Asia

Executive Summary Indonesia’s Balance Of Payments Will Be Under Pressure Indonesian domestic demand is struggling in the face of tight policy settings. High real borrowing costs are constraining credit growth, and hurting non-financial sectors. Monetary authorities have shown little intention to reduce borrowing costs by any good measure, and remain focussed on exchange rate stability. This is a major policy dilemma that the authorities need to break free from before this bourse can embark on a sustainable bull market. Indonesia’s only bright spot since the pandemic, its external accounts, will be deteriorating. Capital inflows will dwindle at a time when the current account balance is set to slip back into deficit. This will put downward pressure on the rupiah, which in turn raises the risk of policy error as the central bank might be tempted to raise rates in a bid to stabilize the currency. Doing so would hurt economic growth and stock prices.  Bottom Line: Currency investors should stay short the rupiah versus the US dollar. Equity investors should wait for relative weaknesses before considering an upgrade in EM and Emerging Asian portfolios. Investors should stay underweight Indonesia in EM local currency bond portfolios. Sovereign EM credit investors, however, should continue to overweight Indonesia. Feature In the past few months, Indonesian stocks have rallied to a pandemic-era high. They have outperformed their emerging market peers as well, albeit from a very low level (Chart 1). Could this mean that Indonesia’s decade-long underperformance is finally coming to an end? We are not convinced. The nation’s equity index in US dollar terms will find it hard to advance to new highs anytime soon. Absolute return investors, therefore, should not chase this bourse up. In terms of relative performance, odds are that some of the recent gains might be lost. The recent outperformance had more to do with investors fleeing Chinese stocks and Indonesia has been one of the major beneficiaries of this rotation (Chart 2). Meanwhile, Indonesia’s policy setting remains quite restrictive. Its external tailwinds are receding as well, which is making the rupiah vulnerable. Chart 1Indonesian Stocks Are Still Not Geared For A Sustainable Bull Market Chart 2Much of The Indonesian Outperformance Had To Do With Investors Leaving China That said, given Indonesia’s drawn-out equity underperformance since early 2013, this bourse’s relative bear market versus the EM benchmark is late. As such, following near-term weaknesses, asset allocators should consider upgrading this bourse from underweight to neutral in EM and Emerging Asian baskets. Domestic bond investors should stay underweight Indonesian local currency bonds in EM and Emerging Asian portfolios. Sovereign credit investors, however, should remain overweight Indonesia. Persistent Domestic Headwinds The recovery in Indonesian domestic demand has been quite slow over the past two years. The top panel of Chart 3 shows that the economy is still struggling. Two years into the pandemic, consumer confidence and retail sales volume are well below pre-pandemic levels. One reason for the muted consumer sentiment is meagre growth in household income. Nominal wage growth has stalled, sapping consumer demand. Wage growth in real terms (deflated by headline CPI) is shrinking outright (Chart 3, bottom panel). Weakness is palpable on the supply side as well. The capacity utilization rate for both manufacturing and other industries remains well below pre-pandemic levels (Chart 4, top two panels), despite the fact that Indonesia’s manufacturing exports have been very strong over the past year (details to come). This underscores the extent of the weakness in domestic demand. Chart 3Consumer Confidence Is Low As Household Income Is Moribund Chart 4Low Capacity Utilization And Labor Usage Points To Poor Domestic Demand Chart 5Fiscal Support Is In Short Supply In line with low capacity utilization, labor usage has also been consistently below par since the onset of the pandemic (Chart 4, bottom panel). That means hiring has been restrained and workers have had little bargaining power, which explains why nominal wage growth has halted. The restrictive macro policy is also exerting a considerable drag on economic recovery. Indonesia’s fiscal stance is rather tight. The government is planning to rein in the fiscal deficit this year to 4.3% of GDP from a revised 4.7% deficit last year. As such, the IMF estimates that the cyclically adjusted fiscal thrust will be a negative 0.9% of potential GDP this year, and a further negative 0.6% next year (Chart 5).  Monetary policy, as we have repeatedly asserted, has remained extremely restrictive for the past six to seven years. Interest rates are prohibitively high.Banks’ lending rates, for instance, have consistently stayed above nominal GDP growth rate since 2012. That will likely be the case going forward as well given the muted growth outlook. If one looks at real bank lending rates (deflated by core CPI) vis-à-vis real GDP, the picture looks even more grim (Chart 6). Such high borrowing costs, which continued for a decade, have been a major headwind for the country’s non-financial sectors. Stock prices of non-financial firms as well as those of SMEs – which had to endure chronically high financing costs − have been in a decade-long bear market in absolute terms. By contrast, banks benefited from the high lending rates, and their share prices have rallied to their pre-pandemic highs (Chart 7). Chart 6Borrowing Costs Have Been Persistently High Relative To The Economy's Growth Rate... Chart 7...Hurting Stocks Of Non-Financial Firms And SMEs, While Benefitting Banks Chart 8Exorbitant Borrowing Costs Have Led To A Stagnation In Credit Penetration Very high real interest rates is one reason Indonesia’s credit penetration, at 34% of GDP, is unusually low for an economy at this stage of development. The ratio has not risen at all in the past 10 years. In fact, it has headed lower recently (Chart 8). This is not a sign of a healthy, recovering economy. As such, for Indonesian stocks to have a sustainable bull market, one of the macro imperatives is that the real borrowing cost needs to decline considerably. Yet, Indonesian monetary authorities have shown little intention to reduce real rates by any meaningful measure. The main reasons behind this hawkish stance on the part of the central bank has had to do with (i) the country’s persistent current account deficit over the past decade, and (ii) the central bank’s mandate of exchange rate stability. Indonesia needed to offer consistently high real rates to attract enough foreign capital so that it can finance its current account deficits, and thereby have a stable rupiah. Yet, that policy has created distortions elsewhere. Persistently high real rates have led to a steady drop in non-financial firms’ return on equity. That, in turn, discouraged foreign equity inflows but encouraged international fixed-income inflows into Indonesia. This is not surprising as equity investors dislike high real rates, while debt investors prefer it. The reliance on foreign debt inflows, in turn, incentivized the authorities to keep real interest rates persistently high − even in periods when growth was rather timid and inflation undershot the central bank’s target. This is a major distortion that the Indonesian economy needs to break free from before this bourse can embark on a sustainable bull market. Incidentally, a bill to expand the central bank’s mandate to include growth and employment was introduced to parliament last year. If passed, the bill-turned-law would allow Bank Indonesia to set interest rates more in line with domestic economic conditions, rather than just focussing on currency stability. Chart 9Inflation Is Inching Up From Very Low Levels Discussions on the bill, however, have been delayed in  Parliament, and it is not clear when, or if, it will be passed. Meanwhile, Bank Indonesia has begun to tighten policy on the margin by draining excess liquidity from the system. More worryingly, the central bank could begin to raise rates in the next couple of months as it fears inflation will creep up due to rising global commodity prices (Chart 9). Outflows from the bond market might also encourage the central bank to raise rates in an attempt to stem them (details in the next section).   Receding External Tailwinds In contrast to Indonesia’s lack of domestic recovery, the country’s external sector was the star performer over the past year or two. Yet, in the next few quarters, it’s the external sector that will likely be a threat to the nation’s growth. This is because Indonesia’s exports are set to shrink and its balance of payments is set to deteriorate. These factors could threaten the rupiah stability, which would then force the central bank to raise rates / tighten liquidity prematurely in a bid to support the rupiah. Tighter policy would be a major headwind for growth, and would hobble stock prices.  Indonesian exports grew remarkably over the past two years, which helped to push the country’s current account balance into surplus for the first time in a decade (Chart 10, top panel). A closer look, however, will reveal that much of it had to do with surging exports to China – which doubled to $55 billion in two years (Chart 11). Chart 10Indonesia's Balance Of Payments Will Be Under Pressure Chart 11Improvements In The Current Account Were Mostly Due to A Surge In Exports To China           That said, much of the improvements in the current account could unravel going forward: Some of the export windfalls accrued to Indonesia when China banned Australian coal imports in 2020 and switched to Indonesian coal instead.   But more recently, a decelerating economy in China has led to slowing electricity generation. The latter has always had a direct bearing on Indonesian coal exports volume – which is now shrinking (Chart 12, top panel). China’s electricity demand and production will slump further due to COVID lockdowns of enterprises and pending weakness in its exports. Chart 12Export Windfalls Are Ending As Chinese Growth Wanes Chinese thermal coal prices have been falling in recent months from the sky-high levels of late 2021, and could fall further by the end of the year as China keeps increasing its own coal output and its electricity generation drops (Chart 12, bottom panel). All these will weigh on Indonesian export earnings in the months to come. For its part, the Indonesian government has restricted coal exports by mandating that miners set aside 25% of their output for local sales as part of their “domestic market obligation.” The government has also banned shipments of some palm oil ingredients for an indefinite period – in an apparent attempt to check domestic food price inflation. Palm oil is the second largest Indonesian export after coal, and together they make up 22% of total export revenues. Indonesia is a large net crude and refined petroleum importer. Global crude prices will likely stay elevated due to sanctions on Russia. This will be a negative for the country’s trade balance. Chart 13Dwindling Goods Demand In The Developed World Will Hurt Indonesian Manufacturing Exports Moving beyond commodities, Indonesian manufacturing exports − which are as large as its’ commodities exports in US dollar terms − will also likely get hurt. A crucial reason for that is a slowing China. Chinese manufacturing imports are set to weaken in the next several months as that economy is entering a soft patch. That usually is an adverse development for Indonesian exports to China (Chart 13, top panel). In fact, Indonesia’s overall manufacturing exports will also likely slow. Falling household goods demand in developed countries will curtail manufacturing exports from Asia, including Indonesia. Notably, early signs of an impending slowdown in Indonesian manufacturing exports often appear in Chinese data − given the heft of the Chinese economy and its trade links in Asia and beyond (Chart 13, bottom panel). More generally, global trade will likely slow going forward, which is a negative for those economies that have relied on an export windfall over the past couple of years. Essentially, the days of boyant current account balances are numbered for Indonesia.  A slipping current account balance could spell larger problems for Indonesia as the country’s financial account surplus has been steadily eroding. From a high of $37 billion annually in 2019, it dropped to just $12 billion by the end of 2021. Much of that drop is due to a fall in net debt inflows – the type of capital inflows Indonesia strives to attract by keeping real interest rates very high (Chart 10, middle panel). Chart 14Falling Real Bond Yields In Indonesia Will Keep Foreign Debt Investors At Bay Critically, the country has not been able to attract much FDI either despite passing an Omnibus Law to boost new investments and create jobs a couple of years back (Chart 10, bottom panel). Chart 14 shows that foreign investor holdings of Indonesian government debt has shrunk materially from almost $80 billion in early 2020 to less than $60 billion now. In terms of their share in total bonds outstanding, the drop is even more remarkable: from 40% of the total to just 18%. Foreign bond purchases clearly react to the ebbs and flows of Indonesian real yields on offer (Chart 14, bottom panel). Given that Indonesian inflation will likely go up from the current very low levels − putting a downward pressure on the real yields available – foreign investors could continue to shun Indonesian bonds. Indonesian policymakers might also worry as such. That apprehension could prompt Bank Indonesia to raise rates preemptively in a bid to attract debt inflows and stabilize the currency. If so, higher real rates would add to the existing policy headwinds for the domestic economy. Growth will suffer; and markets will sell off.  Investment Conclusions The Currency: The rupiah remains vulnerable as the Indonesian balance of payments is set to deteriorate. A slipping current account balance amid receding capital inflows will be putting downward pressures on the rupiah. Stay short the rupiah versus the US dollar. Domestic Bonds: Indonesian bond yields have fallen massively relative to their EM counterparts, and are at 10-year lows in relative terms. As such, the nation’s local currency bonds have little more room to benefit from relative yield compression. The rupiah is also vulnerable. We went underweight Indonesian domestic bonds in November last year, and that recommendation remains in place (Chart 15). Sovereign Credit: Absolute return investors should reduce their exposure as the rupiah weaknesses going forward could lead to widening credit spreads, and result in negative total returns in US dollar terms (Chart 16). Chart 15Stay Underweight Indonesian Domestic Bonds In An EM Bond Portfolio Chart 16Absolute Return Investors Should Reduce Exposure To Indonesian Sovereign Credit   Asset allocators, however, should stay overweight Indonesia in an EM credit basket. This market has transitioned itself into a defensive one over the past several years – thanks to years of orthodox fiscal and monetary policies and low debt. Hence, given that a period of risk-off is around the corner – during which Indonesian credit tends to outperform as it did in 2015 and 2020 − it makes sense to stay overweight this market. Stocks: Absolute return investors should not chase this bourse up. Asset allocators should wait for relative weaknesses before considering an upgrade from underweight to neutral in EM and Emerging Asian portfolios.   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com

Executive Summary Economic Growth in Q2 Will Be Much Softer China’s GDP headline growth in Q1 was better than consensus, but it does not capture the full economic impact of ongoing city lockdowns. Other than infrastructure investment, business activity data from March shows a broad-based slowing in growth momentum. Manufacturing investment decelerated, while both real estate investment and retail sales contracted from a year ago. Exports in value terms continued to grow rapidly through March. However, the resilient rate of expansion is unsustainable given a weakening global manufacturing cycle and softening external demand for goods. China’s domestic supply-chain disruptions will also weigh on its export sector’s activity. Home sales contracted sharply in the first three weeks of April, particularly in larger cities. The lockdowns, coupled with poor funding dynamics among real estate developers, suggest that the real estate sector will remain a huge drag on China’s economy this year. Bottom Line: Even though business activities will resume after the lockdown restrictions are lifted, we do not expect China’s economy to rebound quickly and strongly as it did in 2H20. From a cyclical perspective, we continue to recommend a neutral allocation to Chinese onshore stocks in a global portfolio.   A slew of economic data released during the past two weeks suggests that the negative effects from the COVID-induced lockdowns in China’s largest and most prosperous cities are starting to emerge. The closings, which will likely continue through the end of April, are causing disruptions in both production and demand just as the economy was already in a business downcycle. Other than infrastructure spending, business activity data from March illustrates a broad-based slowing in growth momentum. The longer-term impact of the citywide shutdowns is still to come. Related Report  China Investment StrategyThe Cost Of China’s Zero-COVID Strategy The economic benefits of Beijing’s enhanced stimulus measures will be delayed to 2H22 at the earliest. Moreover, as we discussed in our last week’s report, the post-lockdown recovery in the second half of this year will be much more muted than in H2 2020 . The external environment is less reflationary than in 2H20; China’s domestic demand and sentiment among corporates and households were already declining prior to the latest lockdowns. The deteriorating economic outlook will continue to depress the absolute performance of Chinese onshore stocks in the coming months (Chart 1). Furthermore, against a backdrop of rising US Treasury yields, the interest rate differentials between China and US have become negative for the first time in a decade. A yield disadvantage, coupled with risk-averse sentiment across global financial markets, has discouraged portfolio flows into China. We expect foreign investment outflows to continue in the near term before China’s economy stabilizes sometime in 2H22 (Chart 2). Chart 1Deteriorating Domestic Economic Fundamentals Are The Main Risk To Chinese Onshore Stocks... Chart 2...And Have Triggered Substantial Foreign Investment Outflows From a cyclical perspective, we maintain our neutral position on Chinese onshore stocks in a global portfolio. Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com China’s Credit Conditions: Amble Supply Versus Lack Of Demand Although broad credit growth accelerated in March from the previous month, the improvement mainly reflects a sharp increase in local government bond issuance. Bank loan growth on a year-over-year basis has not improved yet. Loan demand for infrastructure investments escalated, supported by front-loaded fiscal supports in Q1 (Chart 3). However, private-sector credit demand remains very weak. The acceleration in the credit impulse –calculated as a 12-month difference in the annual change in credit as a percentage of nominal GDP –is much more muted when excluding local government bond issuance (Chart 4). Chart 3Infrastructure-Related Bank Loans And Investments Picked Up Sharply In Q1 Chart 4The Rebound In Credit Impulse Is Much More Muted When Excluding Local Government Bond Issuance Sentiment among the corporate and household sectors has plunged to a multi-year low, following two years of stringent COVID-containment measures and last year’s regulatory clampdowns (Chart 5). Furthermore, the corporate sector’s propensity to invest weakened sharply in Q1, despite much looser monetary conditions (Chart 6). A worsening private sector’s sentiment suggests that demand for credit is unlikely to pick up imminently. Chart 5Private-Sector Demand For Credit Remains in The Doldrums... Chart 6...And Unlikely To Turn Around Imminently Despite Accommodative Monetary Conditions Chart 7Significant Foreign Investment Outflows In China's Onshore Bond Market The PBoC announced a 25bps cut in its reserve requirement ratio (RRR) rate on April 15, but has kept its policy rate unchanged. The move was below the market’s expectation of a 50bps RRR cut and/or a policy rate cut. While we still expect that the PBoC will trim the loan prime rate (LPR) in Q2, the recent acceleration in the RMB’s devaluation may make the central bank more cautious in reducing rates and further diverging from the hawkish US Fed and other major central banks  (Chart 7). China GDP: Above-Expectation Growth In Q1, Mounting Concerns In Q2 China’s year-over-year GDP growth in Q1 accelerated to 4.8% from 4.0% in Q4 last year, beating the market expectation of a 4.2% increase. The Q1 growth was mainly supported by strong infrastructure investments and exports (Chart 8). On a sequential basis, however, seasonally adjusted GDP growth in Q1 was 1.3% (non-annualized), slower than Q4’s reading of 1.6% and below its historical mean (Chart 9). Meanwhile, private- sector investment and household consumption remain subdued and activity in the housing sector worsened. Chart 8Economic Growth In Q1 Was Underpinned By Infrastructure Investments And Exports Chart 9Q1 GDP Growth On A Sequential Basis Is Below Its Historical Mean The negative effect from broadening city-wide lockdowns and more supply-chain disruptions in Shanghai and surrounding cities in the Yangtze River Delta region will be much larger in Q2 than in Q1. We expect that year-over-year GDP growth in Q2 will drop well below 4%, sharply down from the 4.8% growth recorded in Q1. Furthermore, the aggregate economic impact from the lockdowns could reduce China’s real GDP growth in 2022 by 1ppt, which poses substantial risks to the country’s 5.5% annual growth target for this year. Exports Growth Set To Decelerate Although the growth of exports in value terms remained resilient in March, China’s exports will be challenged this year by the softening global demand for goods and domestic COVID-induced disruptions in the supply chain. A recent PBoC survey of 5,000 industrial enterprises shows that overseas orders dived sharply (Chart 10). In addition, global cyclical stocks have underperformed defensives. The underperformance has historically been a good leading indicator of a global manufacturing downturn, which will likely lead to a decline in demand for Chinese exports (Chart 11). The weakening external demand is also reflected in softening US demand and falling personal consumption expenditures on goods ex-autos (Chart 12).   Chart 10Overseas Orders For Chinese Industrial Enterprises Dived Sharply Chart 11Global Equity Sector Performance Points To A Relapse In Global Manufacturing Furthermore, China’s imports for processing trade, which historically has been highly correlated with China’s total exports growth, decelerated sharply in March. The drop heralds a slowdown in the growth of Chinese exports in the coming months (Chart 13). Chart 12External Demand For Chinese Export Goods Will Likely Dwindle Chart 13Slowing Processing Imports Point To A Deceleration In Chinese Export Growth   Port congestions and supply-chain disruptions worsened in April after the Shanghai lockdown began on March 28. COVID-related supply-chain disruptions in China’s key ocean ports and reduced shipping volumes will curtail activity of the country’s export sector in the short term. Real Estate Sector Will Remain A Drag On China’s Economy March’s data reflects a broad-based deterioration in housing market activities (Chart 14). The growth in real estate investment rolled over, and all floor space indicators contracted further in March. Moreover, households’ sentiment in the property market remains lackluster (Chart 15). Funding among real estate developers has plummeted to an all-time low, which will continue to dampen housing construction activities (Chart 16). Chart 14A Broad-based Deterioration In Housing Market Indicators In March Chart 15Housing Market Sentiment Shows Little Signs Of Revival Chart 16Housing Construction Activities Are Set To Slow Further Chart 17Home Sales Worsened In April Amid COVID Flareups In Major Cities The March housing transaction data only captures some early indications from the recent round of lockdowns. The negative upshot on home sales will be greater in April. Figures for high-frequency floor space sold show a substantial weakening in home sales, particularly in tier-one and tier-two cities, through the first three weeks of April (Chart 17). The shrinkage in home sales will likely continue through Q2 and poses a significant risk for property investment and construction activities in H2. Regional governments are allowed to initiate their own housing policies, therefore, an increasing number of regional cities have slashed mortgage rates and/or down payment thresholds (Chart 18). However, the easing measures have failed to shore up demand for housing. In addition, pledged supplementary lending, which the government used to monetize massively excess inventories in the 2015/16 market, resumed its downtrend in March after a short-lived rebound earlier this year (Chart 19). Chart 18More Regional Cities Have Eased Local Housing Policies Chart 19PSL Injections Resumed Downward Trend In March Subdued Domestic Demand And Household Consumption Chart 20Strong Pickup In Infrastructure Investment Growth Failed To Offset The Deceleration In Manufacturing And Real Estate Investments China’s domestic demand remained weak in March and will likely worsen in the next few months when more negative fallout from the recent lockdowns spill over to the aggregate economy.   Infrastructure investments picked up strongly in March. However, robust infrastructure investments were insufficient to fully offset the weakness in capital spending in the real estate and manufacturing sectors (Chart 20). The sluggish housing market and a deceleration in exports growth will likely slow China’s capital spending further in Q2. Growth in China’s imports in value terms contracted slightly in March; this was the first time since September 2020. Meanwhile, import growth in volume terms contracted sharply amid weak domestic demand and the early effects of supply-chain disruptions (Chart 21). Moreover, imports of major commodities in volume shrank deeper in March (Chart 22).  Chart 21Chinese Imports Value Growth Fell Into Contraction In March Chart 22The Volume Of China's Key Commodity Imports Contracted Further In March Household consumption has been a laggard in China’s economy in the past two years and the wave of city lockdowns are taking a heavy toll on consumption. Retail sales growth contracted in March, for the first time since August 2020 (Chart 23). Notably, online sales of goods also slowed to a multi-year low, highlighting not only subdued demand but also COVID-related logistic interruptions. Chart 23Retail Sales Growth Slipped Below Zero Chart 24Tame Core And Service CPIs Also Reflect Sluggish Household Demand Weakening core and service CPI readings also reflect a lackluster demand from consumers (Chart 24). We expect that the ongoing lockdowns will continue to weigh on service sector activity and household consumption, at least for the next couple of months (Chart 25). In addition, labor market dynamics are worsening rapidly and the nationwide urban unemployment rate rose to its highest level since mid-2020. The employment situation will also curb household consumption in the medium-term (Chart 26). Chart 26Labor Market Situation Is Deteriorating Sharply Chart 25Surging COVID Cases And Stringent Countermeasures Will Continue To Curb Service Sector Activities Table 1China Macro Data Summary Table 2China Financial Market Performance Summary   Footnotes Strategic Themes Cyclical Recommendations

Listen to a short summary of this report.         Executive Summary Small Caps Are Looking Attractive Relative To Their Large Cap Peers Adverse supply shocks have pushed down global growth this year, while pushing up inflation. With the war raging in Ukraine and China trying to contain a major Covid outbreak, these supply shocks are likely to persist for the next few months. Things should improve in the second half of the year. Inflation will come down rapidly, probably even more than what markets are discounting. Global growth will reaccelerate as pandemic headwinds abate. The return of Goldilocks will allow the Fed and other central banks to temper their hawkish rhetoric, helping to support equity prices while restraining bond yields. Unfortunately, this benign environment will sow the seeds of its own demise. Falling inflation during the remainder of the year will lift real incomes, leading to increased consumer spending. Inflation will pick up towards the end of 2023, forcing central banks to turn hawkish again. Trade Inception Level Initiation Date Stop Loss Long iShares Core S&P Small Cap ETF (IJR) / SPDR S&P 500 ETF (SPY) 100 Apr 21/2022 -5% Trade Recommendation: Go long US small caps vs. large caps via the iShares Core S&P Small-Cap ETF (IJR) and the SPDR S&P 500 ETF (SPY). Bottom Line: Global equities are heading towards a “last hurrah” starting in the second half of this year. Stay overweight stocks on a 12-month horizon. Push or Pull? Economists like to distinguish between “demand-pull” and “cost-push” inflation. The former occurs in response to positive demand shocks while the latter reflects negative supply shocks. In order to tell one from the other, it is useful to look at real wages. When real wages are rising briskly, households tend to spend more, leading to demand-pull inflation. In contrast, when wages fail to keep up with rising prices, it is a good bet that we have cost-push inflation on our hands. Chart 1 shows that real wages have been falling across the major economies over the past year. The decline in real wages has coincided with a steep drop in consumer confidence (Chart 2). This points to cost-push forces as the main culprits behind today’s high inflation rates. Chart 1Real Wages Are Declining Chart 2Consumer Confidence Has Soured A close look at the breakdown of recent inflation figures supports this conclusion. The US headline CPI rose by 8.5% year-over-year in March. The bulk of the inflation occurred in supply-constrained categories such as food, energy, and vehicles (Chart 3). Chart 3The Acceleration In Inflation Has Been Driven By Pandemic And War-Impacted Categories The Toilet Paper Economy When the pandemic began, shoppers rushed out to buy essential household supplies including, most famously, toilet paper. Chart 4In A Break From The Past, Goods Prices Soared During The Pandemic The toilet paper used in offices is somewhat different than the sort used at home. So, to some extent, work-from-home (and do other stuff-at-home) arrangements did boost the demand for consumer-grade toilet paper. However, a much more important factor was household psychology. People scrambled to buy toilet paper because others were doing the same. As often occurs in prisoner-dilemma games, society moved from one Nash equilibrium – where everyone was content with the amount of toilet paper they had – to another equilibrium where they wanted to hold much more paper than they previously did. What has gone largely unnoticed is that the toilet paper fiasco was replicated across much of the global supply chain. Worried that they would not have enough intermediate goods on hand to maintain operations, firms began to hoard inputs. Retailers, anxious at the prospect of barren shelves, put in bigger purchase orders than they normally would have. All this happened at a time when demand was shifting from services to goods, and the pandemic was disrupting normal goods production. No wonder the prices of goods – especially durable goods — jumped (Chart 4).   Peak Inflation? The war in Ukraine could continue to generate supply disruptions over the coming months. The Covid outbreak in China could also play havoc with the global supply chain. While the number of Chinese Covid cases has dipped in recent days, Chart 5 highlights that 27 out of 31 mainland Chinese provinces are still reporting new cases, up from 14 provinces in the beginning of February. The number of ships stuck outside of Shanghai has soared (Chart 6). Chart 527 Out Of 31 Chinese Provinces Are Reporting New Cases, Up From 14 Provinces In The Beginning Of February Chart 6The Clogged-Up Port Of Shanghai Chart 7Inflation Will Decelerate This Year Thanks To Base Effects Nevertheless, the peak in inflation has probably been reached in the US. For one thing, base effects will push down year-over-year inflation (Chart 7). Monthly core CPI growth rates were 0.86% in April, 0.75% in May, and 0.80% in June of 2021. These exceptionally high prints will fall out of the 12-month average during the next few months. More importantly, goods inflation will abate as spending shifts back toward services. Chart 8 shows that spending on goods remains well above the pre-pandemic trend in the US, while spending on services remains well below. Excluding autos, US retail inventories are about 5% above their pre-pandemic trend (Chart 9). Core goods prices fell in March for the first time since February 2021. Fewer pandemic-related disruptions, and hopefully a stabilization in the situation in Ukraine, could set the stage for sharply lower inflation and a revival in global growth in the second half of this year. How long will this Goldilocks environment last? Our guess is that it will endure until the second half of next year, but probably not much beyond then. As inflation comes down over the coming months, real income growth will rise. What began as cost-push inflation will morph into demand-pull inflation by the end of 2023. The Fed will need to resume hiking at that point, potentially bringing rates to over 4% in 2024. Chart 8Spending On Services Remains Well Below The Pre-Pandemic Trend, While Spending On Goods Is Above It Chart 9Shelves Are Well Stocked In The US Investment Implications Wayne Gretzky famously said that he always tries to skate to where the puck is going to be, not where it has been. Macro investors should follow the same strategy: Ask what the global economy will look like in six months and invest accordingly. The past few months have been tough for the global economy and financial markets. Last week, bullish sentiment fell to the lowest level in 30 years in the American Association of Individual Investors poll (Chart 10). Global growth optimism dropped in April to a record low in the BofA Merrill Lynch Fund Manager Survey.    Chart 10AAII Survey: Equity Bulls Are In Short Supply Chart 11The Equity Risk Premium Remains Elevated Yet, a Goldilocks environment of falling inflation and supply-side led growth awaits in the second half of the year. Even if this environment does not last beyond the end of 2023, it could provide a “last hurrah” for global equities. Despite the spike in bond yields, the earnings yield on stocks still exceeds the real bond yield by 5.4 percentage points in the US, and by 7.8 points outside the US (Chart 11). TINA’s siren song may have faded but it is far from silent. Global equities have about 10%-to-15% upside from current levels over a 12-month horizon. We recommend that investors increase allocations to non-US stock markets, value stocks, and small caps over the coming months (see trade recommendation below). Consistent with our view that the neutral rate of interest is higher than widely believed in the US and elsewhere, we expect the 10-year Treasury yield to eventually rise to around 4% in 2024. However, with US inflation likely to trend lower in the second half of this year, we do not expect much upside for yields over a 12-month horizon. If anything, the fact that bond sentiment in the latest BofA Merrill Lynch survey was the most bearish in 20 years suggests that the near-term risk to yields is to the downside.  Trade Idea: Go Long US Small Caps Versus Large Caps Small caps have struggled of late. Over the past 12 months, the S&P 600 small cap index has declined 3%, even as the S&P has managed to claw out a 5% gain. At this point, small caps are starting to look relatively cheap (Chart 12). The S&P 600 is trading at 14-times forward earnings compared to 19-times for the S&P 500. Notably, analysts expect small cap earnings to rise more over the next 12 months, as well as over the long term, than for large caps. Chart 12Small Caps Are Looking Attractive Relative To Their Large Cap Peers Chart 13Small Caps Tend To Outperform When Growth Is Picking Up And The Dollar Is Depreciating Small caps tend to perform best in settings where growth is accelerating and the US dollar is weakening (Chart 13). Economic growth should benefit from a supply-side boost later this year as pandemic headwinds fade and more low-skilled workers rejoin the labor market. With inflation set to decline, the need for the Fed to generate hawkish surprises will temporarily subside, putting downward pressure on the dollar. Investors should consider going long the S&P 600 via the iShares Core S&P Small-Cap ETF (IJR) versus the S&P 500 via the SPDR S&P 500 ETF (SPY). Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on  LinkedIn Twitter   Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Special Report

Executive Summary The Declining Value Of An Old Friendship India may buy cheap oil from Russia, but oil alone cannot expand this partnership. India needs to maintain a balance of power against China and Pakistan. With Russia’s heft set to decline, India will be compelled to explore a configuration with America. India will slowly yet surely move into America’s sphere of influence. Strong geopolitical as well as economic incentives exist for both sides to develop partnership. The US’s grand strategy will continue to collide with that of Russia and China. China will increasingly align with Russia and is doomed to stay entangled in a strategic conflict with India. With India a promising emerging market set to cleave to America, we reiterate our strategic buy call on India. Tactically however we are bearish on India. We also recommend investors go strategically long Indian tech / short Chinese tech. This pair trade is likely to keep rising on a secular basis. Trade Recommendation Inception Date Return LONG INDIAN TECH / CHINESE TECH EQUITIES 2022-04-21   Bottom Line: For reasons of geopolitics as well as macroeconomics, we maintain our constructive view on India and our negative view on China on a strategic time frame. On a tactical timeframe, we remain sellers of India given cyclical political and macro risks. Feature Russia’s invasion of Ukraine has forced all players at the global geopolitical table to show their hand. The one major player at the table who is yet to show her cards is India. Which side India choses matters. Its geopolitical rise is one of the many reasons we live in a brave new multipolar world. India will gain influence in the global economy as a large buyer of oil and guns and as a user of tech platforms and capital. Related Report  Geopolitical StrategyFrom Nixon-Mao To Putin-Xi The situation is complicated by mixed signals. India has played a geopolitically neutral or “non-aligned” role for most of its time since independence in 1947. Those who believe India will stay neutral point to the fact that India has continued buying oil from Russia and has abstained from voting on both anti-Russia and anti-Ukrainian resolutions at the United Nations. Those who predict that India will side with Russia have trouble explaining how India will get along with China, which committed to a “no limits” strategic partnership with Russia prior to the invasion. Those who speculate that India will align with the US have trouble explaining India’s persistent ties with Russia and the Biden administration’s threat of punishment for those who help Russia circumvent US sanctions. In this report we argue that the Indo-Russian friendship is destined to fade over a long-term, strategic horizon. The reason is simple: Russia’s geopolitical power is fading and hence it can no longer help India meet its regional security goals. The growing Russia-China alignment will only alienate India further. Hence, we expect the relationship between India and Russia to be reduced to a transactional status – mainly trade in oil and guns over the next few years, while strategic realities will drive India to tighten relations with the US and its Asian allies. Three geopolitical forces will break down the camaraderie between India and Russia, namely: (1) A collision in the grand strategies of America with that of both China and Russia, (2) India’s need to align with the US to underwrite its own regional security, and (3) China’s rising distrust of India as India aligns with the US and its allies. In fact, we expect China and India to stay embroiled in a strategic conflict over the next few years. Any thaw in their relations will be temporary at best. The rest of this report explains and quantifies these forces. We conclude with actionable investment conclusions. Let’s dive straight in. US Versus China-Russia: A Grand Strategy Collision “For the enemy is the communist system itself – implacable, insatiable, unceasing in its drive for world domination … For this is not a struggle for supremacy of arms alone – it is also a struggle for supremacy between two conflicting ideologies: freedom under God versus ruthless, Godless tyranny. “ – John F. Kennedy, Remarks at Mormon Tabernacle, Utah (September 1960) Chart 1China’s Is An Export-Powered Economic Heavyweight It’s been six decades since these words were spoken and today the quotation is more relevant than at any time since the Cold War ended in 1991. The excerpt captures how the Biden administration has positioned itself with respect to Russia and China, only replacing “communist” with “autocratic” in Russia’s case. The Ukraine war helps America advance its grand strategy with respect to Russia. The Ukraine war is steadily draining Russia’s already limited economic might. Western sanctions aim to weaken Russia further. Russia’s military capabilities are now in greater doubt than before, so that its only remaining geopolitical strengths are nuclear weapons and, significantly, its leverage as an energy supplier. With Russia weakened, yet capable of reinforcing China, America will focus more intensely on China over the coming years and the breakdown in US-China relations will only accelerate. China is a genuine economic competitor to the United States (Chart 1). Its strategic rise worries America. To make matters worse, America poses a unique threat to China. China relies heavily on energy imports (Chart 2) from the Middle East (Chart 3). This is a source of great vulnerability as China’s fuel imports must traverse seas that America controls (Map 1). During peace time, and periods of robust US-China strategic engagement, this vulnerability is not an issue. But China is acutely aware that America has the capability to choke China’s energy access at will in the event of hostilities, just as it did to Japan in World War II. Russia has managed to wage war in Ukraine, against US wishes, since it is a net energy supplier to Europe and the global economy. Chart 2China And India Rely On Imports For Energy​​​​​ Chart 3India And China Both Depend On Middle East For Oil​​​​​​ Map 1US Military Footprint In Middle East Threatens China … Yet US Presence In South Asia Is Weak Atop China’s fuel-supply related insecurities, America has begun a strategic pivot to Asia in recent years. For instance, America has pulled troops out of Iraq and Afghanistan, declared a trade war on China, and strengthening strategic alliances and partnerships with regional geopolitical powers like India and Australia (Table 1). The US has retained its alliance with the Philippines despite an adverse government there, while South Korea has just elected a pro-American president again. With Japan, South Korea and Australia aligned militarily with the US, China’s naval power pales in comparison (Chart 4). Table 1America’s Influence In Asia Is Rising Chart 4China’s Naval Power Pales Versus US Allies In Asia Now China cannot watch America refurbish its grand strategy in Asia silently. Given China’s need for supply security, geopolitical independence, and regional influence, Beijing will double down on building its influence in Asia and in the eastern hemisphere. Against this backdrop of US-China competition, military conflict becomes increasingly likely, especially in the form of “proxy wars” involving China’s neighbors but conceivably even in the form of US-China naval warfare. China’s plans to modernize and enhance its economic prowess will add to America’s worries (Chart 5). A bipartisan consensus of American lawmakers is focused on reviving America’s economic strength but simultaneously limiting China’s benefit by restricting Chinese imports and American high-tech exports (Chart 6). Since Beijing cannot afford to base its national strategy on the hope of lingering American engagement, US-China trade relations will weaken regardless of which party controls the White House. Chart 5China’s Growing Might Worries America​​​​​​ Chart 6US Growth Does Not Equal Growth In Imports From China ​​​​​​ The consensus in global financial media (which we never bought) held that the Biden administration would reduce tensions with China – but the détente never occurred and the remaining window for détente is limited by the uncertainty of the 2024 election. The US is currently occupied with Russia but threatening to impose secondary sanctions on China if it provides military assistance or circumvents sanctions. The Russo-Ukrainian war has led to an energy price shock that hurts an industrial economy like China’s. For the rest of this year China’s leaders will be consumed with managing the energy shock, a nationwide Covid-19 outbreak, and the important political reshuffle this fall. Only in 2023 will Beijing have room for maneuver when it comes to the US. But the US cannot return to engagement, which strengthens China’s economy, while China cannot open up to the US economy and become more exposed to future US sanctions. Bottom Line: A grand strategy collision between the US and China is certain. US dominance of sea routes that China uses for energy imports necessarily intimidates China. America’s pivot to Asia threatens China’s regional influence. This will prompt China to restrict American advances in strategic geographies —and not only the Taiwan Strait but also, as we will see, in South Asia. US-India Strategic Alignment: Only A Matter Of Time “If they [nation states] wish to survive, they must be willing to go to war to preserve a balance against the growing hegemonic power of the period.” – Nicholas J. Spykman, America's Strategy in World Politics (Harcourt, Brace and Co, 1942) For reasons of strategy, China will continue to build its influence in South Asia. South Asia offers prospects of sea access to the Indian Ocean, namely via Pakistan. This factor could ease China’s fuel supply insecurities. Also, penetrating northern India helps China set up a noose around India’s neck, thus neutralizing a potential enemy and US ally. In short China will pursue a two-pronged strategy of Eurasian development and naval expansion, both of which threaten India. Against this backdrop, India needs US support to counter Pakistan to its west, China’s latest intrusions into its eastern flank (Map 2), and China’s maritime challenge. India has historically spent generously on defense, but its military might pales in comparison to that of China. Even partial support from America would help India make some progress toward a balance of power in South Asia (Chart 7). Map 2China’s Newfound Interest In India’s Eastern Flank Chart 7America Can Provide Military Heft To India​​​​​​ Chart 8US Is A Key Trading Partner For India​​​​​​ There’s another reason why US alignment makes sense for India. Much like China, India is highly import-dependent for its fuel needs (Chart 2). Given India’s high reliance on the Middle East for energy, India stands to benefit from America’s solid military footprint in this region (Map 1). The US too has a motive in exploring this alliance. India can provide a strategic foothold on the Eurasian rimland. America will value this new access route to Eurasia because America knows that its military footprint in South Asia is surprisingly weak – a weakness it needs to address against the backdrop of China’s increasing influence in the region (Map 1). Meaningful economic interests also underpin the US-India relationship. India and the US appear like sparring partners from time to time. The US may raise issues of human rights violations in India and the two may bicker over trade. However there exist strong economic incentives for the two countries to keep their differences under check and develop a long-term strategic partnership. The US is a major user of India’s software services and buys nearly a fifth of India’s merchandise exports. The trading relationship that India shares with the US is far more developed than India’s trading relationship with China and Russia (Chart 8). Capital is a factor of production that India desperately needs to finance its high growth. America and its allies are also major suppliers of capital to India (Chart 9). India is averse to granting China the political influence that would go along with major capital infusions and direct investments. Chart 9US And Its Allies Are Major Suppliers Of Capital To India​​​​​​ Chart 10India Offers US Firms Access To High Growth​​​​​​ Chart 11India Is A Key Market For American Big Tech India on its part is a large marketplace which offers high growth prospects (Chart 10) and remains open and accessible to American corporations (unlike say Russia or China). The growth element is something that American firms will value more over time, as the American economy is mature and has a lower potential growth rate. Most importantly if the US imposes sanctions on India, then two key business lobbies are sure to mitigate the damage. In specific: Since India is a key potential market for American tech firms (Chart 11), Big Tech will always desire amicable Indo-US relations. Since India is the third largest buyer of defense goods globally, American defense suppliers will have similar intentions. In both cases, US policy planners will support these industries’ lobbying efforts due to the grand strategic considerations outlined above. Bottom Line: India will slowly yet surely move into America’s sphere of influence. Notwithstanding persistent differences, the Indo-US relationship will strengthen over a strategic timeframe. Strong geopolitical motives as well as notable economic incentives exist for both sides to develop this alignment. Indo-Russian Alignment: Destined To Fade The Indo-Russian friendship can be traced back to the second half of the 20th century. The fulcrum was the fact that Russia was a formidable land-based power and provided an offset against threats from China and Pakistan (Chart 12). The finest hour of this friendship perhaps came in 1971 when Russia sided with India in its war with Pakistan. India’s citizens hold an unusually favorable opinion of Russia (Chart 13). Chart 12The Declining Value Of An Old Friendship​​​​​​ Chart 13Indians Hold A Favorable Opinion Of Russians ​​​​​​ Despite this rich past, the Indo-Russia friendship is doomed to fade over a strategic timeframe. Even if  Russia’s share in Indian oil rises from current low levels of 2%, this glue alone cannot hold the Indo-Russian relationship together for one key reason: Russia’s geopolitical might has been waning and Russia can no longer help India establish a balance of power against China and Pakistan (Table 2). In fact, since 2006, the Russo-Indian partnership has been commanding lower geopolitical power than that of China (Chart 12). Table 2Russia’s Military Heft Is Of Limited Use To India Today Managing regional security is a key strategic concern for India. As Russia’s geopolitical power wanes so will India’s utility of Russia as an effective guarantor of India’s security. Russia’s war in Ukraine is ominous in this regard, as Russian armed forces were forced to retreat from Kyiv, while the country’s already bleak economic prospects have worsened under western sanctions. The solidification of the China-Russia axis will alienate India further (Chart 14). China is essential to Russia’s economy now while Moscow is essential to China’s Eurasian strategy of bypassing American naval dominance to reduce its supply insecurity. Russia holds the keys to Central Asia, from a military-security point of view, and hence also to the Middle East. Furthermore, limited economic bonds exist to prevent India and Russia from falling out. Russia accounts for a smidgen of India’s trade (Chart 8). India is Russia’s largest arms client (accounting for +20% of its arms sales) but this reliance could also decline over time: The Indian government has been pursuing a range of policies to increase the indigenous production of arms. This is a strategic goal that would also reinforce India’s economic need for more effective manufacturing capabilities. Russia’s own defense franchise had been coming under pressure, even before the Ukraine war (Chart 15). On the contrary, Western arms manufacturers’ franchise has been steadily growing. Chart 14China-Russia Axis Will Alienate India ​​​​​ Chart 15The Rise & Rise Of Western Arms Manufacturers ​​​​​​ While the US may look the other way in the short term when India buys arms from Russia, over a period of time the US is bound to pull India away by using a combination of sticks (mild sanctions) and carrots (heavy discounts). Two aforementioned external factors will also work against the Indo-Russia relationship namely (1) The Russo-Chinese alignment and its clash with US grand strategy and (2) The coming-to-life of a US-India strategic alignment. Bottom Line: India’s need for cheap oil will preserve basic Indo-Russian relations for some time. But oil alone cannot drive a deeper strategic alignment. Regional security concerns are paramount for India. Russia’s geopolitical decline will force India to explore an alignment with America, which will offer India security in the Indian Ocean and Persian Gulf in the face of China’s emergence in this region. Is A Realignment In Indo-China Relations Possible? But why should India not join the other Asian giants to balance against America’s threat of global dominance? Would such a bloc not secure India’s interests? And what if the US imposes harsh sanctions for India’s continued trade with Russia and strategic neutrality? Or what if a future US administration grows restless and attempts to force India to choose sides sooner rather than later? Even if the US offends India, it will only lead to a temporary improvement in India’s ties with the China-Russia alliance. This is because America stands to lose if India cleaves towards the Sino-Russian alliance and would thus quickly correct its policy. In specific: Security Interests: America will risk losing all influence in South Asia if India were to cleave towards China. India provides a key foothold for America to control China’s regional ascendance especially given that the US has now withdrawn from Afghanistan and its bilateral relations with Pakistan are weak. Business Interests: India’s movement into the China-Russia sphere of influence can have adverse business implications for American corporations and US allies, given that the US is abandoning the Chinese market over time, while India is a large and fast-growing consumer of American tech exports and services. India could emerge as a major buyer of American defense goods and will import more and more energy provided by the US and its partners in the Persian Gulf. These business groups will lobby for the withdrawal of US sanctions on India given India’s long-term potential. Meanwhile any improvement in Indo-Chinese relations will have a limited basis. In specific: Ascendant Nationalism In China And India: China’s declining potential GDP is motivating a rise in nationalism and an assertive foreign policy. Meanwhile India’s inability to create plentiful jobs for a young and growing population is also fuelling a wave of nationalism. A historic turn toward Sino-Indian economic engagement would require the domestic political ability to embrace and promote each other’s well-being. Pakistan Factor: India’s eastern neighbor Pakistan is controlled by its military. The military’s raison d'être is enforced by maintaining an aggressive stance towards India, while pursuing economic development through whatever other means are available. As long as Pakistan’s military stays influential its stance towards India will be hostile. And as long as Pakistan’s economy remains weak (Chart 16), its reliance on China will remain meaningful (Chart 17). Chart 16Pakistan: High Military Influence, Low Economic Vigor ​​​​​​ Chart 17China & Pakistan: Iron Brothers?​​​​​​ Chart 18Indians View China And Pakistan Negatively   China also benefits from its alliance with Pakistan because it provides an alternative entry point into India and access to the Indian Ocean. Fundamental Distrust: For reasons of history, Indians harbor a negative opinion of both Pakistan and China (Chart 18). This factor reinforces the first point that any Indian administration will see limited political dividends from developing a long-term alignment with China or with Pakistan. Bottom Line: If any Indo-Chinese détente materializes owing to harsh US sanctions, which we do not expect, the result will be temporary. America has limited incentives to push India towards the Sino-Russian camp. More importantly, China and India will stay entangled in a strategic conflict for reasons of both history and geography. Investment Conclusions Chart 19Sell India Tactically But Buy India On A Strategic Horizon The historic Indo-Russia relationship will weaken over the next few years as India and Russia explore new alignments with USA and China respectively. The relationship may not collapse entirely but has limited basis to grow given Russia’s declining geopolitical clout. Indo-American economic interests are set to deepen not just for reasons of security. India may consider looking for alternatives to Russian arms in the American defense industry while American Big Tech will be keen to grow their footprint in India. With India set to cleave to America, a country whose geopolitical power remains unparalleled today, we reiterate our constructive long-term investment view on India (Chart 19). However, tactically we remain worried about near-term geopolitical and macro headwinds that India must confront. China will strengthen relations with Russia over the next few years. It needs Russia’s help to execute its Eurasian strategy and to diversify its sources of fuel supply, over the long run. Given that the US and its allies will be engaged in a conflict with China over a strategic horizon, we reiterate our strategic sell call on China. Tactically we are neutral on Chinese stocks, given that they have already sold off sharply in accordance with our views over the past two years. In view of both these calls, we urge clients with a holding period mandate of more than 12 months to reduce exposure to Chinese assets and increase exposure to Indian assets. We also recommend investors go strategically long Indian tech / short Chinese tech. This pair trade is likely to keep rising on a secular basis.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary China’s Daily New COVID Cases And City Lockdowns, 2020 To Present The ongoing wave of local Omicron infections and city lockdowns pose the largest macro risk in China post Q1 2020. The current lockdowns in major cities - including Shanghai - may shave one percentage point from China’s 2022 GDP growth. Restrictions on activity and travel in Shanghai and surrounding areas in the Yangtze River Delta have led to severe supply-chain disruptions, created by both port and highway transportation congestion and manufacturing plant shutdowns. Unlike in 2H20, chances are lower for a quick and strong post-lockdown recovery in China’s economy and stock prices because the nation’s policy easing will be less aggressive and is less effective than two years ago. The scale of China’s monetary easing will be smaller than in H1 2020 given the Fed is rising interest rates. The country’s fiscal balance sheet is also in worse shape than in 2020, particularly at the local level.  Bottom Line: The wave of lockdowns in China’s major cities will pose substantial risks to China’s economy this year. The post-lockdown recovery will likely be more muted than in 2H20 because there is limited room for the country to stimulate its economy and policy easing measures will likely be less effective than two years ago.   Chart 1China's Daily New COVID Cases And City Lockdowns, 2020 To Present The ongoing lockdowns linked to the spike in Omicron and China’s zero tolerance towards COVID are exacting a heavy toll on China’s economy. While the situation is fluid and official data is lagging, China’s economy faces the largest macro risk since early 2020. In the past four months, China has imposed more lockdowns, with full and partial mobility restrictions, than in the past two years combined (Chart 1). In particular, this round of citywide shutdowns occurred in some of China’s largest and most prosperous cities, such as Shanghai and Shenzhen, and several manufacturing hubs including Jilin province and cities in the Yangtze River Delta region. Furthermore, the post-lockdown recovery this year will likely be more muted than two years ago. Beijing has less room to ease policy and stimulate the economy than in early 2020. In addition, policy easing measures will be less effective in boosting domestic demand, given that private sector sentiment was already downbeat prior to the lockdowns and the country’s zero-COVID policy may lead to more stringent confinement measures in the rest of the year. Serious Economic Implications China’s aggregate economy is suffering significant damage from the current round of city- and province-wide lockdowns in some of China’s most populous and prosperous regions. Chart 2The Economic Impact From Hubei Lockdown In Q1 2020 Economic data following the shutdown of Hubei province in early 2020 can serve as a roadmap to illustrate what to expect from lockdowns in Shanghai, which accounts for 4% of China’s GDP and is the same size as Hubei. During a 60-day lockdown in Q1 2020, Hubei’s retail sales growth nose-dived by 43 percentage points (ppt) and fixed-asset investment growth tumbled by 83ppt in Q1 2020 compared with the previous three months (Chart 2). The aggregate economy in Hubei shrank by 40% in Q1 2020 from a year ago and the decline likely reduced Chinese GDP growth by 1.5% in that quarter alone (Chart 3). The lockdown also dragged Hubei’s government revenues, tourism income and corporate profits into a deep contraction for 2020 (Chart 4). Chart 3The Economic Impact From Hubei Lockdown In Q1 2020 Chart 4The Economic Impact From Hubei Lockdown In Q1 2020 A recent study estimating the economic impact of lockdowns by analyzing the flow of intercity trucking found that freight traffic would plummet by 54% under a full lockdown for a month, versus a 20% drop under a partial lockdown. In addition, the ripple effect of a lockdown would be felt by surrounding cities. According to the article, if the four most important economic centers of the country - Beijing, Shanghai, Guangzhou and Shenzhen - are shut down for one month at the same time, then their real income in that month would decrease by a whopping 61%. Meanwhile, the national real income in the same period would shrink by 8.6%, which translates into a 1ppt decline in China’s annual GDP growth. The scenario that China’s four major cities would be locked down was inconceivable before the onset of Omicron. However, as of April 15, it is estimated that local cities that have experienced full or partial lockdowns account for about 40% of China’s GDP, affecting more than 250 million residents. As such, the aggregate economic losses from the current round of lockdowns could reach 1ppt of China’s 2022 GDP growth. Bottom Line: The economic impact from the current lockdowns has the potential to reduce China’s GDP growth by 1ppt in 2022. Supply Chain Disruptions Shanghai’s lockdown has had economic repercussions on the Yangtze River Delta region, an important manufacturing hub and key supplier in the automobile and electronic equipment industries. Cross-regional travel restrictions have led to supply-chain disruptions through transportation blockades and manufacturing plant shutdowns. These obstacles include: Table 1Top Ten Ports In China Increased port congestion. The Ports of Shanghai and its nearby Ningbo handle nearly 30% of China’s total ocean shipping volume and are key barometers of China’s foreign trade and logistics chain (Table 1). Data from VesselsValue shows an almost fivefold increase in the number of ships waiting to load or discharge at Shanghai in the second half of March (Chart 5). Port congestion worsened in April after the Shanghai lockdown began on March 28. Chart 5Ships Waiting To Load Or Discharge At Shanghai Port Chart 6Chinese Suppliers' Delivery Times Have Lengthened Road transport blockades. Road traffic in the Yangtze River Delta has been restricted, causing significant delays in suppliers’ delivery times (Chart 6). By April 7, nationwide vehicle logistics freight flow fell by 32% from a year ago and plunged more than 80% in the Shanghai area. Highway traffic mobility tracked by Gaode dipped to the same level as in early 2020. Production suspensions. A significant number of businesses from automakers Tesla and Volkswagen to notebook manufacturer Quanta Computer Inc. reportedly suspended operations at their Shanghai plants to comply with government restrictions for virus control. ​​​​​​​The city, together with Jilin and Guangdong provinces, account for more than 30% of China’s auto production. Even if employees at auto and chip makers in Shanghai can return to production plants and work through a “closed-loop” system whereby they live on-site and test regularly, a more serious challenge would be how manufacturers can secure trucks to get materials and products delivered on time.1 Supply-chain disruptions are starting to impact China’s trade. The country’s import growth in nominal value in March dropped sharply to a 0.1% contraction (on a year-on-year basis) (Chart 7). Even though China’s exports in March expanded by 14.7% from a year ago, exports are below that of its Asian manufacturing neighbors, such as South Korea and Vietnam (Chart 8). Chart 7Chinese Import Growth Fell Into Contraction In March Chart 8China's Export Growth Has Dropped Below That Of Vietnam And South Korea Bottom Line: The Shanghai lockdown is having spillover effects on the Yangzte River Delta region through supply-chain disruptions. Strong Post-Lockdown Rebound? Chart 9China Will Need A Stimulus That Is Comparable To 2020 China’s economic growth and stock prices will unlikely repeat the quick and strong recovery registered following the early 2020 lockdown. Beijing has stepped up policy supports, but the challenges from both domestic conditions and the external environment are greater than in 2020. Thus, the country’s stimulus (measured by credit growth including local government bond issuance) will need to at least be similar to that of two years ago to shore up the economy (Chart 9). We are skeptical about both the magnitude and effectiveness of the stimulus in 2022, despite policymakers’ mounting efforts to support the economy. Therefore, we maintain a cautious view on Chinese risk assets (in both onshore and offshore markets).  Our view is based on the following: There may be more frequent shutdowns of business activity as China continues upholding its zero-COVID approach.  Even as we go to press, a few cities that recently recovered from COVID outbreaks have failed to resume their business and social activities. A flareup of COVID cases in the low double digits has dragged cities back to either mass COVID testing or partial city lockdowns. China’s COVID-containment measures escalated when the country’s business activity was already weak which was vastly different from prior to Q1 2020 when the economy was improving (Chart 10). Sentiment among the corporate and household sectors has been beaten down following two years of struggling with COVID, and the sectors’ propensities to invest or spend have been further dampened from last year’s harsh regulatory crackdowns (Chart 11).  Chart 10Business Cycle Was On A Downtrend When Omicron Hit... Chart 11...Sentiment Among Private Sector Has Been Downbeat Input costs are much higher now than two years ago, while demand is weaker (Chart 12). Global energy and commodity prices will remain elevated this year, while external demand for Chinese manufactured goods will dwindle (Chart 13). China’s exports as a share of the global total peaked in July last year; a strong RMB and frequent supply-chain disruptions will likely reduce competitiveness of Chinese exports. Chart 12Elevated Input Costs, Subdued Domestic Demand Chart 13Demand For Chinese Export Goods Will Likely Dwindle This Year Granted the Fed’s tightening, unless China is willing to tolerate meaningful currency depreciation, the PBoC has limited room to cut interest rates. The US Federal Reserve is expected to raise interest rates by 270bps over the coming 12 months, which will further tighten US dollar liquidity conditions and may exacerbate capital flows out of emerging economies. China’s 10-year government bond yield in nominal terms dropped below that of the US for the first time in a decade, prompting global investors to offload Chinese bonds at a record pace (Chart 14). The PBoC refrained from a policy rate cut last week. The move underwhelmed investors and was a sign that the central bank may be cautious in adopting a monetary policy stance that further diverges from the Fed.  Chart 14A Record Bond Market Outflow In Q1 This Year Chart 15Growth In Gov Revenue From Land Sales In Deep Contraction The room for further fiscal expansion is also more limited than two years ago as local governments are more constrained by funding. An expansionary fiscal policy in the past two years has pushed local governments’ debt ratios2 up by more than 20 percentage points to above the international standard of 100%, while the property market slump has led to a deep contraction in local government revenues from land sales (Chart 15). ​​​​​​​ Bottom Line: Business activity will likely rebound when restrictions are eventually lifted, and the existing and/or forthcoming stimulus will work their way into the economy. However, the above mentioned hurdles suggest that China has limited room to further loosen its monetary and fiscal policies compared with two years ago, and the effectiveness of policy easing on the economy will be more muted. Jing Sima China Strategist jings@bcaresearch.com   Footnotes   1     Recently the consumer and auto division head of Huawei Technologies warned that “If Shanghai cannot resume production by May, all of the tech and industrial players that have supply chains in the area will come to a complete halt, especially the automotive industry.” "China’s Auto Industry May Grind to a Halt Amid Shanghai Lockdown", Caixin Global 2     Measured by local governments’ total debt including general and special-purpose bonds, divided by their overall fiscal balance. ​​​​​​​ Strategic Themes Cyclical Recommendations