Economy

Dear client, We will not be publishing the US Equity Strategy next week, as I will be participating in BCA Investment Conference. We will return to our regular publishing schedule on September 19, 2022. Kind Regards, Irene Tunkel   Executive Summary Most Thematic ETFs Are Far Off Their Pandemic Peaks In today’s sector Chart I-pack report we recap our structural investment themes. EV Revolution: The EV cohort benefits from a structural transformation of the automobile industry that is further supported by favorable legislative tailwinds, and shifting consumer preferences. Generation Z: Generation Zers are coming of age and wield an increasing influence over consumer trends. Cybersecurity: The pandemic-driven shift to remote work, broad-based migration to cloud computing and increasing geopolitical tensions, are all structural forces that will ensure a healthy demand pipeline for cybersecurity companies. Green And Clean: Green energy is becoming cheaper to produce, which supports a wider adaptation of green technologies. Green tech also enjoys favorable legislative tailwinds that are coming on the back of rising geopolitical tensions, the ongoing energy crisis, and climate change action. Renewables help to diversify energy sources and offer a path towards energy security. Bottom Line: Thematic investments that capture the latest technological breakthroughs present unprecedented long-term investment opportunities for investors who can stomach short-term volatility. Feature This week we are sending you a Sector Chart I-Pack, which offers macro, fundamentals, valuations, technicals, and uses of cash charts for each sector. In the front section of this publication, we will overview recent equity performance and provide a recap of the US Equity Strategy structural investment themes. August – When The Rally Came To A Stall As we predicted in the “What Will Bring This Rally To A Halt?” report, the “inflation is turning, and the Fed will be dovish” rally has come to a screeching halt. The S&P 500 was down 8% in August as investors finally believe that Jay Powell’s Fed is hell-bound on extinguishing inflation even if it means squelching economic growth (Chart I-1). The message from Jackson Hole was very much Mario Draghi-like: “whatever it takes.” The market reaction was swift and brutal. The rally winners were in the epicenter of the sell-off that ensued on the back of Powell’s comments. Invesco QQQ Trust is already down nearly 9% off its August 16 peak, while Ark Innovation (ARKK) is down 13% (Chart I-2).  We expect that equities will continue to revert to their pre-summer lows. Chart I-1Summer Rally Winners Are At The Epicenter Of The Sell-off Chart I-2Most Thematic ETFs Are Far Off Their Pandemic Peaks With rates on the rise again, last week we shifted our overweight of Growth and underweight of Value to a neutral allocation. The last few months have been a rollercoaster. However, long-term investors may successfully survive the grind by resolutely sticking to some of the winning structural investment themes and ignoring short-term volatility. The fact that many themes are now more than 50% off their pandemic highs may indicate an opportune entry point. EV Revolution We initiated the EV Revolution theme in June 2021. Since then, the theme has outperformed the S&P 500 by 19%. The Auto and Components industry group is in the middle of a momentous transition to electric and autonomous vehicle manufacturing, thanks to technological advances in battery storage, AI, and radars. These technological breakthroughs help overcome most of the obstacles to the wide adoption of EVs. Multiple new entrants develop charging networks. Driving ranges are also rapidly increasing – Lucid promises a 500-mile range compared to Tesla’s 350. Couple that with the rising price of gas, the aging vehicle fleet, and the expectation that EVs will approach sticker parity with gas-powered cars as soon as 2023 (Chart I-3)  and there is no turning back to gas-guzzling vehicles. LMC Automotive forecasts that by 2031, EVs will reach 17 million units. Chart I-3EVs Will Reach Price Parity With ICEs In 2023 The entire EV cohort also benefits from favorable legislative tailwinds, thanks to this administration’s support of decarbonization. The Inflation Reduction Act (IRA) includes approximately $370 billion in clean energy spending, as well as EV tax credits for both new and used cars. In addition, executive action by President Biden has tightened fuel economy standards. California has mandated a complete switch to EV vehicles by 2035. The surge in EV Capex and R&D spending will boost the entire supply chain, which consists of chip manufacturers, battery and lidar R&D, part manufacturers, and charging networks. Many of these companies are still small. An ETF may be the best way to capture the theme (Table I-1). Table I-1EV/AV ETFs Generation Z: The Digital Natives The GenZ theme, which we identified exactly a year ago, has collapsed since the beginning of the market downturn and is down 47%. Its success was at the root of its demise – it captured overcrowded names most popular among GenZers, who are avid investors (Chart I-4). However, the theme is not “dead,” as a new cohort of Americans is coming of age, and they are not shy about it. Generation Z in the US includes 62 million people born between 1997 and 2012 (Chart I-5). With $143B in buying power in the US alone making up nearly 40% of all consumer sales, Gen Z wields increasing influence over consumer trends. This is the first generation of digital natives—they simply can’t remember the world without the internet. They are the early adopters of the new digital ways to bank, get medical treatments, and learn. Gen Z is joining the workforce and replacing retiring baby boomers. Chart I-4Gen Zers Are Avid Investors... Chart I-5Gen Zers Are Taking Over Gen Z is an umbrella theme that captures many other prominent themes, such as Fintech (Paypal & Social Finance), Crypto (COIN), Meme-investing (HOOD), Gaming and Alternative Reality (GAMR & ESPO), and Online Dating. But GenZers have a few behavioral quirks that make them different even from Millennials: Quality-Over-Price Shoppers: Gen Z was found to be less price sensitive when buying products, choosing quality over price. Lululemon (LULU) and Goose (GOOS) are among Gen Z’s favorites. Healthy Lifestyle: Gen Z is a “green” generation that deeply cares about the planet, loves the outdoors and traveling, and is crazy about pets. This is also a generation that prizes a healthy lifestyle and working out: Beyond Meat (BYND), Planet Fitness (PLNT), and Yeti (YETI). Generation Sober Chooses Cannabis: GenZers perceive hard liquor and tobacco as bad for their health. Curiously, marijuana is considered “healthy.” MSOS, CNBS, YOLO, and THCX are the biggest ETFs in this space. How To Invest In Gen Z? Gen Z is a nascent investment theme, so there are no ETFs available in the market yet. We propose that investors follow our Gen Z investment themes or replicate fully or partially our Gen Z basket. Cybersecurity: A Must-Have For Survival Despite its celebrity status, this is an industry that is still in the early innings of a growth cycle. The pandemic-driven shift to remote work, broad-based migration to cloud computing, development of the internet-of-things, and increasing geopolitical tensions create new targets for hackers who are after valuable data or just want to achieve maximum damage to the networks. Ubiquitous digitization requires increasingly more complex cyber defenses. With cybercrime costing the world nearly $600 billion each year and cyberattacks increasing in number and sophistication, the global cybersecurity market is expected to grow from $125 billion in 2020 to $175 billion by 2024. Both large and small businesses are yet to fully implement cybersecurity defenses. According to a survey by Forbes magazine, 55% of business executives plan to increase their budgets for cybersecurity in 2021 aiming to prevent malicious attacks. In response to the numerous breaches, the current US administration is placing a high priority on defensive cyber programs. Since 2017, US government departments have seen the cybersecurity share of their basic discretionary funding rise steadily from 1.38% to 1.73%. These developments are a boon for cybersecurity stocks (Chart I-6 & Chart I-7 ), the sales of which are soaring (Chart I-8). Chart I-6Cybercrime Losses Spur Demand for Cybersecurity Chart I-7Stepped Up Government Spending Will Lift Cybersecurity Stocks Chart I-8Cybersecurity Sales Are Soaring We introduced cybersecurity as a structural investment theme back in October 2021. So far, the CIBR ETF, which we use as a proxy for the performance of the theme, has underperformed the S&P 500 by 11%. Monetary tightening has weighed on the performance of these companies as they tend to be younger, smaller, and less profitable than their S&P 500 counterparts, i.e., CIBR has a strong small-cap growth bias. However, with cybersecurity stocks down 26% off their November-2021 peak and valuation premium back to earth, now may be an opportune moment to add to the theme. After all, these stocks have tremendous growth potential, warranting a long-term position in most equity portfolios. There are several highly liquid ETFs powered by the cybersecurity theme, such as CIBR, BUG, and HACK, which can be excellent investment vehicles (Table I-2). Table I-2Cybersecurity ETFs Green And Clean We introduced the “Green and Clean” theme back in March. Since then, it has outperformed the S&P 500 by 22%, benefiting from this administration’s focus on the mitigation of climate change. Putin’s energy stand-off with Europe has also put the industry into the global spotlight. The development of renewables will help diversify energy sources and offer a path toward energy security. Thus, renewable energy and cleantech companies are at the core of the global push to increase energy security and contain climate change. The International Renewable Energy Agency (IRENA) expects renewables to scale up from 14% of total energy today to around 40% in 2030. Global annual additions of renewable power would triple by 2030 as recommended by the Intergovernmental Panel on Climate Change (IPCC). Solar and wind power will attract the lion’s share of investments. Over the past 20 years, this country has made significant strides in shifting its energy generation toward renewable sources away from fossil fuels, increasing the share of clean energy from 3.7% in 2000 to 10% in 2020 (Chart I-9). Chart I-9A Structural Trend The key reason for the proliferation of green energy generation is that renewable electricity is becoming cheaper than electricity produced by fossil fuels – according to IRENA, 62% of the added renewable power generation capacity had lower electricity costs than the cheapest source of new fossil fuel-fired capacity. Costs for renewable technologies continued to fall significantly over the past year (Chart I-10). Renewables are similar to traditional utility companies: They require a massive upfront investment, but also enjoy substantial operating leverage. As production capacity increases, the cost of energy generation falls. Solar power generation is a case in point (Chart I-11). Hence, we have a positive reinforcement loop: more usage begets even more usage, bolstering the economic case for transitioning to cleaner energy resources. Chart I-10R&D Is Paying Off Chart I-11Capacity Is Inversely Correlated To Prices Increased renewables adaptation is possible thanks to several technological advancements including improved battery storage, implementation of smart grid networks, and an increase in carbon capture activities. There is a host of ETFs that offer investors a wide range of choices for access to renewable energy and cleantech themes (Table I-3). These ETFs differ in geographic span, industry focus, liquidity, and cost, but all are viable investment options. Table I-3Clean Tech ETFs Bottom Line Thematic investments that capture the latest technological breakthroughs present unprecedented long-term investment opportunities. However, these investments come with a warning: Technological innovation themes are intrinsically risky as they are rarely immediately profitable and require both continuous investment and technological breakthroughs to succeed. Also, most technological innovation themes carry high exposure to the small-cap growth style and are sensitive to rising rates and slowing growth. As such, they are fickle over the short term but pay off over a longer investment horizon.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     S&P 500 Chart II-1Macroeconomic Backdrop Chart II-2Profitability Chart II-3Valuations And Technicals Chart II-4Uses Of Cash Communication Services Chart II-5Macroeconomic Backdrop Chart II-6Profitability Chart II-7Valuations And Technicals Chart II-8Uses Of Cash Consumer Discretionary Chart II-9C Macroeconomic Backdrop Chart II-10Profitability Chart II-11Valuations And Technicals Chart II-12Uses Of Cash Consumer Staples Chart II-13Macroeconomic Backdrop Chart II-14Profitability Chart II-15Valuations And Technicals Chart II-16Uses Of Cash Energy Chart II-17Macroeconomic Backdrop Chart II-18Profitability Chart II-19Valuations And Technicals Chart II-20Uses Of Cash Financials Chart II-21Macroeconomic Backdrop Chart II-22Profitability Chart II-23Valuations And Technicals Chart II-24Uses Of Cash Health Care Chart II-25Sector vs Industry Groups Chart II-26Profitability Chart II-27Valuations And Technicals Chart II-28Uses Of Cash Industrials Chart II-29Macroeconomic Backdrop Chart II-30Profitability Chart II-31Valuations And Technicals Chart II-32Uses Of Cash Information Technology Chart II-33Macroeconomic Backdrop Chart II-34Profitability Chart II-35Valuations And Technicals Chart II-36Uses Of Cash Materials Chart II-37Macroeconomic Backdrop Chart II-38Profitability Chart II-39Valuations And Technicals Chart II-40Uses Of Cash Real Estate Chart II-41Macroeconomic Backdrop Chart II-42Profitability Chart II-43Valuations And Technicals Chart II-44Uses Of Cash Utilities Chart II-45Macroeconomic Backdrop Chart II-46Profitability Chart II-47Valuations And Technicals Chart II-48Uses Of Cash Recommended Allocation Recommended Allocation: Addendum

Executive Summary Chair Powell’s Jackson Hole speech did not change our fundamental take on the economy; we still think the expansion will survive through the first half of 2023 at a minimum. Financial markets’ reaction to Powell’s remarks highlighted that volatility will likely remain elevated but we continue to expect that equities will generate meaningful excess returns over Treasuries and cash over the rest of the year. The flow of data continues to send mixed signals about the outlook for financial markets and the economy, but the biggest risks to our view are no closer to occurring today than they were when we laid them out last month. An Eventful Intermeeting Period Bottom Line: We remain more optimistic than the consensus and continue to recommend a risk-friendly tilt in multi-asset portfolios over the next six months. We are still on high alert, however, and remain open to changing our views if incoming data begin to hint at an approaching inflection. Feature At the outset of a Zoom call last week, a US-based client asked if Chair Powell’s Jackson Hole speech had changed our view. The short answer is no, though it certainly roiled financial markets, providing the latest reminder that investors’ conviction levels should be lower than normal. This week’s report offers a longer answer, analyzing Powell’s comments while revisiting the risks to our view that we laid out in August. The principal risks have not gotten any closer to fruition and we therefore stand by our glass-half-full view, though we reiterate that it is contingent on incoming data flows – if they point to a worse outcome than our current base case, we may yet join the bearish chorus. The Fed Bigwigs Went To Grand Teton National Park … Chair Powell opened his speech by promising brevity, focus and directness and he delivered on all three counts. He used less than a third of his allotted 30 minutes to hammer home the Fed’s commitment to bringing inflation back to its 2% target and he didn’t mince words. The speech was short enough to allow the following close reading of it in which we excerpt a key line from nearly every paragraph, followed by our italicized takeaways. Powell: “Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance.” US Investment Strategy: We are prepared to accept a lengthy stretch of subpar growth as the cost of getting inflation under control. Until further notice, fighting inflation takes precedence over encouraging growth. “The labor market … is clearly out of balance, with demand … substantially exceeding … supply[.]” The rip-roaring labor market is so strong that we have no choice but to lean against it given the inflation backdrop. “In current circumstances, … [the dots’] estimates of [the] longer-run neutral [fed funds rate] are not a place to stop or pause.” It will take a good bit more monetary tightening to get inflation back to the 2% target. “I said [in July] that another unusually large increase could be appropriate at our next meeting.” Another 75-basis point hike is on the table in September. The pace of increases will eventually slow, but we don’t yet know when. “Restoring price stability will likely require maintaining a restrictive policy stance for some time.” Don’t count on rate cuts any time soon. “[C]entral banks can and should take responsibility for delivering low and stable inflation.” The Fed is obligated to combat high inflation, even if some of its causes are beyond our control. Though we can’t relieve supply constraints, we can bring demand into better balance with supply. Related Report  US Investment StrategyRisks To Our View (Again) “If the public expects that inflation will remain low and stable over time, absent major shocks, it likely will. Unfortunately, the same is true of expectations of high and volatile inflation.” High inflation expectations can be self-fulfilling and we cannot allow them to become entrenched à la the 1970s. “The longer the current bout of high inflation continues, the greater the chance that expectations of higher inflation will become entrenched.” We cannot take it for granted that inflation expectations will remain well anchored despite high inflation prints. The public’s focus on inflation threatens future price stability and future growth and we would be playing with fire if we didn’t address it now. “[W]e must keep at it until the job is done.” If we do not act forcefully now, the cost of getting inflation back to the 2% target will be much greater. “We will keep at it until we are confident the job is done.” In case you missed my first reference to Paul Volcker’s memoir, Keeping At It, a moment ago, or the two times I spoke his name, understand that we’re willing to do whatever it takes to getting the inflation genie back in the bottle. … And All Investors Got Was A Lousy Selloff Our italicized translations should have sent a chill down the spines of equity investors and the S&P 500 duly plunged 3.4% after Powell’s speech, then followed up by sliding as much as another 3.8% in last week's sessions. BCA has always viewed 2023 rate cuts as something of a pipe dream, and we have been relieved to see the money market raise its terminal fed funds rate estimate while pushing out the date it will be reached. As Chart 1 shows, the expected terminal rate has risen by about 75 basis points and rate cuts have been pushed back since the July FOMC meeting, but even Jackson Hole didn’t get investors to give up on them entirely. Our best guess is that they still question the Fed’s commitment in the face of a slowdown. Chart 1A Lot Can Change In Five Weeks That interpretation offers a ready answer for why the glass-half-full view has taken a beating over the last six sessions but suggests that the glass-half-empty view could be at risk before too long. A higher terminal fed funds rate implies lower near-term earnings as well as a reduced willingness to pay for those earnings, so stocks have suffered as investors revised their expectations to better align with the Fed’s guidance. But the need to hike more and faster than investors expected underscores aggregate demand’s surprising resilience. If the labor market, consumption and corporate earnings all continue to hold up better than expected, equities have a path to move higher once the terminal rate outlook fully discounts the Jackson Hole rhetoric. Risks To Our View: Unanchored Inflation Expectations If it takes longer than markets expect for rate hikes to bite, and corporate earnings and economic growth surprise to the upside while inflation intrinsically recedes along with COVID's threat, underweight investors are likely to find themselves pulled back into equities. That scenario remains our base case, but it would become highly improbable if inflation expectations were to become unmoored, forcing the Fed to race to get the fed funds rate above 4% and keep it there. We therefore deem a breakout in inflation expectations to be an existential threat to our view. One month’s flat headline CPI reading certainly does not meet the Fed’s “clear and consistent” standard for falling inflation but various indications that consumer prices have peaked have begun to provide some near-term expectations relief. Two-year TIPS breakevens fell 35 basis points in two weeks, to 2.3%, their lowest level since January 2021 (Chart 2, top panel). Two-year CPI swap rates dipped 15 basis points in that stretch and are at their lowest level since last October (Chart 3, top panel). Intermediate- (Charts 2 and 3, middle panel) and long-term (Charts 2 and 3, bottom panel) expectations have ticked slightly higher in the last two weeks but reduced near-term expectations will take some of the pressure off them. Consumers see it the same way, with one-year inflation coming down sharply in the University of Michigan’s August survey (Chart 4, top panel) while long-term inflation expectations held steady at the bottom of the 2.9-3.1% range that has been in place for a year (Chart 4, bottom panel). Chart 2Way Lower Near-Term And ...​​​​​ Chart 3... Range-Bound Longer-Term Expectations​​​​​ Chart 4No Vicious Inflation Expectations Cycle Yet Risks To Our View: Consumer Retrenchment Our sanguine take on economic growth and corporate earnings will be in trouble if consumers begin to hoard their excess savings. The Personal Income report released the morning of Powell’s Jackson Hole speech indicated that the aggregate household savings rate was just 5% in July, matching June’s downwardly revised number. We view the steadily declining trend (Chart 5) as ongoing validation of our thesis that consumers will deploy their excess savings to keep consumption and the US economy growing at trend, despite uncomfortably high inflation. Chart 5Staying Out Of The Paradox-Of-Thrift Trap Risks To Our View: A Softening Labor Market The major labor market datapoints that have arrived over the last two weeks have been consistently robust. Job openings, which had appeared to have entered a steady decline, turned out to be in a holding pattern following a significant July beat and an upward revision to June’s reading. Before the release, job openings were projected to be 12.5% below their March peak; instead, they’ve only shrunk by 5%, or about 100,000 more than July’s net payroll additions (Chart 6, top panel). Meanwhile, job quits data softened a little more, falling for the fourth straight month (Chart 7, top panel) and pushing the quits rate to its lowest level since May 2021 (Chart 7, bottom panel). Taken together, the openings and quits data hint that a Goldilocks outcome – labor demand remains strong but not so strong that employees are able to command higher wages simply by walking to the competitor across the street – is not impossible. Chart 6Job Openings Have Gotten A Second Wind ...​​​​​ Chart 7... While Quits Are Slowing​​​​​ The four-week moving average of initial unemployment claims extended its modest decline after a smaller-than-expected number last week and a downward revision in the previous week’s estimate (Chart 8). Markets let out a sigh of relief after the August employment situation report managed to thread the needle,1 showing that net payrolls robust growth is gently moderating (Chart 9). The numbers below the headline were also encouraging; average hourly earnings increased just 0.3% from July and the labor force participation rate rose by 30 basis points to match the post-COVID high set in March (Chart 10). The part rate remains a full percentage point below its pre-COVID level, amounting to 2.75 million missing workers – if they were to return, payrolls would have room to expand even as the unemployment rate ticks higher. Chart 8Jobless Claims Have Been Falling Since Mid-July Chart 9Payrolls Are Still Growing At A Healthy Clip​​​​​​ Chart 10Yet Another Supply Constraint​​​​​ Investment Implications The data received over the last two weeks suggest that the economy retains considerable momentum. Solid nonfarm payrolls gains, the month-and-a-half interruption in initial unemployment claims’ uptrend and the job openings and job quits data paint a picture of a labor market that is still humming even as upward pressure on wages may be moderating. We continue to be heartened by the low and slightly declining savings rate, which lends support to our thesis that excess pandemic savings will provide households with a cushion to keep spending despite painful increases in the price of necessities. Finally, despite eye-popping inflation readings, household, business and investor inflation expectations have remained well anchored. Though the fundamentals have been good since we elaborated on the key risks to our view two weeks ago, the technical picture turned against us with a vengeance. The S&P 500 support at 4,175 folded like a cheap lawn chair after Chair Powell took to the podium at Jackson Hole. We are CFAs, not CMTs, though we posit that technical analysis has a place in fundamental practitioners’ processes as a means of identifying advantageous entry and exit points. Going forward, however, we will not float ideas about technical levels without explicitly defining stops to exit a position if the technical level fails to hold. The stock swoon that ensued after Jackson Hole underlines how much investors are hanging on the Fed. Any perceived change of emphasis or direction has the potential to scramble financial markets and we continue to advise that investors carefully manage their holding periods and benchmark deviations. Although we think the Fed will eventually force a sober reckoning for risk assets, we believe equities can outperform over the next three to six months and therefore recommend overweighting equities in multi-asset portfolios through the end of the year. If inflation decelerates over the rest of the year as we expect, the Fed’s rhetoric should become less frightening and risk assets should see renewed inflows as the gloomy scenarios take longer to arrive than the consensus currently expects.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      As we went to press, however, equities were selling off sharply, apparently on reports of an extended Gazprom pipeline shutdown.

Listen to a short summary of this report     Executive Summary On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall without much loss in production or employment. Skeptics will argue that such benign disinflations rarely occur, pointing to the 1982 recession. But long-term inflation expectations were close to 10% back then. Today, they are broadly in line with the Fed’s target. Equities will recover from their recent correction as headline inflation continues to fall and the risks of a US recession diminish. Go long EUR/USD on any break below 0.99. Contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted Bottom Line: The US economy is entering a temporary Goldilocks period of falling inflation and stronger growth. The latest correction in stocks will end soon. Investors should overweight global equities over the next six months but look to turn more defensive thereafter.   Dear Client, I will be attending BCA’s annual conference in New York City next week. Instead of our regular report, we will be sending you a Special Report written by Mathieu Savary, BCA’s Chief European Strategist, and Robert Robis, BCA’s Chief Fixed Income Strategist, on Monday, September 12. Their report will discuss estimates of global neutral interest rates. We will resume our regular publication schedule on September 16. Best Regards, Peter Berezin, Chief Global Strategist The Hawks Descend On Jackson Hole Chart 1Markets Still Think The Fed Will Start Cutting Rates Next Year Jay Powell’s Jackson Hole address jolted the stock market last week. Citing the historical danger of allowing inflation to remain above target for too long, the Fed chair stressed the need for “maintaining a restrictive policy stance for some time.” Powell’s comments were consistent with the Fed’s dot plot, which expects rates to remain above 3% right through to the end of 2024. However, with the markets pricing in rate cuts starting in mid 2023, his remarks came across as decidedly hawkish (Chart 1). While Fedspeak can clearly influence markets in the near term, our view is that the economy calls the shots over the medium-to-long term. The Fed sees the same data as everyone else. If inflation comes down rapidly over the coming months, the FOMC will ratchet down its hawkish rhetoric, opting instead for a wait-and-see approach. The Slope of Hope Could inflation fall quickly in the absence of a deep recession? The answer depends on a seemingly esoteric concept: the slope of the aggregate supply curve. Economists tend to depict the aggregate supply curve as being convex in nature – fairly flat (or “elastic”) when there is significant spare capacity and becoming increasingly steep (or “inelastic”) as spare capacity is exhausted (Chart 2). The basic idea is that firms do not require substantially higher prices to produce more output when they have a lot of spare capacity, but do require increasingly high prices to produce more output when spare capacity is low. Chart 2The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted When the aggregate supply curve is very elastic, an increase in aggregate demand will mainly lead to higher output rather than higher prices. In contrast, when the aggregate supply curve is inelastic, rising demand will primarily translate into higher prices rather than increased output. In early 2020, most of the developed world found itself on the steep side of the aggregate supply curve. The unemployment rate in the OECD stood at 5.3%, the lowest in 40 years (Chart 3). In the US, the unemployment rate had reached a 50-year low of 3.5%. Thus, not surprisingly, as fiscal and monetary policy turned simulative, inflation moved materially higher. Goods inflation, in particular, accelerated during the pandemic (Chart 4). Perhaps most notably, the exodus of people to the suburbs, combined with the reluctance to use mass transit, led to a surge in both new and used car prices (Chart 5). The upward pressure on auto prices was exacerbated by a shortage of semiconductors, itself a consequence of the spike in the demand for electronic goods. Chart 3The Pandemic Began When The Unemployment Rate In The OECD Was At A Multi-Decade Low Chart 4With Supply Unable To Meet Demand, Goods Prices Surged During The Pandemic The supply curve for labor also became increasingly inelastic over the course of the pandemic. Once the US unemployment rate fell back below 4%, wages began to accelerate sharply. The kink in the Phillips curve had been reached (Chart 6). Chart 5Car Prices Went On Quite A Ride During The Pandemic Chart 6Wage Growth Soared When The Economy Moved Beyond Full Employment Chart 7Job Switchers Usually See Faster Wage Growth Faster labor market churn further turbocharged wage growth. Both the quits rate and the hiring rate rose during the pandemic. Typically, workers who switch jobs experience faster wage growth than those who do not (Chart 7). This wage premium for job switching increased during the pandemic, helping to lift overall wage growth. A Symmetric Relationship? All this raises a critical question: If an increase in aggregate demand along the inelastic side of the aggregate supply curve mainly leads to higher prices rather than increased output and employment, is the inverse also true – that is, would a comparable decrease in aggregate demand simply lead to much lower inflation without much of a loss in output or employment? If so, this would greatly increase the odds of a soft landing. Skeptics would argue that disinflations are rarely painless. They would point to the 1982 recession which, until the housing bubble burst, was the deepest recession in the post-war era. The problem with that comparison is that long-term inflation expectations were extremely high in the early 1980s. Both consumers and professional forecasters expected inflation to average nearly 10% over the remainder of the decade (Chart 8). To bring down long-term inflation expectations, Paul Volcker had to engineer a deep recession. Chart 8Long-Term Inflation Expectations Are Much Better Anchored Now Than In The Early 1980s Chart 9Real Long Terms Bond Yields Are Currently A Fraction Of What They Were Four Decades Ago Jay Powell does not face such a problem. Both survey-based and market-based long-term inflation expectations are well anchored. Whereas real long-term bond yields reached 8% in 1982, the 30-year TIPS yield today is still less than 1% (Chart 9). The Impact of Lower Home Prices Chart 10Supply-Side Constraints Limited Home Building During The Pandemic, Helping To Push Up Home Prices While falling consumer prices would boost real incomes, helping to keep the economy out of recession, a drop in home prices would have the opposite effect on consumer spending. As occurred with other durable goods, a shortage of building materials and qualified workers prevented US homebuilders from constructing as many new homes as they would have liked during the pandemic. The producer price index for construction materials soared by over 50% between May 2020 and May 2022 (Chart 10). As a result, rising demand for homes largely translated into higher home prices rather than increased homebuilding.  Real home prices, as measured by the Case-Shiller index, have increased by 25% since February 2020, rising above their housing bubble peak. As we discussed last week, US home prices will almost certainly fall in real terms and probably in nominal terms as well over the coming years. Chart 11Despite Higher Home Prices, Households Have Not Been Using Their Homes As ATMs How much of a toll will falling home prices have on the economy? It took six years for home prices to bottom following the bursting of the housing bubble. It will probably take even longer this time around, given that the homeowner vacancy rate is at a record low and reasonably prudent mortgage lending standards will limit foreclosure sales. Thus, while there will be a negative wealth effect from falling home prices, it probably will not become pronounced until 2024 or so. Moreover, unlike during the housing boom, US households have not been tapping the equity in their homes to finance consumption (Chart 11). This also suggests that the impact of falling home prices on consumption will be far smaller than during the Great Recession. Inelastic Commodity Supply While inelastic supply curves had the redeeming feature of preventing a glut of, say, new autos or homes from emerging, they also limited the output of many commodities that face structural shortages. Compounding this problem is the fact that the demand for many commodities is very inelastic in the short run. When you combine a very steep supply curve with a very steep demand curve, small shifts in either curve can produce wild swings in prices.  Nowhere is this problem more evident than in Europe, where a rapid reduction in oil and gas flows has caused energy prices to soar, forcing policymakers to scramble to find new sources of supply.  Europe’s Energy Squeeze At this point, it looks like both the UK and the euro area will enter a recession. In continental Europe, the near-term outlook is grimmer in Germany and Italy than it is in France or Spain. The latter two countries are less vulnerable to an energy crunch (Spain imports a lot of LNG while France has access to nuclear energy). Both countries also have fairly resilient service sectors (Spain, in particular, is benefiting from a boom in tourism). The good news is that even in the most troubled European economies, the bottom for growth is probably closer at hand than widely feared. Despite the fact that imports of Russian gas have fallen by more than 60%, Europe has been able to rebuild gas inventories to about 80% of capacity, roughly in line with prior years (Chart 12). It has been able to achieve this feat by aggressively buying gas on the open market, no matter the price. While this has caused gas prices to soar, it sets the stage for a possible retreat in prices in 2023, something that the futures market is already discounting (Chart 13). Chart 12Europe: Squirrelling Away Gas For The Winter Chart 13Natural Gas Prices In Europe Will Come Back Down To Earth Europe is also moving with uncharacteristic haste to secure new sources of energy supply. In less than one year, Europe has become America’s biggest overseas market for LNG. A new gas pipeline linking Spain with the rest of Europe should be operational by next spring. In the meantime, Germany is building two “floating” LNG terminals. Germany has also postponed plans to mothball its nuclear power plants and has approved increased use of coal-fired electricity generators. Chart 14The Euro Is Undervalued France is seeking to boost nuclear capacity. As of August 29, 57% of nuclear generation capacity was offline. Electricité de France expects daily production to rise to around 50 gigawatts (GW) by December from around 27 GW at present. For its part, the Dutch government is likely to raise output from the massive Groningen natural gas field. All this suggests that contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The euro, which is 30% undervalued against the US dollar on a purchasing power parity basis, will rally (Chart 14). Go long EUR/USD on any break below 0.99. Investment Conclusions Chart 15Falling Inflation Should Boost Real Wages And Buoy Consumer Confidence On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall with little loss in production or employment. Will this be the end of the story? Probably not. As inflation falls, US real wage growth, which is currently negative, will turn positive. Consumer confidence will improve, boosting consumer spending in the process (Chart 15). The aggregate demand curve will shift outwards again, triggering a “second wave” of inflation in the back half of 2023. Rather than cutting rates next year, as the market still expects, the Fed will raise rates to 5%. This will set the stage for a recession in 2024. Investors should overweight global equities over the next six months but look to turn more defensive thereafter. 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      

Executive Summary US Military Constraint: Strait Of Hormuz A US-Iran deal would make for a notable improvement in the geopolitical backdrop during an otherwise gloomy year. It would remove the risk of a major new oil shock. We maintain our 40% subjective odds of a deal, which is well below consensus. The risk of failure is underrated. Our conviction level is only moderate because President Biden can make concessions to clinch a deal – and Supreme Leader Khamenei may want to earn some money and time. Yet we have high conviction in our view that the US will ultimately fail to provide Iran with sufficient security guarantees while Iran will pursue a nuclear deterrent. Hence the Middle East will present a long-term energy supply constraint. In the short term, global growth and recession risk will drive oil prices, not any Iran deal. Asset Initiation Date Return LONG GLOBAL AEROSPACE & DEFENSE / BROAD MARKET EQUITIES 2020-11-27 9.3% Bottom Line: Any US-Iran deal will be marginally positive for risky assets. However, the failure of a deal would sharply increase the odds of oil supply disruptions in the short run. Feature Negotiations over Iran’s nuclear program remain in a critical phase. Rumors suggest Iran has agreed to rejoin the 2015 Joint Comprehensive Plan of Action (JCPA) with the United States. But these rumors are unconfirmed, while the International Atomic Energy Agency (IAEA) just announced that Iran has started operating more advanced centrifuges at its Natanz nuclear site.1 In this report we provide a tactical update on the topic. A US-Iran nuclear deal is one item on our checklist for global macro and geopolitical stability (Table 1). We are pessimistic about a deal but it would be a positive outcome for markets. Table 1Not A Lot Of Positive Catalysts In H2 2022 A decision could come at any moment so investors should bear in mind our key conclusions about a deal: Chart 1Oil Volatility: The Only Certainty Of Iran Saga 1.  Any deal will be a short-term, stop-gap measure to delay a crisis until 2024 or beyond. This is not a small point because a crisis could lead to a large military conflict. 2.  The short-run implication of any deal is oil volatility, not a drop in oil prices (Chart 1). Global demand is wobbly and OPEC could cut oil production in reaction to a deal. 3.  Over the long run, global supply and demand balances will remain tight even if a deal is agreed. 4.  If there is no deal, then a major new source of global supply constraint will emerge immediately due to a new spiral of conflict in the Middle East. Iran’s nuclear program will continue which will prompt threats from Israel and the Gulf Arab states and Iranian counter-threats. We are sticking with our subjective 40/60 odds that a deal will occur – i.e. our conviction level is medium, not high. The Biden administration wants a deal and has the executive authority to conclude a deal. Iran wants sanctions lifted and can buy time with a short-term deal. Our pessimism stems from the fact that neither side can trust the other, the US can no longer give credible security guarantees, and Iran has a strategic interest in obtaining nuclear weapons. A deal can happen but its durability depends on the 2024 US election. Status Of Negotiations Table 2Iran’s Three Demands Of US For Rejoining 2015 Nuclear Deal Ostensibly there were three outstanding Iranian demands over the month of August that needed to be met to secure a deal (Table 2). Iran reportedly dropped the first demand: that the US remove the Iranian Revolutionary Guard Corps from the US State Department’s list of Designated Foreign Terrorist Organizations. This concession prompted the news media to become more optimistic about a deal. This leaves two outstanding demands. Iran wants the IAEA conclude a “safeguards” investigation into unexplained uranium traces found at unauthorized sites in Iran, indicating nuclear activity that has not been accounted for. The IAEA will be very reluctant to halt such a probe on a political, not technical, basis. But it could happen under US pressure. Related Report  Geopolitical StrategyRoulette With A Five-Shooter Iran also wants the US to provide a “guarantee” that future presidents will not renege on the nuclear deal and reimpose sanctions like President Trump did in 2019. President Biden cannot give any credible guarantee because the JCPA is an executive action, not a formal treaty, so a different president could reverse it. (The deal always lacked sufficient support in the Senate, even from top Democrats.) Iran is demanding certain diplomatic concessions and/or an economic indemnity in the event of another American reversal. Aside from attempting to incarcerate former President Trump, Biden can only offer empty promises on this front. In what follows we review the critical constraints facing the US and Iran. The US’s Constraints The first constraint on the US is the stagflationary economy. High inflation and oil prices pose a threat to President Biden and the Democrats not only in this year’s midterm elections but also in the 2024 presidential election. A recession is not at all unlikely by that time, given the inverted yield curve (Chart 2). If the US can help maintain stability in the Middle East, then the odds of another major oil supply shock (on top of Russia) will be reduced. Lifting sanctions on Iran will free up around 1 million barrels of oil to feed global demand. With Europe and the US imposing an oil and oil shipping embargo on Russia, the world is likely to lose around two million barrels of crude per day that the Gulf Arab states can only partially make up for, according to our Chief Commodity Strategist Bob Ryan (Table 3). This is a notable material constraint – and the main reason that Bob is more optimistic about an Iran deal than we are. Chart 2US Economic Constraint: Stagflation​​​​​ Table 3The Oil Math Behind Any Iran Deal However, Saudi Arabia would be alienated by a US-Iran détente. The American view is that Iranian production would threaten Saudi market share and force the Saudis to produce more. But the Saudis are seeing weakening global demand and have signaled that they will cut production. There is still an economic basis for an Iran deal but it is not clear that it will lower prices, especially in the short run. Over the long run the Saudis are a more reliable oil producer than Iran for both economic and geopolitical reasons. The second constraint is political. The US public is primarily concerned about the economy. Stagflation or recession could ultimately bring down the Biden administration. However, in the short run, American voters are much more concerned about domestic social issues (such as abortion access) than they are about foreign policy. In the long run, American voters are likely to maintain their long-held negative view of Iran (Chart 3). So the Biden administration has an incentive to prevent geopolitical events from hurting the economy but not to join arms with Iran in a major diplomatic agreement. The third constraint is military. Americans are not as war-weary today as they were in 2008 or 2016 but they are still averse to any new military conflicts in the Middle East. An Iranian nuclear bomb could change that view – but until a bomb is tested it will persist. Chart 3US Political Constraint: Americans Ignore Foreign Policy, Dislike Iran​​​​​​ Chart 4US Military Constraint: Strait Of Hormuz If Iran freezes its nuclear program then it will reduce the odds of a Middle Eastern war and large-scale oil supply disruptions. If Iran does not freeze its nuclear program, then Israel will have to demonstrate a credible military threat against nuclear weaponization, and then Iran will have to demonstrate its region-wide militant capabilities, including the ability to shut down the Strait of Hormuz (Chart 4). The Biden administration wants to delay this downward spiral or avoid it altogether. Chart 5US Strategic Constraint: Avoid Mideast Quagmires The fourth constraint is strategic. The Biden administration wants to avoid conflict if possible because it is attempting to reduce America’s burden in the Middle East so that it can focus on emerging great power competition in Eastern Europe and East Asia. The original motivation for the Iran deal was to enable the US to “pivot to Asia” and counter China. Iranian hegemony in the Middle East is less of a threat than Chinese hegemony in East Asia (Chart 5). This logic is sound if Iran can really be brought to halt its nuclear program. The Europeans need to stabilize and open up the Middle East to create an alternative energy supply to Russia. The Americans need to avoid a nuclear arms race and war in the Middle East that distracts them from China. However, if Iran continues to pursue a nuclear weapon, then the US suffers strategically for doing a short-term deal that provides Iran with time and access to funds. Ultimately the only thing that can dissuade Iran from going nuclear is American power projection in the Middle East – and this capability is also one of the US’s greatest advantages over China. Bottom Line: The US has a strategic, military, and economic interest in concluding a deal that freezes Iran’s nuclear program. It arguably has an interest in a deal even if Iran violates the deal and pursues nuclear weaponization, since that will provide a legitimate basis for what would then become a necessary military intervention. The Biden administration faces some political blowback for a deal but will suffer more if failure to get a deal leads to a Middle Eastern oil shock. For all these reasons Biden administration is attempting to clinch a deal. But Iran is the sticking point. Iran’s Constraints Our reasons for pessimism regarding the nuclear talks hinge on Iran, not the United States. Supreme Leader Ayatollah Ali Khamenei’s goal is to secure the regime and arrange for a stable succession in the coming years. A deal with the Americans made sense in that context. But going forward, if dealing with the Americans does not bring credible security guarantees and yet makes the economy vulnerable again to a future snapback of sanctions, then the justification for the deal falls apart. We cannot read Khamenei’s mind any more than we can read Biden’s mind, so we will look at the material limitations. Chart 6Iran's Economic Constraint: Stagflation First, the economic constraint: The Iranian economy suffered a huge negative shock from the reimposition of sanctions in 2019 (Chart 6). However, the economy has sputtered through this shock and the Covid-19 shock without collapsing. Social unrest is an ever-present risk but it has not spiraled out of control. There has not been an attempted democratic revolution like in 2009. The upswing in the global commodity cycle has reinforced the regime. Sanctions do not prevent exports entirely. There is still a huge monetary incentive to let the Biden administration lift sanctions if it wants to do so: a deal is estimated to free up $100 billion dollars per year in revenue for the regime for ten years.2 Realistically this should be understood as more than $275 billion for two years since the longevity of the deal is in question. The problem is that Iran’s economy would be fully exposed to sanctions again if the US changed its mind. The bottom line is that the economic constraint does not force Iran to accept a deal but it is enticing. Second comes the political constraint. President Ebrahim Raisi hopes to become supreme leader someday and is loath to put his name on a deal with weak foundations. He originally opposed the deal, was vindicated, and does not now want to jeopardize his political future by making the same mistake as his hapless predecessor, Hassan Rouhani. Opinion polls may not be reliable in putting Raisi as the most popular politician in Iran but they probably are reliable in showing Rouhani at the bottom of the heap (Chart 7). There is a significant political constraint against rejoining the deal. Chart 7Iran’s Political Constraint: Risk Of American Betrayal Chart 8Iran’s Military Constraint: Outgunned, Unsure Of Allies Third comes the military constraint. While Iran is extremely vulnerable to Israeli and American military attack, it is also a fortress of a country, nestled in mountains, and airstrikes may not succeed in destroying the entire nuclear program or bringing down the regime. An attack by Israel could convert an entirely new generation to the Islamic revolution. And Iran may believe that the US lacks the popular support for military action in the wake of Iraq and Afghanistan. Iran may also believe that China and Russia will provide military and economic support (Chart 8). Ultimately, America has demonstrated a willingness to attack rogue states and Iran will try to avoid that outcome, since it could succeed in toppling the regime. But if Iran believes it can acquire a deliverable nuclear weapon in a few short years, then it may make a dash for it, since this solution would be a permanent solution: a nuclear deterrent against western attack, as opposed to temporary diplomatic promises. We often compare Iran’s strategic predicament to that of Ukraine, Libya, and North Korea. Ukraine gave up its Soviet nuclear weapons after the 1994 Budapest Memorandum, which promised that Russia, the US, the UK, France, and China would guarantee its security. Yet Russia ended up invading 20 years later – and none of the others prevented it or sent troops to halt the Russian advance. Separately Libya gave up its nuclear program in 2003 but NATO attacked and toppled the regime in 2011 anyway. Meanwhile North Korea played the diplomatic game with the US, ever inching along on the path toward nuclear weapons, and today has achieved nuclear-armed status and greater regime security. The outflow of refugees from the various regimes shows why Iran will emulate North Korea (Chart 9). Chart 9Iran’s Strategic Constraint: The Need For A Nuclear Deterrent Bottom Line: Iran has a short-term economic incentive to agree to a deal and a long-term military incentive. But ultimately the US cannot provide ironclad security guarantees that would justify halting the quest for a nuclear deterrent. A nuclear deterrent would overcome the military constraint. Therefore Iran will continue on that path. Any deal will be a ruse to buy time. Final Assessment The 2015 deal occurred in a context of Iranian strategic isolation, when American implementation was credible, oil prices were weak, and Iran had not achieved nuclear breakout capacity. Today Iran is not isolated (thanks to US quarrels with Russia and China), American guarantees are not credible (thanks to the polarization of foreign policy), oil prices are not weak (thanks to Russia), and Iran has already achieved nuclear breakout (Table 4). Table 4Iran’s Nuclear Program Status Check, Aug. 31, 2022 The US’s strategic aim is to create a balance of power in the region but Iran’s strategic aim is to ensure regime survival. The US’s emerging balancing coalition (Israel and the Gulf Arab states) increases the strategic threat to Iran and hence its need for a nuclear deterrent. While Russia and China formally support the 2015 deal, they each see Iran as a valuable asset in a great power struggle with the United States. Iran sees them the same way. Russia needs Iran as a partner to bypass western sanctions. Regardless, it benefits from Middle Eastern instability, which could entangle the United States. China must develop a deep long-term partnership with Iran for its own strategic reasons and does not look forward to a time when the US divests from that region to impose tougher strategic containment on China. China can survive a US conflict with Iran – and such a conflict could reduce the US ability to defend Taiwan. While neither Russia nor China positively desire Iran to obtain nuclear weapons, neither power stopped North Korea from obtaining the bomb – far from it. Russia assumes that Israel and the US will take military action to prevent weaponization, which would be catastrophic for the region but positive for Russia. China also assumes Israel and the US will act, which reinforces its need to diversify energy options so that it can access Russian, Central Asian, and Middle Eastern oil via pipeline. Investment Takeaways Our negative view on the global economy and geopolitical backdrop is once again being priced into global financial markets as equities fall anew. An Iran deal would delay a notable geopolitical risk for roughly the next 24 months and hence remove a major upside risk for oil prices. This would be marginally positive for global equities, although it will not be the driver. Europe’s and China’s economic woes are the drivers. The failure of a deal would bring major upside risks for oil into the near term and as such would be negative for equities – and could even become the global driver, as Middle Eastern oil disruptions will follow promptly from any failure of the deal. We continue to recommend that investors overweight US equities relative to global, defensive sectors relative to cyclicals, and large caps relative to small caps. We are overweight aerospace and defense stocks, India and Southeast Asia within emerging markets, and underweight China and Taiwan.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1      See Iran International, “Exclusive: Ex-IAEA Official Says US And Iran To Sign Deal Soon,” August 30, 2022, iranintl.com. See also Francois Murphy, “Iran enriching uranium with more IR-6 centrifuges at Natanz -IAEA,” Reuters, August 31, 2022, reuters.com. 2     See Saeed Ghasseminejad, “Tehran’s $1 Trillion Deal: An Updated Forecast of Iran’s Financial Windfall From a New Nuclear Agreement,” Foundation for Defense of Democracies, August 19, 2022, fdd.org. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Special Report

Executive Summary The Recovery of Chinese Property Market Relies On Home Sales Property sales, starts, developers’ total financing, and construction activity will likely continue to contract in the next three-to-six months, albeit at a slower rate. More supportive government policies will be released in the coming months, including mortgage rate cuts. It will take time for a recovery in sales and construction activity to occur, because of enormous excesses in the mainland property market/industry. Plus, China’s economy is challenged by the dynamic zero-COVID policy, a budding contraction in exports, and generally weak income growth.   Property developers started to shift their business model from “pre-selling, then completing” to “completing first, selling after.” The move is a long-term positive for China’s property market by reducing financial stability risk. However, it means that the industry will take a longer time to contribute to growth in the broader economy. Bottom Line: We continue to hold a bearish view on the share prices of both onshore and offshore Chinese property developers in absolute terms and relative to China’s overall equity benchmark. A continued weakness in construction volume in the next few months implies less demand for commodities, such as iron ore, steel, cement, and glass.   Chart 1Low Sentiment in Both Current and Future Income The turmoil in China’s property market has not abated. Homebuyers remain unwilling to buy houses because of concerns over widespread sold but unfinished properties, falling confidence in future incomes, and worsening employment expectations (Chart 1). Property sales, starts, and completions have all collapsed by 25-45% from their mid-2021 peak (Chart 2 and 3). However, these variables will likely start to improve on a rate-of-change basis (i.e., the pace of contraction will moderate) in the months ahead (Chart 3). The rationale is that accelerated policy easing in the housing sector will help on the margin. Notably, policies curbing housing demand have loosened much more this year than they did in 1H2020. Plus, the authorities will introduce more accommodative real estate policy initiatives later this year and early next year, including additional mortgage rate cuts. Chart 2Property Sales, Starts, And Completions Will Further Decline In Their Level Terms… Chart 3...Albeit Improving On A Rate-Of-Change Basis Nevertheless, the construction industry, its suppliers, and the entire economy will take small consolation from the moderating pace of decline in the property sector. The basis for this response is that the level of activity will continue falling in the next three-to-six months, albeit at a slower rate than that of the present moment. Overall, aggressive policy easing will take time to produce a meaningful recovery in the mainland’s property market because it is occurring amid the structural breakdown in the real estate market and a confidence crisis among stakeholders. Policy Support Has Accelerated  Chinese authorities have accelerated their policy initiatives in the real estate sector to restore homebuyers’ confidence and stabilize the sagging domestic property market. Chart 4The Recovery of Chinese Property Market Relies On Home Sales A nearly 30% year-on-year decline in floor space sold in residential commodity buildings has exacerbated a liquidity crisis among property developers. Deposits, advanced payments, and mortgage payments originating from property pre-sales, have historically contributed to about 50% of property developers’ financing (Chart 4, top panel). Hence, renewed homebuyers’ confidence and a revival in house purchases would alleviate the liquidity crunch among cash-strapped developers (Chart 4, bottom panel), who could then complete more housing units under construction. Chinese authorities have introduced an assortment of supportive housing measures, including the following: Measures To Help Complete Pre-Sold Apartments In response to the homebuyer confidence crisis, the Politburo demanded that local governments be responsible for ensuring the delivery of housing projects. Since July, at least 36 local governments in 15 provinces have released concrete policies in this respect (Box 1).   Box 1 Local Governments:  The Delivery Of Pre-sold Housing Units Turns into a Political Task "Pre-sale fund supervision"1 is an important policy related to "guaranteed delivery" for presold properties. Real estate development enterprises must deposit pre-sale funds into a bank's special supervision account, which can only be used for the construction of a specific project and cannot be withdrawn or used at will. Another important policy is implementing "one building, one policy" and stipulating local government involvement to resolve problems. With the support of local government, a fund required to complete an unfinished building can be raised in various ways including, but not limited to the following: 1) increasing financing from local banks or asset management companies;2  2) encouraging good SOEs or high-quality homebuilders to take over stalled projects; 3) local governments purchasing back unused land from property developers; or 4) asking desperate buyers of those pre-sold and unfinished projects to contribute additional funds.3   Last month, the authorities also established a real estate fund of initially RMB 80 billion, which was funded by China Construction Bank and the central bank. In mid-August, China introduced procedures to ensure property projects are delivered to buyers through special loans from policy banks. The amount of this special loan will be about RMB 200 billion.4 This will be also a part of the real estate fund established last month, which could potentially be increased to RMB 300-400 billion and will be used only to ensure the delivery of presold but unfinished projects. Moreover, the government started to ease policies on property developers’ onshore bond issuance. In August, Chinese regulators instructed China Bond Insurance to provide guarantees for onshore bond issuance by private property developers. We expect more policy easing on developers raising funds though bank loans and more onshore bond issuance (Chart 5).  Measures To Increase Homebuyers’ Affordability The average mortgage rate has been decreased three times so far this year, falling to 4.3% for first-time home buyers. This is the lowest rate since 2009 (Chart 6).  Chart 5Chinese Developers Needs More Policy Easing On Their Borrowing Chart 6Easing Policies On Mortgage Rate Since the beginning of this year, over 80 cities relaxed their restrictive policies on loan borrowing. Among these cities, nearly 60 lowered their down payment ratio for a first home purchase, while about 40 reduced their down payment ratio for a second home purchase.5 Local governments also offered financial support for shantytown renewal and cash rebates for home purchases. Multiple cities have also issued incentives to encourage households with second or third children to buy additional properties. Bottom Line: Authorities have ramped up their supportive housing policies in recent months.  We expect more policy stimulus (e.g., another mortgage rate cut) to be announced over the next three-to-six months. Housing Turnaround Takes Time Despite considerable supportive policies in place, housing starts and construction activity will continue to contract and home prices will deflate further in the next three-to-six months. The policies will take time to work, especially ones related to ensuring the delivery of pre-sold housing. A significant amount of financing will be required for problematic projects that real estate developers are unable to build and deliver. Many local governments are also facing financial distress. Therefore, it will take time to arrange financing from third parties. Even after securing financing for incomplete housing projects, there will be delays in the construction and delivery of these units. Potential homebuyers may be willing to purchase in installments and provide funds to developers, but only if they witness increased deliveries of pre-sold homes. These funds are critical to developers as they account for about half of their total financing (Chart 4 above). The willingness to buy has been suppressed by falling confidence over future incomes, worsening future employment expectations and weakening growth of current income (Chart 1 on page 2). The willingness of households to save recently hit a record level; it is higher than during the first outbreak of COVID-19 in early 2020. Meantime, the propensity to invest has tumbled to a multi-year low (Chart 7). Chart 7More Chinese Households Intend To Save Rather Than Invest Chart 8Property Sales In Rich Eastern Provinces: Still In A Deep Contraction The growth of residential floor space sold in the eastern provinces often leads the rest of China (Chart 8). The Eastern provinces account for about 44% of China’s total residential floor space sales. Residential floor space sales in the Eastern provinces were still down by 30% in July.  The lack of an upturn in the Eastern provinces, especially after the re-opening in Shanghai and Shenzhen, indicates that a property market recovery will not be imminent or V-shaped. Chart 9A Majority Of Key Cities Have Declining Housing Prices Currently still 70% and 85% of the 70-city house price indexes are showing year-over-year price declines in newly constructed houses and secondary houses, respectively (Chart 9).  Shrinking pre-sales mean less financing for homebuilders and, ultimately, contracting property investment in the next three-to-six months (Chart 10). Many developers will continue to struggle to attract sufficient financing. Hence, they must cut their starts and completions (Chart 11). Chart 10Shrinking Pre-sales Will Lead To Falling Property Investment Chart 11Property Developers Have Been Starting And Preselling But Not Completing High prices/low affordability, speculative behavior of both developers and homebuyers, very high leverage and risky financing schemes, large volumes of supply and high inventories and vacancies , all need to be absorbed. A dynamic zero-COVID policy, a budding contraction in exports and generally weak income growth will challenge China’s economy in general.  Chart 12Insufficient Financing Will Lead To Weaker Construction Activity Ahead Bottom Line: The authorities’ supportive policies will take time to relieve the liquidity crisis among property developers and boost sentiment among homebuyers. Property sales, starts, developers’ total financing and construction activity will likely continue to contract in the next three-to-six months, albeit at a slower rate (Chart 12). A Structural Shift In Developers’ Business Model Chinese property developers started to shift their business model from “preselling, then completing” to “completing first, selling after.” The move is a long-term positive for China’s property market. It will lower the leverage of and curb real estate assets hoarding by developers and, thereby, improve stability in the industry. The old model of “preselling then completing” is not sustainable. In the past decade, Chinese real estate developers aggressively pursued a business model of “buying land, quickly starting property projects, and preselling unfinished homes but not completing them.”6  Chart 13A Structural Shift In Developers' Business Model As this model was essentially raising funds via launching property starts despite shrinking completions (Chart 13, top panel), it has resulted in a significant increase in Chinese property developers’ liabilities and unfinished construction carried on the balance sheet of developers. In short, as we have argued before, real estate developers have been involved in a massive carry trade. This is one of the root causes of the current crisis in China’s real estate sector. With this business model, developers carried real estate assets (land and started properties) on their balance sheets to benefit from the positive “carry”; i.e., the difference between the cost of funding and real estate asset price appreciation. However, the carry has turned negative as property asset prices are now flat or deflating rather than rising at double-digit rates. Hence, developers are under pressure to liquidate their assets and reduce their debts. Yet, to sell their not-pre-sold housing projects that are under construction, they first need new funds to complete unfinished homes before they can be sold. Furthermore, both the “three-red lines” policy for property developers and the new bank lending regulations limiting lending to the real estate sector – both put into effect in H2 2020 – remain in place. This means that Chinese real estate developers have no choice but to change their business model to a more sustainable one – the one with more sales coming from existing properties instead of pre-sales. The new model of “completing first, selling after” is a sustainable one. Homebuyers fear buying unfinished houses, preferring existing ones. Critically, increasing sales of existing houses will provide extra funds to debt-laden builders. In contrast, delivery of pre-sold units does not generate new cash for developers because most cash are received long before completion of a dwelling. Facing a liquidity crunch, there is no incentive for developers to complete pre-sold units. Chart 13 shows such a shift has been underway since mid-2021. Sales of completed houses increased considerably, while properties sold in advance plummeted. This trend also reflects a rising preference among homebuyers for completed properties. Buyers can visit and check the quality of a construction-completed unit versus paying for a future unknown unit. Meanwhile, property developers’ leverage will decline with this new business model. A caveat is that less financing from pre-sales means that developers will have a diminished ability to complete projects already started, and that they also need to reduce land purchases and land hoarding. Local government financing will remain tight as land sales account for 23% of local government aggregate expenditure. This will have negative ramifications on infrastructure spending. Bottom Line: Chinese real estate developers have begun shifting from an unsustainable and high-leverage business model to a new way of operating by which sales of completed properties will be prioritized at the expense of falling pre-sales. This will reduce financial stability risks in the future. Investment Implications We expect a continued decline in property sales, starts, completions, and property price deflation in the next three-to-six months. Thus, we maintain our bearish view of both onshore and offshore Chinese property developers’ share prices in absolute terms and relative to China’s overall equity benchmark (Chart 14).  Construction volume will be persistently weak in the coming months, which means less demand for commodities, such as iron ore, steel, cement, and glass. Hence, we expect prices for those commodities to drop further in the near run (Chart 15). Chart 14Chinese Property Developers' Stocks: Structural Breakdown Chart 15Bearish On Prices Of Construction-related Commodities   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Footnotes 1     Supervision of pre-sale funds of presold properties refers to the third-party supervision of such funds by the real estate administrative department in conjunction with the bank. 2     This year, at least six asset management companies injected funds into stalled property projects. So far, the total funds raised for three projects amounts to RMB 17 billion. Source: https://m.huxiu.com/article/644633.html?f=rss 3    Desperate buyers face two options: either add funds to build an unfinished home or continue to wait for an indeterminate period. Buyers tend to increase funds to enable the resumption of construction. 4    Source: https://www.bloomberg.com/news/articles/2022-08-22/china-plans-29-billion-in-special-loans-to-troubled-developers  5    Source: https://news.stcn.com/sd/202208/t20220826_4822460.html  6    Please see China Investment Strategy Special Reports "China’s Property Market: Making Sense Of Divergences," dated May 9, 2019, and "China: Is The Property Carry Trade Over?" dated October 28, 2021, available at cis.bcaresearch.com Strategic Themes Cyclical Recommendations