Emerging Markets

Special Report

Highlights Few emerging market peers have a track record of democracy like India does. Russia and others have long histories of political instability and one-man rule. Several large EMs have experienced stints of military rule in the post-WWII era. While India’s democratic credentials are real, these should not be exaggerated. India’s political system suffers from some structural and cyclical vulnerabilities. These imperfections deserve attention today, more than ever, given that India trades at a record premium to peers. From a strategic perspective, we remain Buyers of India. India’s democratic traditions will lend political stability as the country’s economic heft grows. However, on a time horizon, we recommend paring exposure to Indian assets. A loaded state election calendar awaits in 2022, which will be followed by crucial state elections in 2023 and general elections in 2024. While we expect the incumbent political party to retain power in 2024, history suggests that the road to general elections is paved with policy risks. Policymakers tend to shift attention from market friendly-reform to voter-friendly policies as these key state elections approach. Additionally, geopolitical risks for India are ascendant as dangerous transitions are underway to India’s west and east too. Feature Investors regard India as being exceptionally well-off on political parameters. It is viewed by many as the blue-eyed boy of emerging market democracies. And for good reason. Despite its massive population and very low per capita incomes, India has remained a functional democracy for over seventy years. Democratic political regimes are a relatively new trend. The number of democracies began exceeding the number autocracies in the world only very recently in 2002 (Chart 1). India was one of the earliest adopters of this trend compared to emerging market peers. Its democratic traditions are so well-entrenched now that they are comparable to those of some of the most developed economies of the world (Chart 2). To add to these democratic credentials, every government at the national level in India has completed its full five-year term since 1999, thereby offering stability. Investors greatly value the political stability that India offers. While political stability is only one factor that investors consider, India has traded at a 28% premium relative to democracies and a 67% premium to non-democracies like Russia and China over the last decade (Chart 3). ​​​​ ​​​​​​ In this report we highlight that while India’s democratic credentials are real, these should not be exaggerated. The political system in India is solid but far from perfect. It suffers from both structural and cyclical vulnerabilities. These imperfections deserve attention today more than ever, given that India trades at a record premium to peers (Chart 3). Also, a closer look at India’s political system is warranted given that both geopolitical and macroeconomic risks for India are ascendant. With India, the devil always lies in the details. India is the largest democracy of the world but is also one of the few large democracies that follows a first-past-the-post (FPTP) method of determining election winners and has no effective limit on the number of political parties that can contest elections. Most democracies, either combine an FPTP system with natural or legislative limit on the number of competing political parties (such as in the case of UK and US) or rely on a non-FPTP system, with specific vote thresholds to enter Parliament. The combination of an FPTP system along with a system that allows multiple small political parties to exist entails challenges and makes the system vulnerable to some structural policy problems that are often overlooked. These include: A Tendency To Go All-In: An FPTP system means that at an election, the contestant with the highest number of votes is declared the winner even if the victory margin is very low. For instance, the narrowest victory margin recorded at an Indian constituency-level election is a mere 9 votes! Such a system where the winner takes all, irrespective of the victory margin, creates perverse incentives for contesting candidates to go all-in on populism ahead of elections. Indian elections have thus seen candidates offer everything from food and free laptops, to free alcohol and hard cash, in a bid to woo voters in the run up to elections. Too Many Players Can Spoil The Election: An FPTP system alongside a multi-party system can lead to very high degrees of political competition. While competition is usually a virtue, very high levels of political competition tend to fragment the electorate. Owing to these reasons, political competition in India tends to be very high in general. For instance, the last two general elections in India saw 15 candidates contest from each constituency on average. This compares to an average number of contestants from each constituency being 5 for UK or 6 for Canada. The problem with this fragmentation is that the victorious politician may lack a strong popular mandate. Smaller Indian states bear the brunt of this problem. The smaller the state, the cost of the pre-election campaign is lower, so the number of contestants shoots up in smaller regions (Chart 4). Rent-Seeking Becomes A Necessity: Such a system which combines FPTP and no major entry barriers for contestants arguably encourages rent-seeking behavior, which election winners frequently display. Populist spending promised by candidates to lure voters ahead of elections can be very high, especially when political competition is stiff. Winners then are keen to recover this “sunk cost” and to create a war chest for the next election. This prompts the rent-seeking that often becomes a necessity for candidates who run expensive election campaigns. To conclude, few emerging market peers have a sustained track record of democracy like India does. Russia and others have long histories of both political instability and one-man rule. Brazil, Turkey, Thailand, South Korea, Taiwan, and Indonesia have all experienced stints of military rule and revolutions in the post-WWII era. Whilst India’s political stability credentials are solid, the existence of high degrees of political competition alongside high degrees of social complexity will spawn both structural and cyclical policy risks in India. Navigating India’s Political Peculiarities It is heuristically convenient to assume that policy risks in India are uniform across time. However, in this report, we highlight that policy risks for India hardly tend to be the same through the five-year term of a political party in charge at the national level. The five-year term of any central government in India is paved with cyclical policy risks. The good news is that there is a method to the madness. We present a simple method to identify a “pattern” to the cyclical policy risks: We break down India’s general election cycle into a five-year sequence. Year 1 is defined as the year after a general election takes place (such as 2020) and Year 5 is defined as the year in which a general election takes place (such as 2019 or 2024). (See the Appendix for a quick overview of India’s political system.) Given that India has 28 states and a state government’s term lasts five years, about six state elections are held each year. After identifying this five-year sequence, we then identify specific states that become due for state elections during this five-year period. Such a characterization of India’s election cycle shows how the five-year period from one election to the other is hardly the same. In fact, it becomes clear how policy risks tend to be definitively elevated in the years leading up to a general election. Year 3 in such a framework sees elections in some of India’s largest states (size), India’s politically most sensitive states (sensitivity), and India’s socially most complex states (complexity). 2022 will mark the beginning of Year 3 of the current five-year cycle and will see: Size: The most loaded state election schedule which will affect more than a quarter of India’s population (Chart 5). Sensitivity: Elections take place in most of India’s northern region (Chart 6), which is a key constituency for the ruling Bhartiya Janata Party (BJP). ​​​​​​ ​​​​​​ Complexity: Elections take place in some of the most socially conflict-prone states such as say Manipur (Chart 7). Year 3 of India’s cycle is also worth bracing for as it typically sees the policy machinery’s attention shift away from big-ticket reform to populism. This is probably because Year 4 sees some of the poorest states in India undergo elections (Chart 8) and then Year 5 sees a general election. ​​​​​​ ​​​​​​ What becomes clear now is that India is set to enter the business-end of its five-year election cycle in 2022. So, what specific policy changes should investors expect? The Road To Elections … Is Paved With Policy Risks Irrespective of the political party in power at the centre, populism as a theme tends to become more defined in the two years leading to a general election in India. For instance, history suggests that government spending in the two years leading up to a general election tends to be higher than in the previous three years (Chart 9). The last time this theme did not play out was in the run up to the elections of 2014 when in fact the incumbent i.e., the Indian National Congress (INC) lost elections to the Bhartiya Janata Party (BJP). Distinct from the fiscal support to the economy that tends to rise in the run up to elections, it is notable that even money supply growth, inflation to an extent and even the pace of Rupee depreciation tends to be faster in India in the years leading up to a general election (Chart 10). ​​​​​​ The run up to Year 3 and Year 4 of India’s election cycle also tends to see the announcement of voter-friendly policies that may not necessarily be market-friendly. Examples of this phenomenon include: Record Increase In Revenue Spends Ahead Of 1999 General Elections: In 1998 the-then Finance Minister oversaw a whopping 20% year-on-year increase in revenue expenditure. This is almost double the average growth rate of 13% seen in this metric over the last 25 years. Farm-loan Waiver Ahead of 2009 General Elections: In 2008 i.e., the year before the general elections of 2009, the Indian National Congress (INC)-led central government announced its decision to write off farm loans of about $15 billion (in inflation-adjusted terms today). Demonetization Decision Ahead Of 2017 Uttar Pradesh State Elections: The BJP-led central government announced its decision to demonetize 86% of currency in circulation in November 2016 in a bid to prove the government’s commitment to crackdown on black money. GST Rate Cuts Ahead Of 2017 Gujarat State Elections: The Goods and Services Tax (GST) council announced a cut in the GST rate for over 150 items in November 2017. This was ahead of Gujarat state elections that were due in December 2017. Such decisions are known to work with voters. The incumbent political party that announced these policy decisions, in each of the three cases cited above, won the elections that they subsequently contested. Just last week, the Indian Government decided to repeal farm sector reform related laws which it had announced a year ago. It is not entirely coincidental that this pro-voter decision has been announced just a few months ahead of critical state elections due in 2022. Key State Elections To Watch In 2022 State elections are due in seven states in India in 2022. State elections due in 2022 will have an indelible impact on India’s policy outlook for 2022 because the BJP is the incumbent party in most of these states and BJP’s popularity has suffered because of the pandemic (Chart 11). The government’s decision last week to roll back farm sector reform is a great example of this phenomenon. Of all the state elections due in 2022, the two key elections that will have the biggest bearing on the 2024 general elections will be the elections in Uttar Pradesh in February 2022 and in Gujarat in December 2022. BJP’s popularity in these states should be closely watched to get a better sense of the 2024 general election outcome. The BJP won about 80% of the cumulative seats these two states offer at the 2019 general elections. At the last state elections held in Uttar Pradesh in 2017, the BJP stormed into power in the state, winning 77% of seats. BJP’s entry into power there was symbolic as the road to New Delhi is said to pass through this state (Chart 12). Gujarat on the other hand has been a BJP stronghold and PM Modi began his political innings as the chief minister of this state. Despite being in power in Gujarat for over two decades, the BJP managed to retain power in this state at the last elections held in 2017 (Chart 13). ​​​​​​ ​​​​​​ Accurate pre-poll data for these states will be available only closer to election day. Our early on-ground checks suggest that the BJP is set to almost certainly retain power in Uttar Pradesh in 2022. However, the BJP runs the risk of losing some vote share in Gujarat owing to the anti-incumbency effect it faces and owing to the rise of parties like the Aam Aadmi Party (AAP) in the state of Gujarat. Another tool that can be used to estimate the likely result of these two key state elections is the economic growth momentum in these states. State election results from 2021 suggest that this macro variable matters a great deal. While it is not the only variable that matters, the incumbent lost elections in large states in 2021 when growth decelerated excessively (Chart 14). For instance, in 2021, Tamil Nadu saw its GDP growth decelerate significantly but West Bengal saw its GDP growth decelerate by a lesser extent. Notably, the incumbent was displaced out of power in Tamil Nadu but managed to retain power in West Bengal possibly because of several factors including a lesser slowdown in economic growth (Chart 14). If GDP growth were to affect election outcomes in 2022 as well then, the incumbent i.e., the BJP, will comfortably retain power in Uttar Pradesh but may have to deal with the risk of losing some vote share in Gujarat. This is because economic growth accelerated in Uttar Pradesh over the last five years before the pandemic. GDP growth rates remained high in Gujarat but the pace of acceleration was weaker (Chart 15). ​​​​​​ ​​​​​​ However, from the perspective of the general elections of 2024, BJP’s position in these two states remains fairly strong, and this is true even if it experiences minor setbacks in the upcoming state elections. National parties like the BJP tend to enjoy greater fervor amongst voters in general elections as opposed to state elections. It hence would take an earthquake defeat in these state elections to alter this assumption – an outcome which appears unlikely at this stage. The takeaway from the above is that investors must brace for the BJP pursuing populist policies over the next two years. In fact, we are increasingly convinced that the BJP government’s budget for FY23 (due to be announced on 1 February 2022) will see a marked increase in transfer payments for farmers in specific or low-income groups in general. The announcement of a brand-new program aimed at lifting incomes of India’s lowest economic strata cannot be ruled out. But from the perspective of the 2024 elections, the BJP appears well-placed to retain power. Investors will face negative policy turbulence in the short run but should maintain a base case of policy continuity over the long run. Investment Conclusions If You Are Playing A Long Game, Then Hold: From a strategic perspective, we remain Buyers of India. India’s democratic traditions will lend political stability as the country’s economic heft grows. Its democratic credentials will also yield geopolitical advantages as America aims to create an axis of democracies to contain autocratic regimes. It is notable that the US’s most recent alliance-formation efforts - such as the Quadrilateral Security Dialogue or the AUKUS nuclear submarine deal - involve some of the oldest democracies of the world. As India sheds its historical stance of neutrality, in favor of closer alignment with the US against China, its democratic credentials will help India deepen its engagement with geopolitically powerful democracies. If You Are Playing A Short Game, Then Fold: The Indian market appears priced for perfection today. We recommend paring exposure to Indian assets on a tactical time horizon. Historically India’s premium relative to emerging markets has shown some correlation with the BJP’s popularity (Chart 16). However, India’s premium relative to EMs has shot through the roof over the last year and hence even if BJP wins the Uttar Pradesh elections (our base case), then it is unclear if that victory will drive another bout of price-to-earnings re-rating for India. Moreover, as outlined, the road to state elections in 2022 will be paved with policy risks as the government prioritizes populism ahead of pro-market reform. The BJP has managed to expand its influence in India over the last decade (Chart 17). But a unique problem now confronts Indian policymakers: while stock markets in India have risen almost vertically, wage inflation has collapsed (Chart 18). Additionally, India has administered a weak post-pandemic fiscal stimulus (Chart 19). We reckon that this fiscal restraint will be tested in the run up to key elections in 2022-23. ​​​​​​ ​​​​​​ Unlike in developed economies, where fiscal stimulus is seen as pro-market because it suggests policymaking is improving and deflationary risks will be dispelled, fiscal stimulus can be market-negative in the context of an EM like India. Increases in populist spending can end up adding to existent inflationary pressures and hence can drive bond yields higher. Stock market earnings too may not end up getting a major boost on the back of increase in transfer payments to low-income groups. This is because the share of market cap accounted for by sectors which directly benefit from pro-poor spending, like Consumer Staples, has been drifting lower on Indian bourses from 10.8% in 2013 to 8.9% today. As we have been highlighting, distinct from policy risks that confront India on a tactical horizon, geopolitical risks confronting India are elevated too. Dangerous transitions are underway to India’s west (involving Pakistan and Afghanistan) as well as east (involving China). While China’s woes drive EM investors to India, any clashes with neighbors will create much better entry points into Indian stocks.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Appendix: An Overview Of India’s Political System India follows a parliamentary model of democracy with a federal structure where the government at the centre as well as state level is elected for a period of five years. The central government of India is formed through general elections that are held every five years. Power is held by a political party (or a coalition of parties) that can secure and maintain a simple majority in the Lower House (or Lok Sabha) through this five-year term. India also constitutes 28 states, each with its own legislative assembly. Each state government is formed through a state election held every five years. Much like at the centre, power is held by a political party that can maintain a simple majority at the legislative assembly for this five-year term.  

Dear Client, Next week, we will be sending you BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic, financial and commodity market outlook for the year ahead. All the best, Bob Ryan Chief Commodity & Energy Strategist  Highlights Local politics in Chile and Peru will become critical to the global energy transition, particularly as regards the supply side of the most critical metal for this transition: copper. Chile's runoff elections next month will pit a former congressman portrayed as a hard-right candidate against a protest leader-turned-legislator in a battle for the presidency of a country that accounts for ~ 30% of global copper mining output. In Peru, which accounts for just over 10% of global copper production, the left-of-center administration indicated it will mediate talks to close two gold and silver mines, despite protests from its corporate owners. Tightly balanced supply-demand fundamentals will keep inventories of refined copper extremely low, which will slow the early-stage global transition to renewable power generation until these stocks can be replenished (Chart of the Week).  Chinese copper smelters reportedly are collaborating to move refined metal to LME-approved warehouses to restock depleted inventories.  While this could reduce backwardations in futures markets, it has not overly depressed flat-price levels, which are within ~ 7% of all-time highs of $4.78/lb ($10,533/MT) put up in May. Fundamentally, base metals – especially copper and aluminum – will remain tight, which supports our long positions in the S&P GSCI and the COMT ETF. Feature Despite a marked deceleration of growth in China brought on by fuel and power shortages, and a strong USD creating tighter financial conditions globally, copper prices – and base metals generally – remain well supported, even as speculative interest, for the most part, has waned this year (Chart 2). Chart of the WeekTight Copper Inventories Support Prices, Backwardation Chart 2Specs Back The Truck Up For Copper Spec Interest Wanes   Copper and the other metals are well bid because of tight fundamentals – the level of demand has been and remains above the level of supply globally (Chart3). This will continue to exert pressure on inventories and force a re-shuffling of stocks globally – likely from China bonded warehouses to the LME (Chart 4). The London Metal Exchange (LME) was forced to take extraordinary measures to maintain orderly markets and has prompted Chinese smelters to collaborate on shifting material to LME sheds in Asia.1 However, much more refined copper will have to be shipped to these sheds to keep markets from launching into another steep backwardation on the LME similar to last month's $1,100/MT first-to-third-month spread last month – an indication of desperation on the buy side. Chart 3Low Copper Stocks Will Persist That said, if the only thing that improves LME stocks is a re-shuffle from existing inventories, the net position of the world will largely remain unchanged over time. Demand will be met with inventory draw-downs, but supply will not have increased, which, at the end of the day, means markets will continue to tighten. Chart 4Globally, Exchange Warehouses Tighten Chile, Peru Politics Become Fundamental Geopolitics always is at the heart of commodity markets: Who's in power and the agendas being pursued matter so much, because, in many cases, unrefined exports of raw commodities sustain governments and important elements of economies in many states. This is becoming clear in Chile and Peru, two states with contestable elections, where the outcomes can profoundly affect the supply side of global fundamentals. Earlier this year, it looked like Chile's presidential and congressional elections would favor left-of-center candidates who did not campaign on market-oriented policies. National elections this past weekend resulted in a run-off that will be held 19 December, as neither the left- nor right-of-center candidates polled an absolute majority. Right-of-center candidates also polled unexpectedly well in congressional elections. This likely translates into something resembling the divided government in the US, which means neither side will be able to get all it wants through the legislature. In the lead-up to the Constitutional re-write expected following elections, the agendas of the left and right are markedly opposed. On the left, greater government involvement in the resources sector has been part of the campaigning, while on the right increased private investment in the stated-owned Codelco, the largest copper producer in the world, is advocated. Both sides also disagree on changes in taxes and royalties, which obviously is of great concern to investors and copper-market participants.2 Chile also is a world-class supplier of lithium, zinc, gold, silver and lead, so it's not just copper markets following developments there with concern. In Peru, the country's newly sworn-in prime minister said she is willing to broker talks on shutting down gold and silver mines in communities where residents have been protesting as soon as possible. This drew a heated reply from mining interests immediately. Peru is the second largest copper miner in the world behind Chile, and the treatment of the owner of the disputed gold and silver mines, Hochschild Mining, is being followed closely. Base and precious metals markets are being forced to factor in a new set of political dynamics, as local political tensions spill into the supply side, causing overall political uncertainty in critical mining states to increase. This will restrain investment, which bodes ill for the global renewable- energy transition. Copper Defies Stronger USD  Despite a stronger-than-expected USD this year – boosted most recently by the re-appointment of Jay Powell as Fed Chair and the elevation of Lael Brainard as Vice Chair – copper and base metals have held up well.3 Generally, a strong dollar is bearish for base metals prices (Chart 5), and copper especially (Chart 6). A stronger USD tightens global financial conditions, which, not unexpectedly, is bearish for copper; however, as Chart 7 shows, this effect also has been overcome by the tight copper fundamentals globally.4 We remain bearish the USD going into next year, in line with our colleagues at BCA's Foreign Exchange Strategy. Massive fiscal stimulus in the US in particular, along with continued monetary accommodation from the Fed to fund the deficits this will produce, is expected to weaken the dollar and boost trade. Chart 5Base Metals Defy Strong USD Chart 6Copper Defies USD Strength, Boosted By Cyclicals Performance Chart 7Copper Overcomes Tighter Global Financial Conditions In a recent simulation, we show a 10% fall in the USD and a 5% pick-up in EM imports, along with continued strong performance from cyclicals would lift copper prices to $5.30/lb on the CME Comex by year-end 2022, in our estimation (Chart 8). Chart 8Weaker USD, Stronger EM Imports, Cyclical Strength Would Booster Copper. Investment Implications Base metals markets, particularly copper, have withstood tightening financial conditions brought on by a strong USD, a sharp slowdown in Chinese growth brought on by an energy shortage and rising interest rates. This is largely due to extremely tight supply-demand fundamentals, which continue to keep global inventories under pressure. Copper, metals generally, and precious metals also will get a lift from local political tensions spilling into the supply side of markets as overall political uncertainty in critical mining states restrains investment. We remain long the S&P GSCI and the COMT ETF, anticipating higher copper prices and a return to steeper backwardation.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodities Round-Up Energy: Bullish Oil markets looked right through the announcement the US will tap its Strategic Petroleum Reserve (SPR) for 50mm barrels beginning next month, rallying 3.3% to $82.31/bbl by Tuesday's close following the announcement (Chart 9). Under a Congressionally mandated release, the 18mm barrels already authorized had been factored into market balances. The incremental 32mm barrels of crude oil being supplied to the market will be released to successful bidders between 16Dec21 and 30Apr22. These volumes will be repaid during US fiscal years 2022-24, with a volumetric premium added to the initial volume lifted by the successful bidders, which will be specified in the terms of the crude-oil loan. The US fiscal year begins on 1 October. The longer it takes to return the crude oil back to the SPR, the higher the premium volume of crude oil will be required, per the SPR's terms and conditions. The Biden administration succeeded in persuading the governments of China, India, Japan, South Korea and the UK to release unspecified volumes from their SPRs as well. Although volume commitments and release dates were not included in the press release from the White House some 20mm to 30mm barrels reportedly could be supplied from these SPRs. Precious Metals: Bullish Gold prices fell violently, and the US dollar rose following Jay Powell’s re-nomination to Fed chair (Chart 10). Markets assume the Fed will stay the course on its current monetary policy, as opposed to loosening further, which would have lifted gold prices on the back of higher inflation expectations. We believe interest rate hikes will not be brought forward unless inflation expectations become unhinged. In the short run, however, high fuel prices and logistical bottlenecks will continue to feed into higher inflation, implying the Fed will remain behind the curve. Both Powell and Lael Brainard, who was nominated as vice chair of the Fed, stressed vigilance against inflation. In his statement following Biden's decision to re-appoint him as Fed Chair, Powell noted: "Today, the economy is expanding at its fastest pace in many years, carrying the promise of a return to maximum employment. … We know that high inflation takes a toll on families, especially those less able to meet the higher costs of essentials like food, housing, and transportation. We will use our tools both to support the economy and a strong labor market, and to prevent higher inflation from becoming entrenched." Brainard's remarks struck a similar tone. Chart 9 Chart 10   Footnotes 1     Please see Column: All eyes on China as LME copper spreads collapse: Andy Home, published by reuters.com 18 November 2021. 2     Please see Chile elections may impact a third of the world’s copper supply, published by mining.com on November 19, 2021.  3    Please see Precious Metals commentary in the Commodity Round-Up section. 4    The model shown in Chart 7 also includes iron ore and steel traded in China as explanatory variables.  It is noteworthy that copper prices remain resilient to a collapse in iron ore prices brought on by forced closures in China of steel mills to conserve coal and natural gas supplies for human-needs use going into what is expected to be a colder-than-normal winter on the back of a second La Niña in the Northern Hemisphere.  Please see our report published 30 September entitled La Niña And The Energy Transition for additional discussion.   Investment Views and Themes Strategic Recommendations

Dear Client, We will be working on our 2022 Outlook for China, which will be published on December 8. Next week we will be sending you BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic and financial market outlook for the year ahead. Best regards, Jing Sima China Strategist Feature In meetings with our North American clients this past week, we expressed the view that China’s economic growth is on a downward trend and easing measures have been gradual and modest in scope. Most clients agreed that China’s economy faces tremendous headwinds, however, some investors were more optimistic about the outlook for Chinese stocks in the next 6 to 12 months. Valuations in both China’s onshore and offshore equity markets have dropped to multi-year lows and macro policies have started to ease. Cheaply valued Chinese stocks should have more upside in the wake of policy support. Policy tone recently pivoted to a more growth supporting bias, but the existing easing measures will not offset the deceleration in both credit growth and domestic demand. China’s economic activity may worsen before it stabilizes in mid-2022. Moreover, China’s financial markets do not seem to have priced in the economic weakness. Therefore, in the next one to two quarters, risks to Chinese stocks are tilted toward the downside. Chart 1Chinese Stocks Will Truly Bottom When The Economy Troughs Below are some of the main questions from our meetings and our answers. Q: Policies have started to be more pro-growth. Why do you still underweight Chinese stocks? A: There are two reasons that we maintain a cautious view on Chinese stocks for at least the next six months, in both absolute terms and relative to global equities. First, we do not think that the magnitude of existing easing measures is sufficient to offset the economy’s downward momentum. Secondly, China’s business cycle lags credit growth by about six to nine months. The timing of a turnaround in the economy and stock prices may be later than investors have priced in. In short, we need to see more reflationary measures and a rebound in credit growth to have a legitimate macro fundamental basis to overweight Chinese stocks (Chart 1). Credit growth on a year-on-year basis stopped falling in October. The underlying data in credit creation, however, points to a weakening in demand for corporate loans (Chart 2). Loans to the housing sector are well below a year ago (Chart 3). Chart 2Weakening Loan Demand Chart 3Bank Loans To The Housing Sector Have Not Turned Around Chart 4It Will Take Time For Policy Easing To Restore Confidence In The Corporate Sector Despite an acceleration in local government bond issuance in October and RMB300 billion in additional bank loans to support small and medium enterprises, growth in medium- to long-term corporate loans peaked (Chart 4). In previous cycles, a rollover in corporate demand for longer-term bank lending on average lasted more than nine months, suggesting that any policy adjustments will take a while to restore confidence in the corporate sector. Without a decisive pickup in credit growth, corporate earnings growth will be at risk of deteriorating. Moreover, policy tightening since earlier this year is still working its way through the economy and major economic indicators in China continue to decline (Chart 5). We think that China’s economy is set to decelerate even more in the next several months, suggesting that earnings uncertainty will likely rise. This, combined with reactive policymakers, already slowing earnings momentum, and a downward adjustment in 12-month forward earnings, suggests that investors have not yet reached the maximum bearishness for Chinese stock prices (Chart 6). Chart 5No Signs Of Improvement In The Economy Chart 6The Earnings Adjustement Process Is Only Beginning   Q: What is the impact of China’s property market slowdown on the economy? Will recent policy easing stop deterioration in the real estate sector? A: Policy has been recalibrated by relaxing restrictions on mortgage lending and rules for land sales.1 However, the negative financing loop among developers, households and local governments may take longer to improve. Meanwhile, the market may underestimate the downside risks in housing-related activity in the next 6 to 12 months. Chart 7Households' Home Buying Intentions Have Plummeted Our view is based on the following: Home sales will likely remain in contraction in the next two quarters. Aggressive crackdowns on property market speculation in the past 12 months have fundamentally shifted consumers’ expectations for future home prices. The impending pilot property tax reform2 (details yet to be disclosed) will only encourage the wait-and-see sentiment of potential buyers. Home sales contracted by 24% in October from a year ago. In previous cycles, contractions in home sales normally lasted for more than 12 months. Moreover, the proportion of households planning to buy a house dropped to only 7.7% in Q3 2021 from 11.6% in Q4 2020 (Chart 7). Real estate developers have slashed new projects and land purchases to preserve liquidity for debt servicing (Chart 8, first and second panels). Policymakers may succeed in prompting banks to resume lending to developers in order to alleviate the escalating risk of widespread defaults. However, so far the marginal easing has failed to reverse the downward trend in bank credit to developers along with home sales (Chart 8, third and bottom panels). Funding constraints for real estate developers will probably be sustained for another six months, despite the recent easing measures. Construction activity, housing starts, and real estate investment will likely remain in doldrum at least through 1H22 (Chart 9). Chart 8Housing Activities Are Still Falling Chart 9Less Funding = Less Investment And Completions The marked reduction in land sales will impede local governments’ revenues and weigh on infrastructure investment (Chart 10). Real estate and infrastructure financing contributed 50% of the increase in total Chart 10Local Government Revenues Largely Depend On The Housing Sector social financing in 2020. Given that local governments face funding constraints from a slump in land sale incomes, policies on leverage from local government financing vehicles (LGFVs) will have to meaningfully loosen up to allow a rise in bank lending to support infrastructure investment. As discussed in previous reports, an acceleration in local government special-purpose bond issuance can only partially offset weak credit growth. Furthermore, shadow banking activity, which comprises LGFV borrowing and is highly correlated with China’s infrastructure investment growth, remains in contraction and indicates that growth in infrastructure investment is unlikely to rebound strongly (Chart 11). The sharp weakening of real estate construction activities will drag down the demand for building materials, machinery, home appliances and automobiles. Real estate accounts for about 60% of Chinese households’ wealth, thus any substantial drop in home prices will further weaken households’ propensity to consume (Chart 12). Chart 11More Easing Needed For A Meaningful Pickup In Infrastructure Investment Chart 12Falling Demand For Commodities And Consumer Goods Chart 13AOn The Surface Housing Inventories Are Lower Than Six Years Ago... There are nontrivial risks that the real estate slowdown will evolve into a downturn similar to that of 2014-15. Although the existing housing inventory is more modest than the start of the 2014/15 property downturn, developers have accumulated more debt and unfinished projects in this cycle than in the past (Charts 13A & 13B). Policymakers will have to relax property sector policies much more forcefully to prevent the downturn from intensifying. In the interim, we will likely witness more deterioration in the sector. Chart 13B...But Developers Have Built Up Massive Leverages And Hidden Inventories In The Past Three Years   Q: If the property market accounts for such a big portion of local governments’ revenues, why hasn’t the waning housing market forced policymakers to loosen restrictions? A: We think regulators have been slow to backtrack property market reforms because this year China’s fiscal deficit has narrowed from last year due to lower government spending and improved income from corporate taxes. In previous property market downturns, such as 2011/12, 2015/16 and 2019, property policy restrictions were lightened following major declines in government revenues (Chart 14). However, in 2021 China’s fiscal balance sheet has been stronger than in previous cycles; central and local governments have collected much more taxes, particularly corporate taxes, than in 2020 (Chart 15). Meanwhile, government expenditures so far this year have been lower, resulting in a large improvement in the country’s fiscal deficit (Chart 16). Chart 14Falling Gov Revenues Forced Policymakers To Backtrack Reforms In The Past... Chart 15...But This Year Gov Tax Revenues Have Been Strong Chart 16Fiscal Deficit Improved This Year Despite Falling evenues From Land Sales As discussed above, slightly loosened restrictions on land purchases by some regional governments will not restore developers’ confidence and boost the demand for land. The sharp increase in government's corporate tax collection will also start to ebb as economic growth slows and corporate profits decline. As such, even if government expenditures remain the same next year, the fiscal deficit will grow because revenues will be under substantial downward pressure. We expect that Chinese policymakers will have to take more actions to stabilize fiscal conditions. Forecasting exactly when this will occur is difficult, but a benign government balance sheet in much of this year is delaying policymakers’ response to the flagging housing market. Meantime, both policymakers and investors may be complacent about the state of the economy until the full scale of the property sector spillover risk becomes clear.   Q: Rates are low and industrial profit growth has been strong this year. Why has capex been so sluggish? A: Investment growth in the manufacturing sector has been lackluster because their profit margins have been squeezed by rising input costs. On the other hand, investment in the mining industry has been constrained by policy restrictions. An acceleration in China’s de-carbonization efforts this year has likely constrained investment in the mining sector. Even though industrial profit growth has been concentrated among the upstream industries such as mining which profits grew by a stunning 100% this year, investment in the sector was mostly flat from a year ago (Chart 17). During the first half of the year, mid- to downstream firms were caught between rising input prices and a weak recovery in domestic consumption. Manufacturing investment grew faster than the mining sector, but manufacturing profit growth only increased by about 30% year to date (Chart 18). However, we think manufacturing investment growth may improve slightly into 2022 as the sector continues to gain pricing power. Chart 17Mining Sector's Profit Growth Way Outpaced Investment Chart 18Manufacturing Sector Profit Growth Has Been Much More Muted Than Upstream Industries   Q: The RMB has been strong against the dollar, despite China’s maturing business cycle. What is your outlook for the RMB next year? A: The RMB exchange rate has been boosted by China’s record current account surplus, wide interest rate differentials and speculation that tension between the US and China will abate. However, all three favorable conditions supporting the RMB are in danger of reversing next year. Chart 19The RMB Has Been Appreciating Despite A Strong USD Chart 20The RMB's Appreciation Deviates From Economic Fundamentals Despite broad-based dollar strength, the CNY/USD has appreciated by 4.5% year to date (Chart 19). The RMB’s appreciation deviates from China’s economic fundamentals (Chart 20).       Strong global demand for goods has boosted Chinese exports while travel restrictions curbed foreign exchange outflows by domestic households (Chart 21). China-US real interest rate differentials have been in favor of the CNY versus USD, bringing net foreign inflows to China’s onshore bond market (Chart 22). Additionally, the recent meeting between President Joe Biden and President Xi Jinping has prompted speculation that the US will lessen tariffs on Chinese imports. Chart 21Large Current Account Surplus Chart 22Favorable Interest Rate Differentials And Strong Fund Inflows Chart 23China's Extremely Robust Export Growth Unlikely To Sustain In 2022 Chart 24A Strong RMB Does Not Bode Well For Chinese Exporters' Profits These factors will likely turn against the CNY next year. First, export growth will moderate as the composition of US consumption rotates from goods to services (Chart 23). Secondly, it would not be in the PBoC’s best interests to let the RMB strengthen too rapidly because an appreciating currency would be a deflationary force on China’s export and manufacturing sectors (Chart 24). While we expect policymakers to maintain their preference for a gradual approach to stimulus, we assign a high probability to a reserve requirement ratio (RRR) cut in early 2022. In this environment, Chinese bond yields will decline, which would narrow the China-US interest rate differential. Finally, while there may be some changes to US tariffs on China, it is doubtful that there would be a broad-based removal of tariffs. Chart 25The CNY/USD Will Likely Fall And Converge To Chinese Stocks' (Under)performance The CNY’s outperformance stands out as it marks a break from its correlation with China’s relative equity performance vis-à-vis the US (Chart 25). The signal from the currency suggests that either global equity investors are overly pessimistic about economic and regulatory risks in China, or overly optimistic about the value of China’s currency. The latter option is more likely at the moment, and the CNY/USD exchange rate is at the risk of converging to the underperformance of Chinese investable stocks next year.   Jing Sima China Strategist jings@bcaresearch.com Footnotes 1  China Cities Ease Land Bidding Rules as Property Stress Spreads - Bloomberg 2  China’s Pilot Property Tax Reforms Benefit Markets Despite Short-Term Pain, Analysts Say - Caixin Global Market/Sector Recommendations Cyclical Investment Stance

Highlights The euro has entered a period of acute stress. Some of the EUR/USD’s plunge reflects the dollar’s broad-based strength. The dollar is supported by the market’s pricing of the Fed and China’s economic weakness. The euro also suffers from idiosyncratic forces. Investors appreciate better now that the Eurozone’s inflation is much narrower than that of the US. They are adjusting their ECB pricing accordingly. Europe’s growth prospects are also hurt by a renewed wave of lockdowns and China’s property woes. The revival of the European natural gas surge is the coup de grâce that is hurting the Euro. Nonetheless, euro sentiment is extremely depressed, which suggests that the euro already discounts many of these negatives. Consequently, we are adhering to our long EUR/USD trade implemented four weeks ago, but we will not re-open it if the stop-loss is triggered. Feature Four weeks ago, we tentatively recommended buying the euro, acknowledging that this view was fraught with near-term risks. However, the recent collapse in the euro forces us to revisit this stance. 2022 will be a better year for EUR/USD; nevertheless, the next three months could result in pronounced weakness in the currency, and the odds have increased that this pair might retest the pandemic lows. We are sticking with our long EUR/USD bet for now, as we have a floor under the position, the result of our stop at 1.1175. If this stop is reached, we will wait before reinstating a long euro position. What’s Going Well With The USD? The first element of the euro’s weakness is the generalized strength in the USD. The dollar is rallying against all the components of the DXY, which is pushing the USD’s Advanced/Decline line up (Chart 1). Moreover, as BCA’s Emerging Market Strategy team recently highlighted, the dollar is breaking out above its three-year moving average, which constitutes an important technical signal.  The dollar strength is multi-faceted and reflects both domestic and international factors. On the domestic front, markets are responding to growing inflationary forces and signs of economic vigor to price in a more aggressive Fed outlook than two months ago (Chart 2), especially following the implementation of the Fed’s tapering program this month. Chart 1The Dollar Is Strong Chart 2More Hikes Prices In The inflation picture is of prime concern to investors. As Chart 3highlights, US core CPI is at a 30-year high and median inflation measures are also strengthening. Most concerning, inflationary pressures are broadening beyond energy and goods, with shelter prices accelerating anew (Chart 3, bottom panel). The labor market is also gearing up to move toward full employment conditions. The quits rate is near a record high, which corroborates the impression among households that jobs are easy to secure (Chart 4). Moreover, wages among low-skill employees are strengthening, which indicates that the labor market is tight (Chart 4, bottom panel). Granted, this is happening in a context in which the labor force participation rate is low, especially for women, and could rise anew, which would alleviate the labor market’s tightness. However, this process will likely entail higher wages first. Chart 3Broadening US Inflation Chart 4Getting To Maximum Employment? Economic data is also firming up, despite rises in COVID cases in many states. For example, nominal retail sales were robust in October, even if inflation contributed to their strength. Moreover, both the New York Fed’s Empire State Manufacturing Survey and the Philly Fed’s Manufacturing Business Outlook Survey highlighted an acceleration in activity (Chart 5). As a result, the Atlanta Fed’s Q4 GDPNow Forecast has rebounded to 8.2%, which would represent a marked improvement from the 2.2% quarterly annualized rate recorded in Q3. Whether or not this is an error, market participants may continue to use this economic backdrop to price in additional hikes by the Fed and feed the dollar rally. The international backdrop also helps the USD. The main positive comes from China. BCA’s emerging market strategists highlight that the weakness in the Chinese credit impulse is often a harbinger of dollar strength (Chart 6). The US economy is less exposed to manufacturing and trade than the economies of Europe, Australia, and EM, which means that it is less impacted by Chinese growth slowdowns than other parts of the world. This explains why the dollar loves a slowing Chinese economy. Chart 5A Pick Up In US Growth Chart 6The Dollar Loves A Weaker China China’s economic problems have once again become more relevant to market participants, as recent prints have been weak. Following the fall of Chinese GDP growth to 4.9% in the third quarter, new releases have shown that house prices are contracting and property investment is decelerating. These data sets are feeding the dollar rally. The dollar’s strength will beget further dollar appreciation. We have often highlighted that the dollar is the premier momentum currency within the G-10, along with the yen (Chart 7). Today, the most reliable momentum indicator for the greenback, the crossover of the 20-day MA above the 200-day one, continues to send a very supportive signal, which the economic backdrop reinforces (Chart 8). Moreover, historically, the dollar’s trading in the first few weeks of January often echoes the trend of the previous year. Hence, we may witness a continued blow off until February 2022. Chart 8Positive Momentum Signal For The Dollar Bottom Line: The dollar is breaking out on a broad basis. Not only is the US economy inviting investors to reprice the Fed’s expected policy path, but the economic weakness in China is also contributing to the rally. Technically, the dollar’s pro-momentum attribute accentuates the risk that this breakout morphs into a melt-up until February 2022, especially if US equities continue to outperform the rest of world and attract flows into the USD. The Euro’s Specific Problems Chart 9Europe Doesn't Have The US Inflation Problem The spectacular collapse in EUR/USD goes beyond the strength in the dollar, because crucial catalysts are also pushing the euro lower. First, investors are increasingly differentiating between the Eurozone and the US inflation picture. We have often made the case that European inflation is much more limited than that of the US. For example, the dynamics in the trimmed-mean inflation and the CPI adjusted for VAT highlights that lack of broad inflation in Europe (Chart 9). Moreover, recent ECB’s communications have made it eminently clear that it is in no rush to raise rates. As a result, investors have been curtailing the number of ECB hikes priced in for 2022 compared to early November. Second, European economic activity is unable to catch a break. The recent uptick of COVID-19 cases in Germany, the Netherlands, and Austria is prompting local governments to impose renewed lockdowns of various scales, as worries emerge that hospital capacity will suffer as it did last winter (Chart 10). We doubt these lockdowns will last as long or will be as severe from a pan-European perspective, but, for now, they are weighing on investor sentiment and contributing to the euro-bearish widening in US-German 2-year yield differentials (Chart 11). Chart 10A New Wave Chart 11Rate Differentials Hurt The Euro   Third, the Chinese economy continues to act as a drag on Europe. China’s real estate activity is slowing, as credit spreads and share prices of property developers remain distressed (Chart 12). It is of concern that the Chinese and EM credit market stresses are broadening beyond this sector, which indicates a tightening in financial conditions for a large swath of the Eurozone’s important trading partners. Moreover, Europe’s machinery exports are particularly exposed to the Chinese construction sector. Under these circumstances, the wave of weakness in Chinese construction activity could herald additional problems for EUR/USD, since they amount to a weakening in Euro Area growth relative to the US (Chart 13). Chart 12Downside To Chinese Construction Activity Chart 13Slowing Chinese Construction Is A Threat to EUR/USD Fourth, equity outflows out of the Eurozone into the US are likely to continue as long as China suffers. BCA’s Emerging Market strategists anticipate the deterioration in China’s stock-to-bond ratio (SBR) to last, because this economy is weakening. Over the past five years, a deteriorating Chinese SBR has coexisted with a deepening underperformance of European equities relative to those of the US (Chart 14). Over this timeframe, equity flows have played a significant role in the EUR/USD exchange rate determination; thus, the weaker Chinese SBR also correlates well with a softer euro (Chart 14, bottom panel). Finally, the renewed energy crisis is particularly painful for the euro. German regulators indicated that they will temporarily suspend the approval of the Nord Stream 2 pipeline, which prompted European natural gas prices to surge anew. As Chart 15 shows, this proved to be the coup de grâce for the euro. The response of the euro to higher natural gas prices is rational. Surging natural gas prices are a growth shock for the region, yet they are unlikely to prompt a tightening in policy by the ECB, because they only push headline inflation, not the core measure. In fact, they could widen the dichotomy between underlying and headline inflation, because rising energy costs sap other spending categories. In other words, rising energy prices point to a stagflationary outcome this winter in Europe, which is poison for the euro. Chart 14More European Equity Outflows? Chart 15The Nat-Gas Coup De Grace Bottom Line: The weakness of the euro reflects more than the strength in the USD. The narrower nature of European inflation prevents a hawkish repricing of the ECB to take place, while renewed lockdowns are hurting growth sentiment. Moreover, the travails of China’s property sector are harming European economic activity, while also inviting equity outflows. Finally, the recent revival of the natural gas price surge is once again raising the specter of stagflation this winter in Europe, which is a dreadful scenario for the euro. What To Do? Our long EUR/USD bet initiated four weeks ago has a stop loss at 1.1175. Due to the bullish dollar forces and bearish euro factors described in this report, we will not re-open the trade if the stop-loss is triggered. Its activation would indicate that the bear-trend in the euro is gathering steam. When coupled with the momentum nature of the dollar and the euro’s anti-dollar behavior imparted by EUR/USD’s great market liquidity, this combination could easily push EUR/USD to 1.08 or lower by January 2022. We are not closing the trade either. While the list of euro-negative forces is long, sentiment toward EUR/USD is now quite lopsided, which suggests that a significant proportion of the euro bearish factors are already discounted. One-month, three-month, and six-month risk reversals in EUR/USD have fallen close to their Q2 2020 levels. Moreover, investors now hold large short positions in EUR/USD, especially compared to their large long bets on the DXY (Chart 16); meanwhile, the Euro Capitulation Index is now depressed relative to that of the dollar (Chart 16, bottom panel). Finally, the most important signal comes from our Intermediate-Term Timing Model (ITTM), which is an augmented interest-rate parity model that accounts for global risk aversion and the currency’s trend. The ITTM is now trading at 1 sigma, a level that has historically been followed by a positive return six months later 75% of the time since 2002 (Chart 17). Chart 16Negative Euro Sentiment Chart 17Much Pessimism Is In The Price Chart 18Peak US Inflation? Finally, the US is likely experiencing peak inflationary pressures right now. If inflation rolls over in the near future, investors will breathe a collective sigh of relief, and they will not price in more rate hikes. The decline in DRAM prices and the recent ebb in shipping costs, with the Baltic Dry down 57% from its peak and the WCI Composite Container Freight Benchmark 12% below its September apex, suggest that the most severe supply bottlenecks are passing while energy indexes are also softening (Chart 18). In this context, the best strategy remains to keep the trade open and to follow the discipline imposed by the stop loss.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades   Currency Performance Fixed Income Performance Equity Performance