized shipments to Asia, where prices – measured by the Japan Korea Marker (JKM) – have been trading below the TTF so far this year on average (Chart 7). This has allowed European gas inventories to refill at a rapid pace. As of 4 June, the EU’s working gas inventories were ~49% full and are above last year’s level for this time of the year (Chart 8). Chart 7Natural Gas Markets Eerily Quiet Chart 8European Gas Storage Refill Off To A Good Start Shanghai’s reopening will propel Chinese economic activity and demand for natgas, making an already tight global natural gas market tighter. However, the risk of rolling lockdowns in China will keep Asia’s LNG demand in check.5 LNG vessel charter rates have increased sharply since the Russia-Ukraine war began, largely on the back of European demand (Chart 9). We expect this to be a regular feature of the international gas market going forward, as more LNG export capacity is added in the US – it will rise to 12.6 Bcf/d next year, e.g. – and global demand remains strong. Chart 9Surge in LNG Charter Rates   Europe Is Critically Short LNG Infrastructure Most of the EU’s existing 158 Bcm of annual regasification capacity is located around the Iberian Peninsula (Chart 10), which is not well-connected to the rest of Europe. As a result, to substitute Russian piped gas for LNG imports, investments for import terminals and regasification capacity will be required. In its REPowerEU program the European Commission expects to move closer to complete independence from Russian fossil fuels by importing an additional 50 Bcm of LNG per year, reducing demand, and ramping up renewable energy. Germany is aiming for independence from Russian gas flows by planning a shoreside LNG terminal and ordering four Floating Storage and Regasification Units (FSRUs). The FSRUs, which are expected to come online between year-end and the start of next year will have a combined capacity under 24 Bcm per year. Chart 10Europe Needs More Re-Gasification Capacity These plans, however, are not aligned with the nation’s pathway to go carbon neutral by 2045. An environmental activist group has filed a lawsuit to halt the construction of the LNG terminal. The group also is opposed to Germany’s draft LNG acceleration bill, which will allow imports until two years before 2045.6 This reflects two problems all EU nations will face as they transition to LNG from pipeline Russian gas imports. Firstly, member states will need to invest billions of euros in new LNG capacity, and given current politics, likely will have to decide to scrap or repurpose this infrastructure in during the transition to green energy. Opposing this possibility is the high likelihood that EU states will need to enter long-term LNG contracts to ensure supply security and shield themselves from volatile natgas prices. For the immediate future, the EU likely will kick this can down the road for as long as possible. Investment Implications Back in March, Germany and Austria began preparing their citizens for natgas rationing.7 Now the IEA is warning all of Europe the likelihood of such action is increasing rapidly.8 State and local planners throughout Europe will spend the next five months or so lining up as much LNG and pipeline gas as possible going into the coming winter season. While the inventory-injection in Europe is off to a good start, planners most likely hope to exceed their minimum target for filling 80% of storage in time for the November-March withdrawal season. In addition to the risk of a Russian cutoff of supplies, planners have to account for a higher likelihood of a colder-than-normal winter, given the odds of another La Niña winter, which is associated with colder-than-normal winters in the Northern Hemisphere. The US Climate Prediction Center makes the odds of such an event – the third such event in as many years – just over 60%. If European states are forced to implement rationing of natgas, knock-on effects resulting from prioritizing human needs over industrial concerns will, once again, restrict base metals, fertilizer and food supplies. We remain long energy, metals and grains exposure via the S&P GSCI and COMT ETF as the natural-gas drama in Europe plays out. In addition, we remain long the XOP, XME, PICK, and CRAK ETFs to maintain our equity exposure to industrial commodities. At tonight’s close, we will be getting tactically long 1Q22 futures on the ICE, expecting prices to again exceed €225/MWh. This will complement our existing tactical commodity exposures in 4Q22 TTF futures.     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     Commodities Round-Up Energy: Bullish US refined product demand rose just under 4% for the week ended 3 June 2022, led by a surge in jet-fuel demand of 26.5% yoy – finishing at 1.6mm b/d vs. 1.26mm b/d the year earlier, according to the US EIA. This provides further evidence consumer pent-up demand for travel is being released, after the long shut-downs in travel caused by COVID-19 beginning in 1Q20. The surge in jet-fuel demand was enough to offset yoy declines in gasoline and distillates such as diesel fuel and heating oil of 0.9% and 2.8%, respectively. Gasoline inventories were down 800k barrels yoy, which put them 10% below their five-year average level at the end of the reporting week. Distillate inventories rose 2.6mm barrels, but this still left them 23% below their five-year average. Crude oil inventories in the US including those in the Strategic Petroleum Reserve (SPR), which is being drawn down to provide charging stock to refiners, drew 7.3mm barrels, and stood at 519mm barrels. Versus year-ago levels, crude inventories including the SPR are down 17%. Base Metals: Bullish Copper production in Chile fell 9.8% yoy in April as state-owned copper giant Codelco’s monthly supply fell 6.1% yoy to 116,000 tons. In Peru, protests against mines by displaced communities have seen suspensions in copper mine production, including that of MMG-owned Las Bambas. Although the International Copper Study Group (ICSG) expects a physical surplus for refined copper markets next year, falling production in Chile and civil unrest in Peru continue to plague the rebuilding of stocks (Chart 11). Globally, a risk matrix we reproduced in a report last year showed that approximately 570 million Metric Tons of copper faced a significant ESG risk.9 This increases the risk of new copper projects being stymied by activist groups, and further curtailing future copper production.   Precious Metals: Bullish According to data from World Gold Council, gold ETFs faced net outflows in May as the USD and interest rates strengthened, following the Fed rate hikes (Chart 12). In his speech, Fed Governor Christopher Waller explained that by increasing interest rates, the Fed aims to match labor demand to supply and reduce wage growth, which in turn will lower inflation.10 This, however, does not deal with high inflation via the mechanism of elevated food and fuel prices, which will remain high as long as supply disruptions continue in these markets. Chart 11 Chart 12     Footnotes 1     Please see The Institute For The Study Of War for daily updates of the Russia-Ukraine war. 2     Please see Higher Gasoline, Diesel Prices Ahead, which we published last week, for further discussion of the EU’s embargo of Russian oil imports. The EU embargo initially will be on Russian seaborne oil imports, which will tighten global crude oil and refined-product markets further. Pipeline imports are due to phase out by year-end. Cumulatively, this will translate to a 90% decrease in Russian crude and product exports to the EU, representing ~ 3mm b/d of lost sales. Our report is available at ces.bcaresearch.com. 3    Please see Energy Cutoff Continues (GeoRisk Update), published by BCA Research’s Geopolitical Strategy on June 1, 2022. It is available at gps.bcaresearch.com. 4    According to a recent report from Gemeinshcafts Diagnose institution prepared on behalf of Germany’s Federal Ministry of Economics and Climate Protection, if Russia embargos oil and gas to Germany immediately the German economy will fall into a sharp recession.  The cumulative loss to macroeconomic output in 2022 and 2023 will amount to 220 billion euros, or more than 6.5% of annual economic output. 5    For more on the risk of rolling lockdowns in China, please see Not The Time To Be A Contrarian, published by BCA’s Emerging Markets Strategy on May 19, 2022.   6    Please see Germany’s Cabinet Moves to Head Off Lawsuits Against LNG Terminals, published by The Maritime Executive on May 11, 2022 7     Please see Germany Closer To Rationing Natgas, which we published on March 31, 2022. 8    Please see Europe at risk of winter energy rationing, energy watchdog warns, published by ft.com on June 8, 2022. 9    Please see Renewables ESG Risk Grows With Demand, which we published on April 29, 2022 10   For the speech, please see  Responding to High Inflation with Some Thoughts on a Soft Landing.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trades Closed in 2022

Executive Summary Singapore stocks are at risk as an impending contraction in global trade will hurt this very open economy and its markets. The country’s foreign reserves are already shrinking as the balance of payments has slid into deficit. The Monetary Authority of Singapore’s (MAS) attempts to rein in inflation by pushing up the currency is also causing foreign reserves to contract, and local money supply to decelerate sharply. Inflationary pressures in Singapore are not entrenched and will soon subside. Wage growth is under control, and unit labor cost increases are subdued. Singapore’s export competitiveness remains robust; yet that does not preclude it from a period of shrinking exports over the next 6-12 months. Falling exports, shrinking foreign reserves, decelerating money supply and peaking inflation will dissuade MAS from pushing up the Singapore dollar much higher from current levels. Manufacturing Cycles Dictate The Performance Of Singapore Stocks Recommendation Inception Date RETURN Downgrade Singapore stocks from overweight to neutral May 10, 2021 2.3% Bottom Line: Equity investors should reduce their exposure to Singapore stocks in EM and Asian portfolios by downgrading their allocation from overweight to neutral. Absolute return investors should wait for a better entry point. Feature Chart 1Singapore Stocks' Outperformance Is Set To Take A Breather Like most global markets, Singapore stocks have sold off materially since early this year. Relative to EM and Asian counterparts, however, they have fared well – in line with our call back in May 2021 when we upgraded this bourse to overweight (Chart 1). The question is, given the changing macro backdrop − where a whiff of stagflation has permeated global investment landscapes – what should investors now do about this market? We believe that higher inflation in Singapore is a temporary phenomenon and will subside sooner rather than later. Contracting global trade, on the other hand, is a much more vital risk for this very open economy and its equity markets; and is a reason to downgrade this bourse. Indeed, Singapore stocks in absolute US dollar terms face more downside over the next several months. Relative to its EM and Asian counterparts also, this bourse’s outperformance is likely to take a breather.  Asian and EM equity portfolios would therefore do well to downgrade this market by a notch from overweight to neutral in EM and Asian equity baskets. Absolute return investors should stay on the sidelines for now. Unfavorable Settings Contracting global trade and tightening liquidity will weigh on Singapore stocks in the months ahead. Global trade volumes will fall as developed countries’ demand for goods (ex-auto) shrinks following the pandemic-era binge. Chinese growth will also likely be struggling to recover. What this means is that both global manufacturing and exports are heading towards a contraction. As a very open economy where goods exports make up 115% of GDP (and services exports another 55%), manufacturing and exports of goods drive income for the entire Singaporean economy and influence its stock market cycles. Chart 2 shows how ebbs and flows in manufacturing new orders dictate Singapore’s equity market performances. Chart 2Manufacturing Cycles Dictate The Performance Of Singapore Stocks The performances of financial and real estate stocks, which make up two-thirds of the MSCI Singapore index, are also highly dependent on business cycles − which in turn, are driven by swings in manufacturing and exports (Chart 3). One reason for that is, at 23% of GDP, manufacturing is the single largest sector in the economy. By comparison, finance and insurance make up 14% of the nation’s output, and real estate 3%. Any acceleration or deceleration in manufacturing activity therefore has a strong impact on the performance of tertiary sectors, including those of banking and real estate. In addition, MAS’ tightening is causing local money supply to decelerate (discussed in more detail later). Slower money growth is never bullish for stock prices (Chart 4). Chart 3Banks And Real Estate Stocks Also Move With Manufacturing And Exports Chart 4Decelerating Money Supply Is A Bad Omen For Share Prices   In sum, given the changing global macro backdrop of slowing manufacturing and trade, and elevated US inflation, Singapore stocks have not yet found a sustainable bottom in absolute terms. Relative to their EM counterparts, Singapore’s outperformance could also take a breather. During periods of weakening global trade and manufacturing, Singapore stocks usually do poorly relative to their EM peers. The top panel of Chart 5 shows US manufacturing PMI new orders as decelerating rapidly. Periods of falling and/or sub-50 PMI prints usually herald Singapore stocks’ underperformance relative to EM, with a few months lag. Singapore’s own new export orders are also about to slip into contraction territory. If history is any guide, this too entails a period of underperformance of this bourse versus EM going forward (Chart 5, bottom panel). Is Inflation Genuine In Singapore? The short answer is no; there is little genuine inflation in Singapore. The country is not witnessing any wage-price spiral either, unlike in the US. What we see there instead is just a one-off surge in inflation. Average monthly wages in Singapore have accelerated in the past year but are not out of line when compared to the past 20 years (Chart 6, top panel). Chart 5Weakening Manufacturing Orders Foreshadow Singapore Equities' Underperformance Chart 6Limited Wage Growth And Subdued Unit Labor Costs Will Rein In Inflationary Pressures   A controlled rise in wages has helped keep Singaporean firms’ unit labor costs (ULCs) in check. The middle panel of Chart 6 shows ULCs for the overall economy vis-à-vis the consumer price index. ULCs are much below pre-pandemic levels. This happens to be the case even in the service sector of the economy where productivity gains are much harder to achieve. In the goods producing sector, where productivity gains are relatively easier to achieve, ULCs have remained particularly low (Chart 6, bottom two panels). What this means is that firms are facing little wage-related cost pressures. They are, therefore, less likely to pass it on to customers via higher selling prices. That, in turn, will help cap inflationary pressures in the economy. Chart 7Sharply Slowing Money Growth Points To Peaking Inflation In fact, much of the recent rise in headline and core consumer inflation in Singapore has had to do with the explosive money growth seen during the pandemic. Both narrow (M1) and broad money (M3) growth rates in Singapore accelerated in 2020 to levels not seen since the Global Financial Crisis of 2008-09. Inflation usually follows money growth with several months lag, and this time was no different. That said, both measures of money have since decelerated markedly this year. This will rein in inflationary pressures going forward (Chart 7).  Looking forward, money supply itself will likely decelerate further in the months ahead. A critical reason for that is the manner in which the central bank (MAS) uses the currency to achieve its monetary policy objectives (i.e., to maintain price stability).   When inflation rises, MAS typically guides the trade-weighted Singapore dollar to appreciate, in an attempt to rein in inflation. In so doing, MAS buys local currency and sells foreign currency. This reduces local liquidity and money supply. Chart 8 shows that MAS is indeed guiding the Singapore dollar up: the trade weighted currency has risen by over 3% in the past six months tracking inflation. Not surprisingly, money growth in Singapore has decelerated meaningfully. In time, that will help pull inflation lower. There was an external factor too. In the past couple of years, the country had witnessed a massive improvement in its balance of payments (BoP). It skyrocketed from a minus 3% of GDP in 2019 to a plus 27% in 2021. To prevent the currency from surging, the central bank had resorted to a rapid accumulation of foreign reserves. As MAS pumped local currency into the system while purchasing foreign currencies, local money supply boomed (Chart 9). Chart 8In Order To Check Inflation, The MAS Has Pushed The Singapore Dollar Up... Chart 9...Causing Foreign Reserves To Drop, And Money Supply To Decelerate Materially Chart 10The Trade Surplus Will Narrow, Putting More Pressure On The Balance Of Payments But the tide has turned this year. The trade surplus has rolled over and will continue to shrink as global trade is set to weaken further this year as explained above. As such, Singapore’s current account surplus will also likely roll over. The capital account has already slipped back into massive deficits; so has the BoP (Chart 10). The upshot is that foreign reserves have begun to contract. This means MAS is now selling foreign reserves to buy back local currency. This is causing a deceleration in local money supply (Chart 9, above). In sum, the absence of meaningful wage pressures, a decelerating money supply, and a strengthening currency will help Singapore see its inflation ease sooner than in the US. Can Singapore Withstand A Stronger Currency? As discussed above, Singapore’s monetary policy entails tackling higher inflation by letting the Singapore dollar appreciate in nominal terms. But given the high inflation prints, an appreciating currency would mean that it gets even stronger in real terms (i.e., in inflation-adjusted terms). An expensive currency in real terms could erode competitiveness. So, the question is, can the Singapore economy withstand a stronger currency? The short answer is yes. Chart 11 shows that while the Singapore dollar has appreciated to new highs in nominal trade weighted terms, in real terms (ULC-based) it remains at around 15-year lows. As such, currency competitiveness should not be an issue anytime soon. Notably, real exchange rates calculated using ULCs are more representative of currency competitiveness than the use of consumer prices allows. The reason is that employee compensation is a major component of any company’s overall cost structure; and therefore, ULCs matter for a company much more directly than do consumer prices. The very low levels of the ULC-based real exchange rate indicates that the Singapore dollar is still very competitive. Indeed, Singapore’s export volumes have been on an upward trend relative to global exports (Chart 12). Chart 11The Singapore Dollar Remains A Highly Competitive Currency Chart 12Singapore Is Grabbing Export Market Share From The Rest Of The World Notably, Singapore continues to attract a very high amount of FDI. This will help raise productivity going forward, thereby keeping ULCs in check down the line. All that said, strong competitiveness (i.e., the ability to maintain global market share) does not preclude Singapore from experiencing a drop in its export revenues over the next 6-to-12 months. The reason is faltering goods demand in the US and Europe after a pandemic-era overconsumption. Falling exports, in turn, will lead to shrinking foreign reserves, decelerating money supply, and finally slowing growth and inflation. This will discourage MAS from pushing the Singapore dollar much higher from current levels. As Chart 11 showed, the Singaporean currency is already at an all-time high in trade-weighted terms. The rally in the trade-weighted Singapore dollar is therefore in late stages. Investment Recommendations Chart 13The Singapore Dollar's Outperformance Vesus Other Asian Currencies Is Late Singapore stocks, with a P/E ratio of 21.5, have become relatively expensive vis-à-vis their EM (13.1) and Asian (14.1) counterparts. In terms of the price-to-book value ratio however, they are not expensive. Considering all, we recommend that investors reduce their exposure to Singapore stocks in EM and Asian equity portfolios by downgrading their allocation from overweight to neutral. Our overweight stance since May 10, 2021, has yielded a gain of 2.3% so far. Absolute return investors should wait for a better entry point. The depreciation of the Singapore dollar vis-à-vis the US dollar likely has some more room given the impending deterioration in global trade. But the latter will also soon check the appreciation of the Singapore dollar versus other Asian currencies − as MAS will be dissuaded from guiding the currency up in view of peaking domestic inflation and shrinking trade (Chart 13). Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com

Executive Summary The Efficient Market Hypothesis (EMH) is flawed. This Holy Grail of financial economics assumes that investors are a homogenous bunch with identical investment horizons, when the reality is that investors have a wide spectrum of time horizons. The alternative but less well-known Fractal Market Hypothesis (FMH) recognizes that investors with different time horizons interpret the same facts and information differently. The key conclusion of the FMH is that when the different investment horizons are all active in the market, the price reflects all available information, meaning that the market is efficient, liquid, and stable. But when the different investment horizons start to converge and coalesce, the market becomes inefficient, illiquid, and vulnerable to a trend reversal. Using the FMH over the past six months, 5 structured recommendations were closed in profit: Short ILS/GBP, Short Coffee versus Cocoa, Short World Basic Resources versus Market, Long EUR/CHF, and Short Semiconductors versus Tech. Against this, 3 structured recommendations were closed in loss: Short Nickel versus Silver, Long Polish Bonds versus US Bonds, and Short World Semiconductors versus Biotech. Within the 10 open trades, 3 are in healthy profit, 4 are flat, and 3 are in loss. The Efficient Market Hypothesis Does Not Describe The Truth; The Fractal Market Hypothesis Does Bottom Line: As few investors are aware of the Fractal Market Hypothesis, it gives a competitive advantage to those that use it to identify potential trend reversals. Feature For nations and societies, disagreement and conflict are unhealthy. But for financial markets, the opposite is true – it is the lack of disagreement and conflict that is unhealthy. This is because the market needs disagreement to generate liquidity, the ability to trade quickly and in large volume without destabilizing the market price. If I want to buy a share, then somebody must sell me that share. It follows that I and the seller must disagree about the attractiveness of the share at the current price. Likewise, if I and like-minded individuals want to buy ten million shares, it follows that lots of market participants must disagree with us. If lots of market participants do not disagree with us, there will be insufficient liquidity to complete the transaction without a price change. And if too many people are engaged in groupthink, the price change could be extreme. Markets Become Inefficient When There Is Not Enough Disagreement How can there be major disagreement about the attractiveness of an investment when we all have access to the same facts and information? According to the Efficient Market Hypothesis (EMH) there cannot be, because asset prices always reflect all available information.1   Unfortunately, the Efficient Market Hypothesis is flawed. This Holy Grail of financial economics assumes that investors are a homogenous bunch with identical investment horizons, when the reality is that investors have a wide spectrum of time horizons – ranging from the milliseconds of momentum-driven high-frequency trading (HFT) to the decades of a value-driven pension fund. The market is efficient only when a wide spectrum of investment horizons is setting the price, signified by the market having a rich fractal structure. The alternative but less well-known Fractal Market Hypothesis (FMH) recognizes the reality of different time horizons. Crucially, the FMH acknowledges that investors with different time horizons interpret the same facts and information differently. In other words, they disagree (Box I-1). Box 1-1The Efficient Market Hypothesis Does Not Describe The Truth; The Fractal Market Hypothesis Does For example, the momentum-based high frequency trader might interpret a sharp one-day sell-off as a sell signal, but the value-based pension fund might interpret the same information as a buying opportunity. This disagreement will create liquidity without requiring a big price adjustment. Thereby it also fosters market stability. The key conclusion of the Fractal Market Hypothesis is that when the different investment horizons are all active in the market, the price does reflect all available information, meaning that the market is efficient, liquid, and stable. But when the different investment horizons start to converge and coalesce, the market becomes inefficient, illiquid, and vulnerable to a trend reversal. Buy and sell orders will no longer match without a price change, possibly extreme. Can we measure the loss of efficiency in a specific investment, and thereby anticipate a potential trend reversal? The answer is yes, by monitoring its fractal dimension, using the expression in the Appendix. Although many readers may find the concept of a fractal dimension intimidating, the idea is simple and intuitive. It just measures the complexity – or information content – in an object or structure. Thereby, when an investment’s fractal dimension reaches its lower limit, it warns that the information content of longer-term investors is missing from the price.  When the longer-term investors do ultimately re-enter the price setting process, the question is: will they endorse the recent trend because of some major change in the fundamentals – such as the start of the Russia/Ukraine war? Or will they reject it, as an unjustified deviation from a fundamental anchor. In most cases, it is the latter: a rejection and a trend reversal. As few investors are aware of the Fractal Market Hypothesis, it gives a competitive advantage to those that use it to identify potential trend reversals. Fractal Trading Update Using the Fractal Market Hypothesis over the past six months, 5 structured recommendations were closed in profit: Short ILS/GBP, Short Coffee versus Cocoa, Short World Basic Resources versus Market, Long EUR/CHF, and Short Semiconductors versus Tech. A fragile fractal structure warns of a crowded trade. One structured recommendation was closed flat: Short Personal Goods versus Consumer Services. Against this, 3 structured recommendations were closed in loss: Short Nickel versus Silver, Long Polish Bonds versus US Bonds, and Short World Semiconductors versus Biotech. Within the 10 open trades, 3 are in healthy profit, 4 are flat, and 3 are in loss. As for the unstructured recommendations, for which we do not define profit targets or expiry dates, we are pleased to report that out of 31 recommendations, only 2 failed to experience a countertrend reversal. Wins 1) November 18th: Short ILS/GBP Achieved its profit target of 4.2 percent. 2) November 25th: Short Coffee versus Cocoa (Chart I-1) Achieved almost half of its 30 percent profit target at expiry. Chart I-1Fractal Analysis Correctly Predicted A Reversal In Coffee Versus Cocoa 3) January 20th: Short World Semiconductors versus Tech (Chart I-2) Achieved its profit target of 6 percent. Chart I-2Fractal Analysis Correctly Predicted A Reversal In World Semiconductors Versus Technology 4) March 10th: Long EUR/CHF Achieved its profit target of 3.6 percent. 5)  April 14th: Short World Basic Resources versus Market (Chart I-3) Achieved its profit target of 11.5 percent. Chart I-3Fractal Analysis Correctly Predicted A Reversal In World Basic Resources Versus Market In addition, Short World Personal Goods versus Consumer Services which was opened on December 9th reached a high-water mark of 10.5 percent but expired flat. Losses 1) December 2nd: Short World Semiconductors versus Biotech Hit its stop loss of 9.5 percent. 2) January 13th: Long Poland versus US: 10-Year Government Bonds Reached a high-water mark of 3.7 percent, but then reversed to hit its stop loss of 8 percent. In the current geopolitical crisis, Poland has been a casualty due to its lengthy border with Ukraine. 3) February 3rd: Short Nickel versus Silver (Chart I-4) Hit its stop loss at 20 percent following an explosive short-squeeze rally in the Nickel price. Chart I-4Nickel's Short-Squeeze Rally Forced A Price Trend Prolongation Open Trades 1) January 27th: Long MSCI Korea versus All-Country World (Chart I-5) Open, in profit, having reached a high-water mark of 6 percent (versus an 8 percent target). Chart I-5Fractal Analysis Correctly Predicted A Rebound In Korea Versus All-Country World 2) February 24th: Long US Biotech versus US Tech Open, in profit, having reached a high-water mark of 10.5 (versus a 17.5 percent target). 3) March 3rd: Short World Banks versus Consumer Services Reached a high-water mark of 7.3 percent (versus a 12 percent target), but then reversed and is in loss. 4) March 24th: Long 5-Year T-bond Open, in modest loss. 5) April 7th: Short World Non-Life Insurance versus Homebuilders (Chart I-6) Open, in profit having reached a high-water mark of 12.4 percent (versus a 14 percent target). Chart I-6Fractal Analysis Correctly Predicted A Reversal In World Non-Life Insurance Versus Homebuilders 6) April 7th: Long JPY/CHF Reached a high-water mark of 3.4 percent versus a 4 percent target, but then reversed into modest loss. This suggests that the trade needed a narrower profit target. 7) April 28th: Short High Dividend ETF versus US 10-Year T-bond Open, in modest loss, having reached a high-water mark of 2.9 percent (versus a 6 percent target). 8) May 19th: Short FTSE 100 versus STOXX Europe 600 Open, and flat. 9) June 2nd: Long JPY/USD (Chart I-7) Open, and flat. Chart I-7The Sell-Off In JPY/USD Has Reached A Potential Turning Point 10) June 2nd: Short Australia Basic Resources versus World Market (Chart I-8) Open, and flat. Chart I-8The Australian Basic Resources Sector Is Vulnerable To Reversal   Our full watchlist of 29 investments that are at, or approaching turning points, is available on our website: cpt.bcaresearch.com Appendix: Calculating The Fractal Dimension Of A Financial Market Chart 1AUD/KRW Is Vulnerable To Reversal Chart 2Canada Versus Japan Is Reversing Chart 3Canada's TSX-60's Outperformance Might Be Over Chart 4US Healthcare Providers Vs. Software At Risk of Reversal Chart 5BRL/NZD At A Resistance Point Chart 6Homebuilders Versus Healthcare Services Has Turned Chart 7CNY/USD Has Reversed Chart 8CAD/SEK Is Vulnerable To Reversal Chart 9Financials Versus Industrials To Reverse Chart 10The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 11The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 12FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing Chart 13Netherlands Underperformance Vs. Switzerland Is Ending Chart 14The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 15The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 16Food And Beverage Outperformance Exhausted Chart 17The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 18The Strong Trend In The 3 Year T-Bond Is Fragile Chart 19A Potential Switching Point From Tobacco Into Cannabis Chart 20Biotech Is A Major Buy Chart 21Norway's Outperformance Could End Chart 22Cotton Versus Platinum Is Reversing Chart 23Switzerland's Outperformance Vs. Germany Has Ended Chart 24The Rally In USD/EUR Has Ended Chart 25The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 26A Potential New Entry Point Into Petcare Chart 27Czech Outperformance Near Exhaustion Chart 28US REITS Are Oversold Versus Utilities Chart 29GBP/USD At A Turning Point Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Hadi Elzein Research Associate hadi.elzein@bcaresearch.com Footnotes 1  Strictly speaking, the EMH assumes there is some disagreement, but that this disagreement is random and follows a standard Gaussian (bell-curve) distribution. Therefore, the EMH assumes that a share price just follows a random walk until new (unpredictable) fundamental information arrives. 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