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Highlights Going into the new crop year, we expect the course of the broad trade-weighted USD to dictate the path taken by grain and bean prices (Chart of the Week). Higher corn stocks in the coming crop year, flat wheat stocks and lower rice stocks will leave grain markets mostly balanced vs the current crop year.  Soybean stocks and carryover estimates from the USDA and International Grains Council (IGC) are essentially unchanged year-on-year (y/y). In the IGC's estimates, changes in production, trade, and consumption for the major grains and beans largely offset each other, leaving carryovers unchanged. Supply-demand fundamentals leave our outlook for grains and beans neutral.  This does not weaken our conviction that continued global weather volatility will tip the balance of price risk in grains and beans over the coming year to the upside. Our strategically bearish USD view also tips the balance of price risk in grains – and commodities generally – to the upside. We believe positioning for higher-volatility weather events and a lower US dollar is best done with index products like the S&P GSCI and the COMT ETF, which tracks a version of the GSCI optimized for backwardation.  Feature Chart of the WeekUSD Will Drive Global Grain Markets USD Will Drive Global Grain Markets USD Will Drive Global Grain Markets Chart 2Opening, Closing Grain Stocks Will Be Largely Unchanged Global Grain, Bean Markets Balanced; USD Expected To Drive '21/22 Prices Global Grain, Bean Markets Balanced; USD Expected To Drive '21/22 Prices Going into the new crop year, opening and closing stocks are expected to remain flat overall vs the current crop years, with changes in production and consumption largely offsetting each other in grain and bean markets (Chart 2).1 This will leave overall prices a function of weather – which no one can predict – and the path taken by the USD over the coming year. The IGC's forecast calls for mostly unchanged production and consumption for grains and beans globally, with trade volumes mostly flat y/y. This leaves global end-of-crop-year carryover stocks essentially unchanged at 594mm tons. The USDA expects wheat ending stocks at the end of the '21/22 crop year up a slight 0.5%; rice down ~ 4.5%, and corn up ~ 4%. Below we go through each of the grain and bean fundamentals, and assess the impact of COVID-19 on global trade in these commodities. We then summarize our overall view for the grain and bean complex, and our positioning recommendations. Rice The IGC forecasts higher global rice production and consumption, and, since they expect both to change roughly by the same amount, ending stocks are projected to remain unchanged in the '21/22 crop year relative to the current year (Chart 3). The USDA, on the other hand, is expecting global production to increase by ~ 1mm MT in the new crop year, with consumption increasing by ~ 8mm MT. This leaves ending inventories for the new crop year just under 8mm MT below '20/21 ending stocks, or 4.5%. Chart 3Global Rice Balances Roughly Unchanged Global Rice Balances Roughly Unchanged Global Rice Balances Roughly Unchanged Corn The IGC forecasts global corn production will rise 6.5% to a record high in the '21/22 crop year, while global consumption is expected to increase 3.6%. Trade volumes are expected to fall ~ 4.2%, leaving global carryover stocks roughly unchanged (Chart 4). In the USDA's modelling, global production is expected to rise 6.6% in the '21/22 crop year to 1,195mm MT, while consumption is projected to rise ~ 2.4% to 1,172mm MT. The Department expects ending balances to increase ~ 11mm MT, ending next year at 291.2mm MT, or just over 4% higher. Chart 4Corn Balances Y/Y Remain Flat Corn Balances Y/Y Remain Flat Corn Balances Y/Y Remain Flat Wheat The IGC forecasts global wheat production in the current crop year will increase by ~ 16mm MT y/y, which will be a record if realized. Consumption is expected to rise 17mm MT, with trade roughly unchanged. This leaves expected carryover largely unchanged at ~ 280mm MT globally (Chart 5). The USDA's forecast largely agrees with the IGC's in its ending-stocks assessment for the new crop year. Global wheat production is expected to increase 16.6mm MT y/y in '21/22, and consumption will rise ~ 13mm MT, or 1.7% y/y. Ending stocks for the new crop year are expected to come in at just under 292mm MT, or 0.5% higher. Chart 5Ending Wheat Stocks Mostly Unchanged Ending Wheat Stocks Mostly Unchanged Ending Wheat Stocks Mostly Unchanged Soybeans Both the IGC and USDA expect increases in soybean ending stocks for the '21/22 crop year. However, the USDA’s estimates for ending stocks are nearly double the IGC projections.2 We use the IGC's estimates in Chart 6 to depicts balances. USDA - 2021/22 global soybean ending stocks are set to increase by ~3 mm MT to 94.5 mm MT, as higher stocks from Brazil and Argentina are partly offset by lower Chinese inventories. US production is expected to make up more than 30% of total production, rising 6% year-on-year. Chart 6Higher Bean Production Meets Higher Consumption Higher Bean Production Meets Higher Consumption Higher Bean Production Meets Higher Consumption Impact Of COVID-19 On Ags Trade Global agricultural trade was mostly stable throughout the COVID-19 pandemic. China was the main driver for this resilience, accounting for most of the increase in agricultural imports from 2019 to 2020. Ex-China, global agricultural trade growth was nearly zero. During this period, China was rebuilding its hog stocks after an outbreak of the African Swine Flu, which prompted the government to grant waivers on tariffs in key import sectors, which increased trade under the US-China Phase One agreement. As a result, apart from COVID-19, other factors were influencing trade. Arita et. al. (2021) attempted to isolate the impact of COVID on global agricultural trade.3 Their report found that COVID-19 – through infections and deaths – had a small impact on global agricultural trade. Government policy restrictions and reduced mobility in response to the pandemic were more detrimental to agricultural trade flows than the virus itself in terms of reducing aggregate demand. Policy restrictions and lower mobility reduced trade by ~ 10% and ~ 6% on average over the course of the year. Monthly USDA data shows that the pandemic was not as detrimental to agricultural trade as past events. Rates of decline in global merchandise trade were sharper during the Great Recession of 2007 – 2009 (Chart 7). Many agricultural commodities are necessities, which are income inelastic. Furthermore, shipping channels for these types of commodities did not require substantial human interactions, which reduced the chances of this trade being a transmission vector for the virus, when governments declared many industries using and producing agricultural commodities as necessities. This could explain why agricultural trade was spared by the pandemic. Amongst agricultural commodities, the impact of the pandemic was heterogenous. For necessities such as grains or oilseeds, there was a relatively small effect, and in few instances, trade actually grew. For example, trade in rice increased by ~4%. The value of trade in higher-end items, such as hides, Chart 7COVID-19 Spares Ag Trade Global Grain, Bean Markets Balanced; USD Expected To Drive '21/22 Prices Global Grain, Bean Markets Balanced; USD Expected To Drive '21/22 Prices Chart 8Grains Rallied During Pandemic Global Grain, Bean Markets Balanced; USD Expected To Drive '21/22 Prices Global Grain, Bean Markets Balanced; USD Expected To Drive '21/22 Prices tobacco, wine, and beer fell during the pandemic. This was further proof of the income inelasticity of many agricultural products which kept global trade in this sector resilient. Indeed, the UNCTAD estimates global trade for agriculture foods increased 18% in 1Q21 relative to 1Q19. Over this period, Bloomberg's spot grains index was up 47.08% (Chart 8). Investment Implications We remain neutral grains and beans based on our assessment of the new crop-year fundamentals. That said, we have a strong-conviction view global weather volatility will tip the balance of price risk in grains over the coming year to the upside. Our strategically bearish USD view also tips the balance of price risk in grains – and commodities generally – to the upside. Weather-induced grain and bean prices volatility is supportive for our recommendations in the S&P GSCI and the COMT ETF, which tracks a version of the GSCI optimized for backwardation. These positions are up 5.8% and 7.9% since inception, and are strategic holdings for us.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish US natural gas prices remain well supported by increased power-generation demand due to heat waves rolling through East and West coasts, lower domestic production and rising exports. The US EIA estimates natgas demand for July rose 3.9 bcf/d vs June, taking demand for the month to 75.8 bcf/d. Exports – pipeline and LNG – rose 0.4 bcf/d to 18.2 bcf/d, while US domestic production fell to 92.7 bcf/d, down 0.2 bcf/d from June's levels. As US and European distribution companies and industrials continue to scramble for gas to fill inventories, we expect natgas to remain well bid as the storage-injection season winds down. We remain long 1Q22 call spreads, which are up ~214% since the position was recommended April 8, 2021 (Chart 9). Base Metals: Bullish Labor and management at BHP's Escondida copper mine – the largest in the world – have a tentative agreement to avoid a strike that would have crippled an already-tight market. The proposed contract likely will be voted on by workers over the next two days, according to reuters.com. Separately, the head of a trade group representing Chile's copper miners said prices likely will remain high over the next 2-3 years as demand from renewables and electric vehicles continues to grow. Diego Hernández, president of the National Society of Mining (SONAMI), urged caution against expecting a more extended period of higher prices, however, mining.com reported (Chart 10). We remain bullish base metals generally, copper in particular, which we expect to remain well-bid over the next five years. Precious Metals: Bullish US CPI for July rose 0.5% month-over-month, suggesting the inflation spike in June was transitory. While lower inflation may reduce demand for gold, it will allow the Fed to continue its expansionary monetary policy. The strong jobs report released on Friday prompted markets and some Fed officials to consider tapering asset purchases sooner than previously expected. The jobs report also boosted an increasing US dollar. A strong USD and an increase in employment were negative for gold prices on Monday. There also were media reports of a brief “flash crash” caused by an attempt to sell a large quantity of gold early in the Asian trading day, which swamped available liquidity at the time. This also was believed to trigger stops and algorithmic trading programs, which exacerbated the move. The potential economic impact of the COVID-19 Delta variant is the only unequivocally supportive development for gold prices. Not only will this increase safe-have demand for gold, but it will also prevent the Fed from being too hasty in tapering its asset purchases and subsequently raising interest rates. Chart 9 Natgas Prices Recovering Natgas Prices Recovering Chart 10 Copper Prices Going Down Copper Prices Going Down Footnotes 1     The wheat crop year in the US begins in June; the rice crop year begins this month; and the corn and bean crop years begin in September. 2     Historical data indicate this difference is persistent, suggesting different methods of calculating ending stocks.  The USDA estimates ending stocks for the '21/22 crop year will be 94.5mm tons, while the IGC is projecting a level of 53.8mm.  3    Please refer to ‘Has Global Agricultural Trade Been Resilient Under Coronavirus (COVID-19)? Findings from an Econometric Assessment. This is a working paper published by Shawn Arita, Jason Grant, Sharon Sydow, and Jayson Beckman in May 2021.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Image

Dear client,  In addition to this abridged Strategy Report, we are sending a report written by Arthur Budaghyan, Chief Strategist of BCA’s Emerging Market Investment service. Arthur shares his thoughts on the future of Chinese TMT stocks, a subject we trust you will find insightful and beneficial. Jing Sima China Strategist Highlights Wealth and income inequality may be the most important contributors to rising populism in the past three decades. China has its share of increasing populism; reducing income inequality and improving social welfare are core principles of President Xi’s reform agenda. July’s economic data continues to indicate a softening in China’s economy. However, the magnitude of the slowdown is within policymakers’ pain threshold while the economy remains supported by strong external demand. For now, stay underweight in Chinese stocks within a global equity portfolio.  Policy stance has yet to turn reflationary. Feature Populism Takes Root BCA's China Investment Strategy has argued that China is accelerating the pace of its structural reforms; addressing income inequality is at the core of the current administration’s reform agenda. Wealth and income inequality may be the most important structural cause of rising global populism and political polarization (Chart 1). The severity of income inequality in China is illustrated in Chart 2. It is noteworthy that China, whose political and economic ideology is based on creating a classless society, has found itself not far behind the US in terms of a widening wealth and income gap. Chart 1Populism Has Been On The Rise Globally For The Past 30 Years Populism Finds Fertile Ground In China Populism Finds Fertile Ground In China Chart 2The Great Gatsby Curve Paints A Not-So-Great Equality Picture Of China Populism Finds Fertile Ground In China Populism Finds Fertile Ground In China The relationship between inequality and intergenerational income mobility is captured in the "Great Gatsby Curve" – a concept based on a research paper by economist Miles Corak and later introduced by Alan Krueger, the late professor and Chairman of the Council Economic Advisers, during his speech at the Center for American Progress in 2012.1 The US has experienced a sharp rise in wealth and income inequality since the 1980s. On the eve of the Global Financial Crisis, income inequality in the US was as sharp as it had been since the time of "The Great Gatsby” novel set in the 1920s. After three decades of rapid industrialization and economic expansion, China also faces the challenge of escalating income inequality and discontent among middle-class households. Populism, defined as political stances that emphasize the idea of "the people", often benefits middle-class households, but not big business or corporate earnings (“the elite”). An increase in populist governments is usually positively correlated with rising number of antitrust investigations, since populist leaders tend to pander to popular outcries against big corporations by limiting or breaking up the corporations. In the US, the rise of Reaganism/neoliberalism in the 1980s led to a big drop in antitrust cases – a trend that was sustained for nearly three decades as the free-market Washington Consensus pushed against antitrust and other populist stances (Chart 3). However, the tide turned in 2016 when the US elected a populist president for first time, and antitrust threats started reemerging (Chart 4). Chart 3Antitrust Reinforcement In The US Has Been On A Secular Decline In The Past Two Decades… Populism Finds Fertile Ground In China Populism Finds Fertile Ground In China Chart 4...But Antitrust Noise Is Getting Louder In The US (And Lately In China) ...But Antitrust Noise Is Getting Louder In The US (And Lately In China) ...But Antitrust Noise Is Getting Louder In The US (And Lately In China) Both China and the US have transitioned towards larger government involvement in the economy.  More restrictions on private enterprise and a greater redistribution of wealth will be forthcoming. In the US, there has been a shift towards a larger share of labor compensation versus capital in the country’s national income (Chart 5). In China, the “dual circulation” economic goal set by the 14th Five Year Plan, coupled with an economic divorce between the Middle Kingdom and the US, requires that China expands its domestic market. However, that expansion is constrained by its relatively low labor share (Chart 6). The external and internal challenges are fertile ground for rising and sustaining populism. Thus, reforms that promote the bargaining power of workers at the expense of corporate earnings will likely become a secular trend in China. Chart 5Labor Makes A Comeback Versus Capital In The US... Labor Makes A Comeback Versus Capital In The US... Labor Makes A Comeback Versus Capital In The US... Chart 6...And In China Too ...And In China Too ...And In China Too Checking In On The Data China’s economic data continues to soften as evidenced by a slew of new numbers published last weekend. On the growth front, the contraction in the volume of imports in the past two months reflects the sagging domestic economy, despite elevated commodity prices supporting the value of total imports (Chart 7). Global demand for Chinese goods, on the other hand, remains strong compared with the historical norm, and continues to offset weaknesses in China’s old economy sectors. Meanwhile, Chinese producers face persistent inflationary pressures stemming from elevated global commodity prices and a broken price transmission to pass on inflation to domestic consumers (Chart 8). Instead of stimulating demand in the near term, Chinese policymakers will likely address supply-side issues by releasing strategic reserves and curbing raw material exports, and relaxing domestic production restrictions. Chart 7Strong External Demand Continues To Offset Domestic Economic Weaknesses Strong External Demand Continues To Offset Domestic Economic Weaknesses Strong External Demand Continues To Offset Domestic Economic Weaknesses Chart 8Inflationary Pressures On Producers Remains Elevated Inflationary Pressures On Producers Remains Elevated Inflationary Pressures On Producers Remains Elevated We expect that Beijing will need greater economic pain before it decides to stimulate the economy more substantially. Monetary conditions have eased since earlier this year on the back of rising inflation, falling real interest rates and recently a breather in the RMB’s ascent (Chart 9). Nonetheless, as we noted in a previous report, a decisive rebound in the rate of credit expansion requires clear easing signals from China’s top leadership for local governments and corporates to ramp up leverage again. The July Politburo meeting pledged more fiscal support for the economy this year. Meanwhile, policymakers have intensified their tough regulatory stances on private-sector businesses and oversight on the public-sector’s balance sheet. Hence, the current policy backdrop does not suggest any imminent or meaningful reflationary measures. Chart 9A Meaningful Rebound In Credit Growth Requires More Than Monetary Easing A Meaningful Rebound In Credit Growth Requires More Than Monetary Easing A Meaningful Rebound In Credit Growth Requires More Than Monetary Easing Chart 10War Against Delta-Variant Remains A Risk War Against Delta-Variant Remains A Risk War Against Delta-Variant Remains A Risk The COVID-19 Delta-variant remains the biggest risk to our view. The mutated virus has spread to 14 provinces in China and triggered the strictest pandemic-control measures since Q1 last year. The drag on the service sector’s activities and employment will be substantial if measures are maintained for more than a month (Chart 10). In this case, the leadership may need to step in with policy supports to stabilize the economy and sentiment. For now, the pullback of stimulus and ongoing regulatory tightening since Q4 last year continue to dominate China’s financial assets. Thus, investors should maintain an underweight allocation to Chinese equities within a global equity portfolio.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1Krueger, Alan (12 January 2012). "The Rise and Consequences of Inequality in the United States" (PDF).  Market/Sector Recommendations Cyclical Investment Stance

Highlights Chinese authorities’ regulatory crackdown on new economy companies reflects new socio-political and economic shifts in China. Hence, this regulatory crackdown is not transitory. Investors in Chinese TMT/new economy stocks are facing uncertainty on multiple fronts which warrants lower valuation multiples. These companies will experience weaker profit growth and lower profitability relative to the past due to disruptions to their business models. Elsewhere, widening credit spreads among Chinese property developers reflects the property market’s poor outlook. In turn, shrinking Chinese construction heralds weaker demand for commodities and manufacturing goods. This poses a material risk to raw material prices and, consequently, EM in general. Feature Chart 1Chinese Growth/TMT Share Prices And P/E Ratio Chinese Growth/TMT Share Prices And P/E Ratio Chinese Growth/TMT Share Prices And P/E Ratio The Chinese MSCI Investable Growth stock index is down by 35% from its February peak (Chart 1, top panel). Such a drawdown in the previous market leaders has produced a temptation to buy. The enticement is especially strong given that US FAANGM stocks are hitting new all-time highs. Is the latest crash in Chinese new economy/growth/TMT stocks a bad dream that will soon end, or does it mark a new reality for these companies? In our opinion, Chinese authorities’ regulatory crackdown on new economy companies reflects new socio-political and economic shifts in China. Hence, this regulatory crackdown is not transitory but is a part of China’s ongoing transformation. In brief, these companies are facing a new reality. What’s more, their outlook is very uncertain and equity valuations are not low enough to offset potential risks related to owning these stocks. Overall, investors should not start bottom fishing in Chinese stocks in general and Chinese TMT stocks in particular. Uncertainty = Lower Equity Multiples Immense uncertainty surrounds the outlook for Chinese TMT share prices. Even though China’s growth stocks have been de-rated, their trailing P/E ratio remains at 36.5 (Chart 1, bottom panel). Table 1A Snapshot Of Drawdown And Valuations Chinese TMT Stocks: A Bad Dream Or A New Reality? Chinese TMT Stocks: A Bad Dream Or A New Reality? Table 1 shows the drawdowns and trailing P/E ratios for TMT/new economy/growth indexes as well as their largest constituencies: Alibaba, Tencent and Meituan. These equity multiples are still high given the uncertainty these companies are facing. By extension, investors in Chinese TMT/new economy stocks are also facing uncertainty on multiple fronts: Regulatory crackdowns mean that the business models of many of these companies will have to undergo substantial changes. Corporations may need to overhaul their product lines or abandon existing products/markets and find new niches and introduce new offerings. It is impossible to know what the long-term revenue and profit growth rates of these companies will be so that they can be properly valued. Such heightened uncertainty about the long-term outlook warrants a higher equity risk premium and, hence, lower equity multiples. President Xi Jinping’s long-term objective is to reduce income equality and achieve more equal wealth distribution. There will therefore be little tolerance for excessive profitability of individual companies. Chart 2 illustrates the large income gap between the top 10% and bottom 50% of the population. In turn, the mean-to-median wealth ratio points to a large and rising wealth gap – a higher ratio reflects greater wealth concentration among rich households (Chart 3). Chart 2China: Income Disparity Has Not Been Narrowing Wealth Concertation Remains High In China Wealth Concertation Remains High In China Chart 3Wealth Concentration Remains High In China Wealth Concertation Remains High In China Wealth Concertation Remains High In China   President Xi’s goal is to appease the broader population, not shareholders or businesses. Top authorities have been using phrases such as “disorderly expansion of capital” since last fall. This language marked a major shift in government policies regarding market power and dominance of private companies. Investors should take note that they are now dealing with a new investment regime in China. For some time, we have argued that China’s regulatory tightening on private platform companies would aim to limit their monopolistic or oligopolistic power and ration their profitability. As a result, we alleged that these new economy companies would end up being regulated like utilities or become quasi-government entities. Consequently, their profitability would decline to close to that of utilities or SOEs. Yet, utility stocks or SOEs in China command much lower equity multiples than those at which platform companies’ stocks have been trading. Even as of today, the trailing P/E ratio on the China MSCI Growth Investable index is 36.5. Meanwhile, global utility stocks command a trailing P/E ratio of 19. It is hard to know where the P/E ratios of these Chinese TMT stocks will settle, but our hunch is that their multiple compression is not over yet. Regulatory clampdowns will not only curtail their revenues and pricing power but also increase their costs. These companies will need to spend money to comply with the new regulatory regime. They will, for instance, be expected to take on more in the way of social responsibilities, as SOEs in China have been doing. This and other measures will eat into their profit margins and will lower the return on capital. Finally, many Chinese TMT companies that have their ADRs listed in the US have been caught in the crossfire of the “big data war” between the US and China. On the one hand, US authorities want to oblige these Chinese issuers to comply with US regulations in terms of information and risks disclosure. On the other hand, Chinese authorities are reluctant to allow more data/information disclosure by their dominant platform companies to foreign investors. Given that the US-China confrontation is likely to escalate on many fronts going forward, odds are low that there will be a lasting solution to this conflict around US-traded Chinese equities. Authorities in the Middle Kingdom are not very sensitive to the fact that foreign shareholders are losing money in Chinese offshore trading stocks. Unless the crash in offshore stocks spills into the domestic financial markets and the economy, their willingness to compromise will be limited. In turn, the US will not “encourage” American investors to invest more in Chinese stocks where its regulatory authority and influence is weak. Overall, such high uncertainty regarding offshore Chinese stocks in general and the ones trading in the US in particular warrants a higher equity risk premium and lower equity multiples. Despite these negatives, there is a silver lining: China’s new economy segments have been and will continue expanding at a rapid pace. Chinese authorities are genuinely interested in supporting new economy sectors which could help boost productivity and be growth engines as the growth contribution from construction/infrastructure/manufacturing diminishes. The challenge for investors is to find companies that benefit from the continued expansion of new economy sectors, and acquire their stocks at reasonable multiples to secure limited drawdowns during market selloffs. Bottom Line: Chinese growth stocks/TMT share prices – on the index level – remain at risk of further de-rating/multiple compression. These companies also face potentially weaker profit growth and lower profitability compared to the past due to disruptions to their business models and/or higher costs of doing business. A Breakdown In Chinese Property Stocks And Bonds Is Flying Under The Radar Chart 4Property Stocks And Bond Prices Have Crashed Property Stocks And Bond Prices Have Crashed Property Stocks And Bond Prices Have Crashed While Chinese TMT stocks are at the center of the global investment community’s interest, there has been a breakdown in mainland real estate share prices and a spike in property companies’ offshore credit spreads (Chart 4). The rising cost of capital imply that real estate developers will curtail their new property launches and construction. In addition, authorities will not ease regulatory tightening in the property market in general and property companies in particular. The objective is to halt the rise in property prices so that the continuous increase in personal income brings down the household income-to-property price ratio. The latter is extremely high in China making housing unaffordable for average Chinese. Authorities are very sensitive to the issue of housing unaffordability. Not only are property developers under pressure from tightening but also authorities are curbing demand for housing. In particular, two weeks ago the PBoC ordered banks in Shanghai to raise the rate of mortgage loans for first-time homebuyers to 5% from 4.65% and for people who are buying second homes to 5.7% from 5.25%. This measure might be extended to other tier-1 cities if house prices do not stop rising. As a result of the clampdown on property developers and move to restrain investment/speculative demand for housing, construction activity will shrink. The top panel of Chart 5 illustrates that the level of aggregate building construction starts has turned down. Residential property sales are decelerating and starts are contracting (Chart 5, bottom panel). Bottom Line: Property construction in China will start shrinking in the coming months. This will spill into other industrial/manufacturing sectors that supply construction and produce durable consumer goods. Chinese industrial output is set to decelerate materially as is predicted by a relapse in the nation’s manufacturing PMI’s new and backlog orders (Chart 6). This poses a material risk to raw material prices and, consequently, to EM in general. Chart 5Chinese Property Construction Is Set To Contract Chinese Property Construction Is Set To Contract Chinese Property Construction Is Set To Contract Chart 6China's Manufacturing To Decelerate China's Manufacturing To Decelerate China's Manufacturing To Decelerate   Investment Conclusions From a short-term perspective, Chinese growth stocks are oversold, however this is not true from a long-term perspective. As shown in the top panel of Chart 1 above, the Chinese MSCI Investable Growth Stock Index is only back to its June 2020 levels. In fact, the parabolic rise in Chinese TMT stocks in late 2020 and early 2021 reflected investor euphoria that typically occurs at the end of a major bull market. Hence, the February peak in these equities could mark a major top. If so, these stocks are unlikely to embark on a sustainable bull market any time soon. For now, investors should fade rebounds in Chinese TMT stocks. We have been overweight Chinese stocks within an EM equity portfolio but this has been a bad call. However, among Chinese stocks we have recommended the following strategy since March 4th of this year: long A shares/short Investable stocks. The basis has been that we foresaw more downside risks in TMT stocks than onshore equities indexes (Chart 7). This recommendation is up by 15.5% since then and investors should maintain this strategy. Chart 7Stay Long Chinese A-Shares / Short Offshore Trading Stocks Stay Long Chinese A-Shares / Short Offshore Trading Stocks Stay Long Chinese A-Shares / Short Offshore Trading Stocks Chinese equities are oversold relative to the EM index, and we are reluctant to downgrade them now. We are also waiting for our view of the continued US dollar rebound and lower commodities prices to play out before we downgrade Chinese equities. Other EM bourses typically underperform when the US dollar rallies and commodities sell off markedly. As we argued in last week’s report, the weakness in EM equities has not been limited to Chinese TMT stocks. EM ex-TMT share prices have also rolled over, which is consistent with rising EM corporate bond yields (Chart 8). Chart 8Rising EM Corporate Bond Yields Herald Lower EM ex-TMT Share Prices Rising EM Corporate Bond Yields Herald Lower EM ex-TMT Share Prices Rising EM Corporate Bond Yields Herald Lower EM ex-TMT Share Prices Although most of the rise in EM corporate bond yields/spreads can be attributed to Chinese property companies, their widening credit spreads reflect the mainland property market’s poor outlook. In turn, shrinking Chinese construction heralds weaker demand for commodities and manufacturing goods. Notably, Chart 9 reveals that there has been a widening gap between a declining Chinese manufacturing PMI and resilient industrial metals prices. Odds are that commodity prices will recouple with China’s manufacturing PMI to the downside. Chart 9An Unsustainable Divergence: Beware Of Risks To Commodity Prices An Unsustainable Divergence: Beware Of Risks To Commodity Prices An Unsustainable Divergence: Beware Of Risks To Commodity Prices We continue to recommend underweighting EM versus DM for global equity and credit portfolios, a strategy we initiated on March 25, 2021. We also recommend shorting a basket of EM currencies versus the US dollar and maintaining a cautious stance on commodity prices. The full list of our country recommendations for equity, fixed-income and currency investors is available at the end of this report. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com  

Highlights China’s July Politburo meeting signaled that policy is unlikely to be overtightened. The Biden administration is likely to pass a bipartisan infrastructure deal – as well as a large spending bill by Christmas. Geopolitical risk in the Middle East will rise as Iran’s new hawkish president stakes out an aggressive position. US-Iran talks just got longer and more complicated. Europe’s relatively low political risk is still a boon for regional assets. However, Russia could still deal negative surprises given its restive domestic politics. Japan will see a rise in political turmoil after the Olympic games but national policy is firmly set on the path that Shinzo Abe blazed. Stay long yen as a tactical hedge. Feature Chart 1Rising Hospitalizations Cause Near-Term Jitters, But UK Rolling Over? China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Our key view of 2021, that China would verge on overtightening policy but would retreat from such a mistake to preserve its economic recovery, looks to be confirmed after the Politburo’s July meeting opened the way for easier policy in the coming months. Meanwhile the Biden administration is likely to secure a bipartisan infrastructure package and push through a large expansion of the social safety net, further securing the American recovery. Growth and stimulus have peaked in both the US and China but these government actions should keep growth supported at a reasonable level and dispel disinflationary fears. This backdrop should support our pro-cyclical, reflationary trade recommendations in the second half of the year. Jitters continue over COVID-19 variants but new cases have tentatively peaked in the UK, US vaccinations are picking up, and death rates are a lot lower now than they were last year, that is, prior to widescale vaccination (Chart 1). This week we are taking a pause to address some of the very good client questions we have received in recent weeks, ranging from our key views of the year to our outstanding investment recommendations. We hope you find the answers insightful. Will Biden’s Infrastructure Bill Disappoint? Ten Republicans are now slated to join 50 Democrats in the Senate to pass a $1 trillion infrastructure bill that consists of $550 billion in new spending over a ten-year period (Table 1). The deal is not certain to pass and it is ostensibly smaller than Biden’s proposal. But Democrats still have the ability to pass a mammoth spending bill this fall. So the bipartisan bill should not be seen as a disappointment with regard to US fiscal policy or projections. The Republicans appear to have the votes for this bipartisan deal. Traditional infrastructure – including broadband internet – has large popular support, especially when not coupled with tax hikes, as is the case here. Both Biden and Trump ran on a ticket of big infra spending. However, political polarization is still at historic peaks so it is possible the deal could collapse despite the strong signs in the media that it will pass. Going forward, the sense of crisis will dissipate and Republicans will take a more oppositional stance. The Democratic Congress will pass President Joe Biden’s signature reconciliation bill this fall, another dollop of massive spending, without a single Republican vote (Chart 2). After that, fiscal policy will probably be frozen in place through at least 2025. Campaigning will begin for the 2022 midterm elections, which makes major new legislation unlikely in 2022, and congressional gridlock is the likely result of the midterm. Republicans will revert to belt tightening until they gain full control of government or a new global crisis erupts. Table 1Bipartisan Infrastructure Bill Likely To Pass China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 2Reconciliation Bill Also Likely To Pass China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 3Biden Cannot Spare A Single Vote In Senate China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Hence the legislative battle over the reconciliation bill this fall will be the biggest domestic battle of the Biden presidency. The 2021 budget reconciliation bill, based on a $3.5 trillion budget resolution agreed by Democrats in July, will incorporate parts of the American Jobs Plan that did not pass via bipartisan vote (such as $436 billion in green energy subsidies), plus a large expansion of social welfare, the American Families Plan. This bill will likely pass by Christmas but Democrats have only a one-seat margin in the Senate, which means our conviction level must be medium, or subjectively about 65%. The process will be rocky and uncertain (Chart 3). Moderate Democratic senators will ultimately vote with their party because if they do not they will effectively sink the Biden presidency and fan the flames of populist rebellion. US budget deficit projections in Chart 4 show the current status quo, plus scenarios in which we add the bipartisan infra deal, the reconciliation bill, and the reconciliation bill sans tax hikes. The only significant surprise would be if the reconciliation bill passed shorn of tax hikes, which would reduce the fiscal drag by 1% of GDP next year and in coming years. Chart 4APassing Both A Bipartisan Infrastructure Bill And A Reconciliation Bill Cannot Avoid Fiscal Cliff In 2022 … China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 4B… The Only Major Fiscal Surprise Would Come If Tax Hikes Were Excluded From This Fall’s Reconciliation Bill China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 5Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing There are two implications. First, government support for the economy has taken a significant step up as a result of the pandemic and election in 2020. There is no fiscal austerity, unlike in 2011-16. Second, a fiscal cliff looms in 2022 regardless of whether Biden’s reconciliation bill passes, although the private economy should continue to recover on the back of vaccines and strong consumer sentiment. This is a temporary problem given the first point. Monetary policy has a better chance of normalizing at some point if fiscal policy delivers as expected. But the Federal Reserve will still be exceedingly careful about resuming rate hikes. President Biden could well announce that he will replace Chairman Powell in the coming months, delivering a marginally dovish surprise (otherwise Biden runs the risk that Powell will be too hawkish in 2022-23). Inflation will abate in the short run but remain a risk over the long run. Essentially the outlook for US equities is still positive for H2 but clouds are forming on the horizon due to peak fiscal stimulus, tax hikes in the reconciliation bill, eventual Fed rate hikes (conceivably 2022, likely 2023), and the fact that US and Chinese growth has peaked while global growth is soon to peak as well. All of these factors point toward a transition phase in global financial markets until economies find stable growth in the post-pandemic, post-stimulus era. Investors will buy the rumor and sell the news of Biden’s multi-trillion reconciliation bill in H2. The bill is largely priced out at the moment due to China’s policy tightening (Chart 5). The next section of this report suggests that China’s policy will ease on the margin over the coming 12 months. Bottom Line: US fiscal policy is delivering, not disappointing. Congress is likely to pass a large reconciliation bill by Christmas, despite no buffer in the Senate, because Democratic Senators know that the Biden presidency hangs in the balance. China’s Khodorkovsky Moment? Many clients have asked whether China’s crackdown on private business, from tech to education, is the country’s “Khodorkovsky moment,” i.e. the point at which Beijing converts into a full, autocratic regime where private enterprise is permanently impaired because it is subject to arbitrary seizure and control of the state. The answer is yes, with caveats. Yes, China’s government is taking a more aggressive, nationalist, and illiberal stance that will permanently impair private business and investor sentiment. But no, this process did not begin overnight and will not proceed in a straight line. There is a cyclical aspect that different investors will have to approach differently. First a reminder of the original Khodorkovsky moment. After the Soviet Union’s collapse, extremely wealthy oligarchs emerged who benefited from the privatization of state assets. When President Putin began to reassert the primacy of the state, he arbitrarily imprisoned Khodorkovsky and dismantled his corporate energy empire, Yukos, giving the spoils to state-owned companies. Russia is a petro state so Putin’s control of the energy sector would be critical for government revenues and strategic resurgence, especially at the dawn of a commodity boom. Both the RUB-USD and Russian equity relative performance performed mostly in line with global crude oil prices, as befits Russia’s economy, even though there was a powerful (geo)political risk premium injected during these two decades due to Russia’s centralization of power and clash with the West (Chart 6). Investors could tactically play the rallies after Khodorkovsky but the general trend depended on the commodity cycle and the secular rise of geopolitical risk. Chart 6Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer President Xi Jinping is a strongman and hardliner, like Putin, but his mission is to prevent Communist China from collapsing like the Soviet Union, rather than to revive it from its ashes. To that end he must reassert the state while trying to sustain the country’s current high level of economic competitiveness. Since China is a complex economy, not a petro state, this requires the state-backed pursuit of science, technology, competitiveness, and productivity to avoid collapse. Therefore Beijing wants to control but not smother the tech companies. Hence there is a cyclical factor to China’s regulatory crackdown. A crackdown on President Xi Jinping’s potential rivals or powerful figures was always very likely to occur ahead of the Communist Party’s five-year personnel reshuffle in 2022, as we argued prior to tech exec Jack Ma’s disappearance. Sackings of high-level figures have happened around every five-year leadership rotation. Similarly a crackdown on the media was expected. True, the pre-party congress crackdowns are different this time around as they are targeted at the private sector, innovative businesses, tech, and social media. Nevertheless, as in the past, a policy easing phase will follow the tightening phase so as to preserve the economy and the mobilization of private capital for strategic purposes. The critical cyclical factor for global investors is China’s monetary and credit impulse. For example, the crackdown on the financial sector ahead of the national party congress in 2017 caused a global manufacturing slowdown because it tightened credit for the entire Chinese economy, reducing imports from abroad. One reason Chinese markets sold off so heavily this spring and summer, was that macroeconomic indicators began decelerating, leaving nothing for investors to sink their teeth into except communism. The latest Politburo meeting suggests that monetary, fiscal, and regulatory policy is likely to get easier, or at least stay just as easy, going forward (Table 2). Once again, the month of July has proved an inflection point in central economic policy. Financial markets can now look forward to a cyclical easing in regulation combined with easing in monetary and fiscal policy over the next 12-24 months. Table 2China’s Politburo Prepares To Ease Policy, Secure Recovery China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Despite all of the above, for global investors with a lengthy time horizon, the government’s crackdown points to a secular rise of Communist and Big Government interventionism into the economy, with negative ramifications for China’s private sector, economic freedoms, and attractiveness as a destination for foreign investment. The arbitrary and absolutist nature of its advances will be anathema to long-term global capital. Also, social media, unlike other tech firms, pose potential sociopolitical risks and may not boost productivity much, whereas the government wants to promote new manufacturing, materials, energy, electric vehicles, medicine, and other tradable goods. So while Beijing cannot afford to crush the tech sector, it can afford to crush some social media firms. Chart 7China's Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China's Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China's Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China’s equity market profile looks conspicuously like Russia’s at the time of Khodorkovsky’s arrest (Chart 7). Chinese renminbi has underperformed the dollar on a multi-year basis since Xi Jinping’s rise to power, in line with falling export prices and slowing economic growth, as a result of economic structural change and the administration’s rolling back Deng Xiaoping’s liberal reform era. We expect a cyclical rebound to occur but we do not recommend playing it. Instead we recommend other cyclical plays as China eases policy, particularly in European equities and US-linked emerging markets like Mexico. Bottom Line: The twentieth national party congress in 2022 is a critical political event that is motivating a cyclical crackdown on potential rivals to Communist Party power. Chinese equities will temporarily bounce back, especially with a better prospect for monetary and fiscal easing. But over the long run global investors should stay focused on the secular decline of China’s economic freedoms and hence productivity. What Happened To The US-Iran Deal? Our second key view for 2021 was the US strategic rotation from the Middle East and South Asia to Asia Pacific. This rotation is visible in the Biden administration’s attempt to withdraw from Iraq and Afghanistan while rejoining the 2015 nuclear deal with Iran. However, Biden here faces challenges that will become very high profile in the coming months. The Biden administration failed to rejoin the 2015 deal under the outgoing leadership of the reformist President Hassan Rouhani. This means a new and much more difficult negotiation process will now begin that could last through Biden’s term or beyond. On August 5, President Ebrahim Raisi will take office with an aggressive flourish. The US is already blaming Iran for an act of sabotage in the Persian Gulf that killed one Romanian and one Briton. Raisi will need to establish that he is not a toady, will not cower before the West. The new Israeli government of Prime Minister Naftali Bennett also needs to demonstrate that despite the fall of his hawkish predecessor Benjamin Netanyahu, Jerusalem is willing and able to uphold Israel’s red lines against Iranian nuclear weaponization and regional terrorism. Hence both Iran and its regional rivals, including Saudi Arabia, will rattle sabers and underscore their red lines. The Persian Gulf and Strait of Hormuz will be subject to threats and attacks in the coming months that could escalate dramatically, posing a risk of oil supply disruptions. Given that the Iranians ultimately do want a deal with the Americans, the pressure should be low-to-medium level and persistent, hence inflationary, as opposed to say a lengthy shutdown of the Strait of Hormuz that would cause a giant spike in prices that ultimately kills global demand. Short term, the US attempt to reduce its commitments in Iraq and Afghanistan will invite US enemies to harass or embarrass the Biden administration. The Taliban is likely to retake control of Afghanistan. The US exit will resemble Saigon in 1975. This will be a black eye for the Biden administration. But public opinion and US grand strategy will urge Biden to be rid of the war. So any delays, or a decision to retain low-key sustained troop presence, will not change the big picture of US withdrawal. Long term, Biden needs to pivot to Asia, while President Raisi is ultimately subject to the Supreme Leader Ali Khamenei, who wants to secure Iran’s domestic stability and his own eventual leadership succession. Rejoining the 2015 nuclear deal leads to sanctions relief, without requiring total abandonment of a nuclear program that could someday be weaponized, so Iran will ultimately agree. The problem will then become the regional rise of Iranian power and the balancing act that the US will have to maintain with its allies to keep Iran contained. Bottom Line: The risk to oil prices lies to the upside until a US-Iran deal comes together. The US and Iran still have a shared interest in rejoining the 2015 deal but the time frame is now delayed for months if not years. We still expect a US-Iran deal eventually but previously we had anticipated a rapid deal that would put downward pressure on oil prices in the second half of the year. What Comes After Biden’s White Flag On Nord Stream II? Our third key view for 2021 highlighted Europe’s positive geopolitical and macro backdrop. This view is correct so far, especially given that China’s policymakers are now more likely to ease policy going forward. But Russia could still upset the view. Italy has been the weak link in European integration over the past decade (excluding the UK). So the national unity coalition that has taken shape under Prime Minister Mario Draghi exemplifies the way in which political risks were overrated. Italy is now the government that has benefited the most from the overall COVID crisis in public opinion (Chart 8). The same chart shows that the German government also improved its public standing, although mostly because outgoing Chancellor Angela Merkel is exiting on a high note. Her Christian Democrat-led coalition has not seen a comparable increase in support. The Greens should outperform their opinion polling in the federal election on September 26. But the same polling suggests that the Greens will be constrained within a ruling coalition (Chart 9). The result will be larger spending without the ability to raise taxes substantially. Markets will cheer a fiscally dovish and pro-European ruling coalition. Chart 8European Political Risk Limited, But Rising, Post-COVID China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients The chief risk to this view of low EU political risk comes from Russia. Russia is a state in long-term decline due to the remorseless fall in fertility and productivity. The result has been foreign policy aggression as President Putin attempts to fortify the country’s strategic position and frontiers ahead of an even bleaker future. Chart 9German Election Polls Point To Gridlock? German Election Polls Point To Gridlock? German Election Polls Point To Gridlock? Now domestic political unrest has grown after a decade of policy austerity and the COVID-19 pandemic. Elections for the Duma will be held on September 19 and will serve as the proximate cause for Russia’s next round of unrest and police repression. Foreign aggressiveness may be used to distract the population from the pandemic and poor economy. We have argued that there would not be a diplomatic reset for the US and Russia on par with the reset of 2009-11. We stand by this view but so far it is facing challenges. Putin did not re-invade Ukraine this spring and Biden did not impose tough sanctions canceling the construction of the Nord Stream II gas pipeline to Germany. Russia is tentatively cooperating on the US’s talks with Iran and withdrawal from Afghanistan. The US gave Germany and Russia a free point by condoning the NordStream II. Now the US will expect Germany to take a tough diplomatic line on Russian and Chinese aggression, while expecting Russia to give the US some goodwill in return. They may not deliver. The makeup of the new German coalition will have some impact on its foreign policy trajectory in the coming years. But the last thing that any German government wants is to be thrust into a new cold war that divides the country down the middle. Exports make up 36% of German output, and exports to the Russian and Chinese spheres account for a substantial share of total exports (Chart 10). The US administration prioritizes multilateralism above transactional benefits so the Germans will not suffer any blowback from the Americans for remaining engaged with Russia and China, at least not anytime soon. Russia, on the other hand, may feel a need to seize the moment and make strategic gains in its region, despite Biden’s diplomatic overtures. If the US wraps up its forever wars, Russia’s window of opportunity closes. So Russia may be forced to act sooner rather than later, whether in suppressing domestic dissent, intimidating or attacking its neighbors, or hacking into US digital networks. In the aftermath of the German and Russian elections, we will reassess the risk from Russia. But our strong conviction is that neither Russian nor American strategy have changed and therefore new conflicts are looming. Therefore we prefer developed market European equities and we do not recommend investors take part in the Russian equity rally. Chart 10Germany Opposes New Cold War With Russia Or China China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Bottom Line: German and European equities should benefit from global vaccination, Biden’s fiscal and foreign policies, and China’s marginal policy easing (Chart 11). Eastern European emerging markets and Russian assets are riskier than they appear because of latent geopolitical tensions that could explode around the time of important elections in September. Chart 11Geopolitical Tailwinds To European Equities Geopolitical Tailwinds To European Equities Geopolitical Tailwinds To European Equities What Comes After The Olympics In Japan? Japan is returning to an era of “revolving door” prime ministers. Prime Minister Yoshihide Suga’s sole purpose was to tie up the loose ends of the Shinzo Abe administration, namely by overseeing the Olympics. After the games end, he will struggle to retain leadership of the Liberal Democratic Party. He will be blamed for spread of Delta variant even if the Olympics were not a major factor. If he somehow retains the party’s helm, the October general election will still be an underwhelming performance by the Liberal Democrats, which will sow the seeds of his downfall within a short time (Chart 12). Suga will need to launch a new fiscal spending package, possibly as an election gimmick, and his party has the strength in the Diet to push it through quickly, which will be favorable for the economy. For the elections the problem is not the Liberal Democrats’ popularity, which is still leagues above the nearest competitor, but rather low enthusiasm and backlash over COVID. Abe’s retirement, and the eventual fall of Abe’s hand-picked deputy, does not entail the loss of Abenomics. The Bank of Japan will retain its ultra-dovish cast at least until Haruhiko Kuroda steps down in 2023. The changes that occurred in Japan from 2008-12 exemplified Japan’s existence as an “earthquake society” that undergoes drastic national changes suddenly and rapidly. The paradigm shift will not be reversed. The drivers were the Great Recession, the LDP’s brief stint in the political wilderness, the Tohoku earthquake and Fukushima nuclear crisis, and the rise of China. The BoJ became ultra-dovish and unorthodox, the LDP became more proactive both at home and abroad. The deflationary economic backdrop and Chinese nationalism are still a powerful impetus for these trends to continue – as highlighted by increasingly alarming rhetoric by Japanese officials, including now Shinzo Abe himself, regarding the Chinese military threat to Taiwan. In other words, Suga’s lack of leadership will not stand even if he somehow stays prime minister into 2022. The Liberal Democrats have several potential leaders waiting in the wings and one of these will emerge, whether Yuriko Koike, Shigeru Ishiba, or Shinjiro Koizumi, or someone else. The popular and geopolitical pressures will force the Liberal Democrats and various institutions to continue providing accommodation to the economy and bulking up the nation’s defenses. This will require the BoJ to stay easier for longer and possibly to roll out new unorthodox policies, as with yield curve control in the 2010s. Japan has some of the highest real rates in the G10 as a result of very low inflation expectations and a deeply negative output gap (Chart 13). Abenomics was bearing fruit, prior to COVID-19, so it will be justified to stay the course given that deflation has reemerged as a threat once again. Chart 12Japan: Back To Revolving Door Of Prime Ministers China’s Khodorkovsky Moment? And Other Questions From Clients China’s Khodorkovsky Moment? And Other Questions From Clients Chart 13Japan To Keep Fighting Deflation Post-Abe Japan To Keep Fighting Deflation Post-Abe Japan To Keep Fighting Deflation Post-Abe Bottom Line: The political and geopolitical backdrop for Japan is clear. The government and BoJ will have to do whatever it takes to stay the course on Abenomics even in the wake of Abe and Suga. Prime ministers will come and go in rapid succession, like in past eras of political turmoil, but the trajectory of national policy is set. We would favor JGBs relative to more high-beta government bonds like American and Canadian. Given deflation, looming Japanese political turmoil, and the secular rise in geopolitical risk, we continue to recommend holding the yen. These views conform with those of BCA’s fixed income and forex strategists. Investment Takeaways China’s policymakers are backing away from the risk of overtightening policy this year. Policy should ease on the margin going forward. Our number one key forecast for 2021 is tentatively confirmed. Base metals are still overextended but global reflation trades should be able to grind higher. The US fiscal spending orgy will continue through the end of the year via Biden’s reconciliation bill, which we expect to pass. Proactive DM fiscal policy will continue to dispel disinflationary fears. Sparks will fly in the Middle East. The US-Iran negotiations will now be long and drawn out with occasional shows of force that highlight the tail risk of war. We expect geopolitics to add a risk premium to oil prices at least until the two countries can rejoin the 2015 nuclear deal. Germany’s Green Party will surprise to the upside in elections, highlighting Europe’s low level of geopolitical risk. China policy easing is positive for European assets. Russia’s outward aggressiveness is the key risk.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

Highlights The rapid spread of the COVID-19 delta variant in Asia will re-focus precious metals markets anew on the possibility of another round of lockdowns and the implications for demand, particularly in Greater China and India, which account for 33% and 12% of global physical demand for gold (Chart of the Week).1 Regulatory crackdowns across various sectors in China will continue to roil markets over coming months.  Policy uncertainty around these crackdowns is elevated in local financial markets, and could spill into global markets.  This will support the USD at the margin, which creates a headwind for gold and silver prices. Ambiguous and contradictory signaling from Fed officials following the July FOMC meeting re its $120-billion-per-month bond-buying program also adds uncertainty to precious-metals and general commodity forecasts. Despite this uncertainty, we remain bullish gold and silver.  More efficacious jabs will become available, which will support the global economic re-opening, particularly in EM economies.  In DM economies, vaccination uptake likely increases as risks become more apparent.  We continue to expect gold to trade to $2,000/oz and silver to trade to $30/oz this year. Feature Markets once again are focused on the possibility lockdowns will follow rising COVID-19 infections and deaths, as the delta variant – the most contagious variant to date – spreads through Asia and elsewhere. Chart of the WeekCOVID-19 Delta Variant Rampages Uncertainty Checks Gold's Recovery Uncertainty Checks Gold's Recovery Chart 2COVID-19 Infections, Deaths Rising Uncertainty Checks Gold's Recovery Uncertainty Checks Gold's Recovery Infection and death rates are moving higher globally (Chart 2). COVID-19 infections are still rising in 78 countries. Based on the latest 7-day-average data, the countries reporting the most new infections daily are the US, India, Indonesia, Brazil, and Iran. The countries reporting the most deaths each day are Indonesia, Brazil, Russia, India, and Mexico. Globally, more than 42% of infections were in Asia and the Middle East, where ~ 1mm new infections are reported every 4 days. We expect more efficacious jabs will become available, which will support the global economic re-opening, particularly in EM economies. In DM economies, vaccination uptake likely increases as risks become more apparent. China's Regulatory Crackdown Markets also are contending with a regulatory crackdowns across multiple sectors in China, which is part of a years-long reform process initiated by the Politburo.2 Industries ranging from internet, property, education, healthcare to capital markets will have new rules imposed on them under China's 14th Five-Year Plan as part of this process. Our colleagues in BCA's China Investment Service note the pace of regulatory tightening will not moderate in the near term, as policymakers transition from an annual planning cycle focused on setting economic growth targets to a multi-year planning horizon. "This allows policymakers to have a higher tolerance for near-term distress in exchange for long-term benefits," according to our colleagues. The overarching goal of this reform process is to introduce more social equality in the society. Of immediate import for precious metals markets is the potential for spillover effects outside China arising from the policy uncertainty that already is emanating from that market. Uncertainty boosts the USD and gold. This makes its effect uncertain. In our most recent modeling of gold prices, we have found strong two-way feedback between US and Chinese policy uncertainty.3 We also find that broad real foreign exchange rates for the USD and RMB exert a negative influence on gold prices, while higher economic uncertainty pushes gold prices higher (Chart 3). In addition, across markets – Chinese and US economic policy uncertainty – have similar effects, suggesting economic uncertainty across these markets has a similar effect as domestic uncertainty at home (Chart 4).4 Chart 3Domestic Uncertainty, Real FX Rates Strongly Affect Gold Prices... Domestic Uncertainty, Real FX Rates Strongly Affect Gold Prices... Domestic Uncertainty, Real FX Rates Strongly Affect Gold Prices... Chart 4...As Do Cross-Border Uncertainty, Real FX Rates ...As Do Cross-Border Uncertainty, Real FX Rates ...As Do Cross-Border Uncertainty, Real FX Rates This is yet another reason to pay close attention to PBOC and Fed policy innovations and surprises: they affect each other in similar ways within and across borders. Fed Officials Add Uncertainty Following the FOMC meeting at that end of last month, various Fed officials expressed their views of Chair Jerome Powell's post-meeting remarks, or again resumed their campaigns to begin tapering the US central bank's bond-buying program. Chair Powell's remarks reinforced the data-dependency of the Fed in directing its bond buying and monetary accommodation. He emphasized the need to see solid improvement in the jobs picture in the US before considering any lift-off of rates. As to the Fed's bond-buying program, this, too, will depend on progress on reducing unemployment in the US. Powell also reiterated the Fed views the current inflation in the US as transitory, a point that was emphasised by Fed Governor Lael Brainard two days after Powell's presser. Some very important Fed officials, most notably Fed Vice Chair Richard Clarida, are staking out an early position on what will get them to consider reducing the Fed's current accommodative policies, chiefly an "overshoot" of PCE inflation, the Fed's favored gauge, above 3%. Other Fed officials are urging strong action now: St. Louis Fed President James Bullard is adamant that tapering of the Fed's bond-buying program needed to begin in the Autumn and should be done early next year. Bullard is supported by Governor Christopher Waller. The Fed's bond-buying program is more than a year old. Beginning in July 2020, the Fed started buying $80 billion of Treasurys and $40 billion of mortgage-backed securities every month, or ~ $1.6 trillion so far. This lifted the Fed's balance sheet to ~ $8.3 trillion. Thinking about this as a commodity, that's a lot of asset supply removed from the Treasury and MBS market, which likely explains the high cost of the underlying debt instruments (i.e., their low interest rates). It is understandable why the gold market would get twitchy whenever Fed officials insist the winddown of this program must begin forthwith and be done in relatively short order. The loss of that steady stream of buying could send interest rates higher quickly, possibly raising nominal and real interest rates in the process, which, given the sensitivity of gold prices to US real rates would be bearish (Chart 5). While it is impossible to know when the tapering of the Fed's asset-purchase program will end, these occasional choruses of its imminent inauguration add to uncertainty in the US, which also depresses precious metals prices, as Chart 5 indicates. A larger issue attends this topic: economic policy uncertainty is not contained within national borders. Above, we noted there is a two-way feedback between US and China economic policy uncertainty. There also is a long-term relationship in levels of economic policy uncertainty re China and Europe, which makes sense given the trading relationship between these states. Changes in the two measures of economic policy uncertainty exhibit strong co-movement (Chart 6). Chart 5Taper Talk Makes Precious Metals Markets Twitchy Taper Talk Makes Precious Metals Markets Twitchy Taper Talk Makes Precious Metals Markets Twitchy Chart 6Economic Policy Uncertainty Goes Across National Borders Uncertainty Checks Gold's Recovery Uncertainty Checks Gold's Recovery Investment Implications The increase in COVID-19 infection and re-infection rates, and death rates, is forcing commodity markets to reevaluate demand projections and the likelihood of continued monetary accommodation globally. This ultimately affects the prospects for commodity prices. Conflicting interpretations of the state of local and the global economies increases uncertainty across markets, especially precious metals, which are exquisitely sensitive to even a hint of a change in policy. This uncertainty is compounded when top officials at systematically important central banks provide sometimes-contradictory interpretations of the state of their economies. Despite this uncertainty we remain bullish gold and silver, expecting efficacious vaccines to become more widely available, which will allow the global recovery to regain its footing. We are less sanguine about the prospects for the winding down of the massive monetary accommodation globally, particularly that of the US, where data-dependent policymakers still feel compelled to provide almost-certain policy prescriptions in an increasingly uncertain world.This is a fundamental factor driving global uncertainty. We remain long gold expecting it to trade to $2,000/oz this year, and long silver, expecting it to hit $30/oz.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish While US crude oil inventories rose 3.6mm barrels in the week ended 30 July 2021 gasoline stocks fell 5.3mm barrels, contributing to an overall decline in crude and product inventories in the US of 1.2mm barrels, according to the US EIA's latest tally (Chart 7). US crude and product stocks have been falling throughout the COVID-19 pandemic, and now stand ~ 13% below year earlier levels at 1.7 billion barrels. Crude oil stocks, at 439mm barrels, are just over 15% below year-ago levels. This reflects the decline in US domestic production, which is down 7.1% y/y and now stands at 11.2mm b/d. US refined-product demand, however, is up close to 9% over the January-July period y/y, and stands at 21.2mm b/d. Base Metals: Bullish Workers at the world's largest copper mine, Escondida in Chile, are in government-mediated talks with management that end on Saturday to see if they can avert a strike. There is a chance talks could be extended five days beyond that date, under Chilean law. The mine is majority owned by BHP. Workers at a Codelco-owned mine also voted to strike and will enter government-mediated talks as well. These potential strikes most likely explain why copper prices have been holding relatively steady as other commodities have come under pressure, as markets reassess the odds of a demand slowdown brought about by surging COVID-19 infections, which are hitting Asian markets particularly hard (Chart 8). Chart 7 Uncertainty Checks Gold's Recovery Uncertainty Checks Gold's Recovery Chart 8 Copper Prices Recovering Copper Prices Recovering   Footnotes 1     We flagged this risk in our July 8, 2021 report entitled Assessing Risks To Our Commodity Views, which is available at ces.bcaresearch.com. 2     Please see Pricing A Tighter Regulatory Grip published on August 4, 2021 by our China Investment Strategy.  It is available at cis.bcaresearch.com. 3    We measure this using Granger-Causality tests. 4    These broad real FX rates are handy explanatory variables, in that they combine two very important factors affecting gold prices – inflation and broad FX trade-weighted indexes.  Additional modelling also suggests these broad real FX rates for the USD and RMB coupled with US real 2- and 5-year rates also provide good explanatory models for gold prices. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Image

Highlights Chinese authorities’ regulatory crackdown on new economy companies reflects new socio-political and economic shifts in China. Hence, this regulatory crackdown is not transitory. Investors in Chinese TMT/new economy stocks are facing uncertainty on multiple fronts which warrants lower valuation multiples. These companies will experience weaker profit growth and lower profitability relative to the past due to disruptions to their business models. Elsewhere, widening credit spreads among Chinese property developers reflects the property market’s poor outlook. In turn, shrinking Chinese construction heralds weaker demand for commodities and manufacturing goods. This poses a material risk to raw material prices and, consequently, EM in general. Feature Chart 1Chinese Growth/TMT Share Prices And P/E Ratio Chinese Growth/TMT Share Prices And P/E Ratio Chinese Growth/TMT Share Prices And P/E Ratio The Chinese MSCI Investable Growth stock index is down by 35% from its February peak (Chart 1, top panel). Such a drawdown in the previous market leaders has produced a temptation to buy. The enticement is especially strong given that US FAANGM stocks are hitting new all-time highs. Is the latest crash in Chinese new economy/growth/TMT stocks a bad dream that will soon end, or does it mark a new reality for these companies? In our opinion, Chinese authorities’ regulatory crackdown on new economy companies reflects new socio-political and economic shifts in China. Hence, this regulatory crackdown is not transitory but is a part of China’s ongoing transformation. In brief, these companies are facing a new reality. What’s more, their outlook is very uncertain and equity valuations are not low enough to offset potential risks related to owning these stocks. Overall, investors should not start bottom fishing in Chinese stocks in general and Chinese TMT stocks in particular. Uncertainty = Lower Equity Multiples Immense uncertainty surrounds the outlook for Chinese TMT share prices. Even though China’s growth stocks have been de-rated, their trailing P/E ratio remains at 36.5 (Chart 1, bottom panel). Table 1A Snapshot Of Drawdown And Valuations Chinese TMT Stocks: A Bad Dream Or A New Reality? Chinese TMT Stocks: A Bad Dream Or A New Reality? Table 1 shows the drawdowns and trailing P/E ratios for TMT/new economy/growth indexes as well as their largest constituencies: Alibaba, Tencent and Meituan. These equity multiples are still high given the uncertainty these companies are facing. By extension, investors in Chinese TMT/new economy stocks are also facing uncertainty on multiple fronts: Regulatory crackdowns mean that the business models of many of these companies will have to undergo substantial changes. Corporations may need to overhaul their product lines or abandon existing products/markets and find new niches and introduce new offerings. It is impossible to know what the long-term revenue and profit growth rates of these companies will be so that they can be properly valued. Such heightened uncertainty about the long-term outlook warrants a higher equity risk premium and, hence, lower equity multiples. President Xi Jinping’s long-term objective is to reduce income equality and achieve more equal wealth distribution. There will therefore be little tolerance for excessive profitability of individual companies. Chart 2 illustrates the large income gap between the top 10% and bottom 50% of the population. In turn, the mean-to-median wealth ratio points to a large and rising wealth gap – a higher ratio reflects greater wealth concentration among rich households (Chart 3). Chart 2China: Income Disparity Has Not Been Narrowing Wealth Concertation Remains High In China Wealth Concertation Remains High In China Chart 3Wealth Concentration Remains High In China Wealth Concertation Remains High In China Wealth Concertation Remains High In China   President Xi’s goal is to appease the broader population, not shareholders or businesses. Top authorities have been using phrases such as “disorderly expansion of capital” since last fall. This language marked a major shift in government policies regarding market power and dominance of private companies. Investors should take note that they are now dealing with a new investment regime in China. For some time, we have argued that China’s regulatory tightening on private platform companies would aim to limit their monopolistic or oligopolistic power and ration their profitability. As a result, we alleged that these new economy companies would end up being regulated like utilities or become quasi-government entities. Consequently, their profitability would decline to close to that of utilities or SOEs. Yet, utility stocks or SOEs in China command much lower equity multiples than those at which platform companies’ stocks have been trading. Even as of today, the trailing P/E ratio on the China MSCI Growth Investable index is 36.5. Meanwhile, global utility stocks command a trailing P/E ratio of 19. It is hard to know where the P/E ratios of these Chinese TMT stocks will settle, but our hunch is that their multiple compression is not over yet. Regulatory clampdowns will not only curtail their revenues and pricing power but also increase their costs. These companies will need to spend money to comply with the new regulatory regime. They will, for instance, be expected to take on more in the way of social responsibilities, as SOEs in China have been doing. This and other measures will eat into their profit margins and will lower the return on capital. Finally, many Chinese TMT companies that have their ADRs listed in the US have been caught in the crossfire of the “big data war” between the US and China. On the one hand, US authorities want to oblige these Chinese issuers to comply with US regulations in terms of information and risks disclosure. On the other hand, Chinese authorities are reluctant to allow more data/information disclosure by their dominant platform companies to foreign investors. Given that the US-China confrontation is likely to escalate on many fronts going forward, odds are low that there will be a lasting solution to this conflict around US-traded Chinese equities. Authorities in the Middle Kingdom are not very sensitive to the fact that foreign shareholders are losing money in Chinese offshore trading stocks. Unless the crash in offshore stocks spills into the domestic financial markets and the economy, their willingness to compromise will be limited. In turn, the US will not “encourage” American investors to invest more in Chinese stocks where its regulatory authority and influence is weak. Overall, such high uncertainty regarding offshore Chinese stocks in general and the ones trading in the US in particular warrants a higher equity risk premium and lower equity multiples. Despite these negatives, there is a silver lining: China’s new economy segments have been and will continue expanding at a rapid pace. Chinese authorities are genuinely interested in supporting new economy sectors which could help boost productivity and be growth engines as the growth contribution from construction/infrastructure/manufacturing diminishes. The challenge for investors is to find companies that benefit from the continued expansion of new economy sectors, and acquire their stocks at reasonable multiples to secure limited drawdowns during market selloffs. Bottom Line: Chinese growth stocks/TMT share prices – on the index level – remain at risk of further de-rating/multiple compression. These companies also face potentially weaker profit growth and lower profitability compared to the past due to disruptions to their business models and/or higher costs of doing business. A Breakdown In Chinese Property Stocks And Bonds Is Flying Under The Radar Chart 4Property Stocks And Bond Prices Have Crashed Property Stocks And Bond Prices Have Crashed Property Stocks And Bond Prices Have Crashed While Chinese TMT stocks are at the center of the global investment community’s interest, there has been a breakdown in mainland real estate share prices and a spike in property companies’ offshore credit spreads (Chart 4). The rising cost of capital imply that real estate developers will curtail their new property launches and construction. In addition, authorities will not ease regulatory tightening in the property market in general and property companies in particular. The objective is to halt the rise in property prices so that the continuous increase in personal income brings down the household income-to-property price ratio. The latter is extremely high in China making housing unaffordable for average Chinese. Authorities are very sensitive to the issue of housing unaffordability. Not only are property developers under pressure from tightening but also authorities are curbing demand for housing. In particular, two weeks ago the PBoC ordered banks in Shanghai to raise the rate of mortgage loans for first-time homebuyers to 5% from 4.65% and for people who are buying second homes to 5.7% from 5.25%. This measure might be extended to other tier-1 cities if house prices do not stop rising. As a result of the clampdown on property developers and move to restrain investment/speculative demand for housing, construction activity will shrink. The top panel of Chart 5 illustrates that the level of aggregate building construction starts has turned down. Residential property sales are decelerating and starts are contracting (Chart 5, bottom panel). Bottom Line: Property construction in China will start shrinking in the coming months. This will spill into other industrial/manufacturing sectors that supply construction and produce durable consumer goods. Chinese industrial output is set to decelerate materially as is predicted by a relapse in the nation’s manufacturing PMI’s new and backlog orders (Chart 6). This poses a material risk to raw material prices and, consequently, to EM in general. Chart 5Chinese Property Construction Is Set To Contract Chinese Property Construction Is Set To Contract Chinese Property Construction Is Set To Contract Chart 6China's Manufacturing To Decelerate China's Manufacturing To Decelerate China's Manufacturing To Decelerate   Investment Conclusions From a short-term perspective, Chinese growth stocks are oversold, however this is not true from a long-term perspective. As shown in the top panel of Chart 1 above, the Chinese MSCI Investable Growth Stock Index is only back to its June 2020 levels. In fact, the parabolic rise in Chinese TMT stocks in late 2020 and early 2021 reflected investor euphoria that typically occurs at the end of a major bull market. Hence, the February peak in these equities could mark a major top. If so, these stocks are unlikely to embark on a sustainable bull market any time soon. For now, investors should fade rebounds in Chinese TMT stocks. We have been overweight Chinese stocks within an EM equity portfolio but this has been a bad call. However, among Chinese stocks we have recommended the following strategy since March 4th of this year: long A shares/short Investable stocks. The basis has been that we foresaw more downside risks in TMT stocks than onshore equities indexes (Chart 7). This recommendation is up by 15.5% since then and investors should maintain this strategy. Chart 7Stay Long Chinese A-Shares / Short Offshore Trading Stocks Stay Long Chinese A-Shares / Short Offshore Trading Stocks Stay Long Chinese A-Shares / Short Offshore Trading Stocks Chinese equities are oversold relative to the EM index, and we are reluctant to downgrade them now. We are also waiting for our view of the continued US dollar rebound and lower commodities prices to play out before we downgrade Chinese equities. Other EM bourses typically underperform when the US dollar rallies and commodities sell off markedly. As we argued in last week’s report, the weakness in EM equities has not been limited to Chinese TMT stocks. EM ex-TMT share prices have also rolled over, which is consistent with rising EM corporate bond yields (Chart 8). Chart 8Rising EM Corporate Bond Yields Herald Lower EM ex-TMT Share Prices Rising EM Corporate Bond Yields Herald Lower EM ex-TMT Share Prices Rising EM Corporate Bond Yields Herald Lower EM ex-TMT Share Prices Although most of the rise in EM corporate bond yields/spreads can be attributed to Chinese property companies, their widening credit spreads reflect the mainland property market’s poor outlook. In turn, shrinking Chinese construction heralds weaker demand for commodities and manufacturing goods. Notably, Chart 9 reveals that there has been a widening gap between a declining Chinese manufacturing PMI and resilient industrial metals prices. Odds are that commodity prices will recouple with China’s manufacturing PMI to the downside. Chart 9An Unsustainable Divergence: Beware Of Risks To Commodity Prices An Unsustainable Divergence: Beware Of Risks To Commodity Prices An Unsustainable Divergence: Beware Of Risks To Commodity Prices We continue to recommend underweighting EM versus DM for global equity and credit portfolios, a strategy we initiated on March 25, 2021. We also recommend shorting a basket of EM currencies versus the US dollar and maintaining a cautious stance on commodity prices. The full list of our country recommendations for equity, fixed-income and currency investors is available at the end of this report. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Equities Recommendations Chinese TMT Stocks: A Bad Dream Or A New Reality? Chinese TMT Stocks: A Bad Dream Or A New Reality? Currencies, Credit And Fixed-Income Recommendations