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Highlights Copper prices will continue to rally, following a surge this week to highs not seen since early 2013 on the back of falling inventories, particularly in China, where physical demand has taken stocks to their lowest levels in almost 10 years (Chart of the Week). Physical premiums for the copper cathodes delivered to off-exchange bonded warehouses in China this week are up almost 60% since November – to $73/MT – providing further evidence of market tightness. Mine output in Peru, the second largest producer behind Chile, was down 12.5% to 2.15mm MT last year in the wake of COVID-19 containment measures. Given this large decline in output, the multi-year flattening of supply growth will continue. Upside demand pressure is building, as COVID-19 vaccination rates rise. Funding for the build-out of renewable energy generation is ramping up, and now includes expected US fiscal stimulus focused on renewables. Recovering global GDP, and China’s metals-intensive Five-Year Plan also will contribute to demand growth. We continue to expect COMEX copper to trade above $4/lb this year, but the likelihood this occurs in 1H21 (vs 2H21 as we earlier forecast) is increasing. Forward curves will become more backwardated, as markets continue to tighten. Feature Copper prices will continue to surge on the back of unexpected strength in Chinese demand, which has taken inventory levels to near-decade lows. This is something of an anomaly going into a Lunar New Year – the year of the Metal Ox – when activity typically slows. The big draw from global stocks that went into China’s inventories last year means global stocks will remain tight as the rest of the world continues its recovery from the COVID-19 pandemic (Chart 2). Particularly noteworthy are the huge drops in copper inventories held in the Shanghai Futures Exchange (SHFE, panel 3), and the London Metal Exchange (LME, panel 5), which are driving global drawdowns. Away from the commodity-exchange inventories, premiums for delivery of copper cathodes from bonded warehouses into China surged close to 60% from November levels to $73/MT earlier this week, as demand for physical material surges, according to reuters.com. Cathodes are used to make wire, tubes, for melting stock and in copper alloys. Demand for cathodes is rising outside China, which indicates they will retain a physical premium, even with exports from Chile restored to normal following weather-related disruptions. Chart of the WeekCopper Prices Surge As Global Storage Draws Copper Prices Surge As Global Storage Draws Copper Prices Surge As Global Storage Draws   Chart 2Falling Global Inventories Support Copper Prices Falling Global Inventories Support Copper Prices Falling Global Inventories Support Copper Prices Chart 3Sources of Copper Demand Strength Sources of Copper Demand Strength Sources of Copper Demand Strength This year’s departure from a seasonal demand downturn in Chinese copper demand likely is due to government efforts to limit travel to contain COVID-19 contagion, which means workers remain available to meet stronger demand for manufactured goods domestically and abroad. In addition, domestic demand – from electrification and infrastructure to housing – is particularly robust, which has kept pressure on inventories (Chart 3). Longer-Term Copper Demand Strength Baseline industrial, construction and infrastructure demand for copper – what’s already in place and continues to grow in line with the expansion of global GDP – will be augmented by the global build-out of renewables-based electricity generation, as the world moves toward a low-carbon future (Chart 4). Chart 4Incremental Renewables Demand Requires Significant Capex Copper Surge Welcomes Metal Ox Year Copper Surge Welcomes Metal Ox Year While this will not tax existing resources to the extent other materials will – e.g., copper demand from renewables will require less than 20% of existing identified reserves to meet cumulative demand to 2050 vs. the more than 100% of reserves required to meet cobalt demand by 2050 – this is still significant in a market requiring large capex increases to battle declining ore quality (Chart 5).1 Chart 5Higher Prices Needed To Spur Mining CAPEX Higher Prices Needed To Spur Mining CAPEX Higher Prices Needed To Spur Mining CAPEX Copper Supply Side Remains Challenged Short- and long-term challenges to global copper supply abound. Peru’s mine output was down 12.5% last year – to 2.15mm MT – in the wake of COVID-19 containment measures (Chart 6). Given Peru’s unexpectedly large decline in output, the multi-year flattening of supply growth we highlighted last month will continue.2 Indeed, we expect mined and refined output to show little or no growth this year, as was the case last year. This can partly be blamed on a lethargic recovery in mining capex, which hit a 10-year low in 2017. Longer term, as the continued global inventory drawdowns illustrate, the rate of growth in mined and refined production is far below the rate of growth in consumption globally. This is occurring as the pace of China’s recovery from COVID-19 aggregate demand destruction can be expected to start winding down later this year and growth ex-China ramps up (Chart 7). Chart 6Peru Posts Sharply Lower Output Peru Posts Sharply Lower Output Peru Posts Sharply Lower Output Prices for ore and refined copper will have to move higher to incentivize new production over the near term just to meet existing demand, to say nothing of new demand coming on from the global buildout in renewable-energy generation.3 Chart 7Supply Growth Lags Demand Growth Supply Growth Lags Demand Growth Supply Growth Lags Demand Growth Investment Implications As the rates of COVID-19 infection, hospitalization and deaths continue to fall globally, markets will begin to see evidence of an organic recovery in aggregate demand globally taking hold (Chart 8). We also expect this will remove a significant amount of the embedded risk premium in the broad trade-weighted USD, which will be bullish for commodities generally. The combination of organic growth and a weaker USD will boost the level of copper demand globally, even if China is slowing in 2H21, as our China Investment Strategy expects. This will put the weak y/y production growth in mined and refined copper in sharp perspective vis-à-vis copper demand, and will push copper prices higher. These fundamentals also will deepen the backwardation in CME COMEX copper futures for high-grade refined metal, as inventories continue to draw, and markets continue to tighten. We remain long the PICK ETF, and December 2021 COMEX copper futures, which are up 8.42% and 21.7% respectively since their inception dates on December 10, 2020 and September 10, 2020. Chart 8As COVID-19 Receeds Copper Demand Will Increase As COVID-19 Receeds Copper Demand Will Increase As COVID-19 Receeds Copper Demand Will Increase   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish The US EIA estimates December and January LNG exports will hover close to 10 BCF/d, continuing a trend noted at the end of last year (Chart 9). November and December LNG exports last year were at record levels – 9.4 BCF/d and 9.8 BCF/d. In January, LNG exports were 9.8 BCF/d, another record for that month. Below-normal temperatures in Asia have spurred demand for US LNG at a time when spot outages at other exporting states reduced global supplies. The EIA expects US LNG exports to average 8.5 BCF/d and 9.2 BCF/d this year and next. Working natural gas stocks at the end of January were 2.7 BCF, up 2% y/y and 8% over the rolling five-year average inventory level. Base Metals: Bullish The European Commission estimates EV nickel demand will be the “single-largest growth sector for nickel demand over the next twenty years.” In a study released by the Commission, global nickel demand is expected to increase by 2.6mm tons by 2040, versus 92k tons in 2020. Internal supply will be sufficient to meet demand for the 27 EU states to 2024/25, according to the study, and thereafter physical deficits will follow. The study notes that without an end-of-life recycling buildout, this deficit will persist, as mining.com noted in its report on the study. Precious Metals: Bullish After sustaining a triple bottom in at ~ $840/oz, platinum prices have rallied almost $400/oz since November (Chart 10). Lower supplies and investor demand drove the rally. Going forward, we expect increasing auto demand – first in China, and then, later, in the rest of the world as organic growth revives – will support demand for platinum-group metals, particularly for platinum and palladium. Platinum posted a 390k-ounce deficit in 2020, while palladium demand exceeded supply by just over 600k oz, according to Johnson Matthey, the PGM refiner. The world consumes ~ 10mm ounces of palladium and ~ 7mm ounces of platinum p.a. Ags/Softs: Neutral Corn, wheat and soybeans were trading 2 – 3% lower, following the USDA’s February 2021 World Agricultural Supply and Demand Estimates (WASDE) released on Tuesday. Markets drastically overestimated the amount by which the USDA would cut ending stocks for the 2020/21 crop year, with the Department trimming corn stocks to 1.5mm bushels (vs a 1.4mm bushel estimate of analysts), according to farmprogress.com. Chart 9 Copper Surge Welcomes Metal Ox Year Copper Surge Welcomes Metal Ox Year Chart 10 Platinum Price Rally USD 400 Since November Platinum Price Rally USD 400 Since November     Footnotes 1     Please see Table 13, p. 27 in Dominish, E., Florin, N. and Teske, S., 2019, Responsible Minerals Sourcing for Renewable Energy. Report prepared for Earthworks by the Institute for Sustainable Futures, University of Technology Sydney. 2     Please see Pandemic Uncertainty Will Fall, Weakening USD, Boosting Metals, published 28 January 2021. It is available at ces.bcaresearch.com. 3    Please see Renewables, China's FYP Underpin Metals Demand, published 26 November 2020. It is available at ces.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Summary of  Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Since July 2020, the KOSPI index has been among the best performing equity markets worldwide (Chart 1). Will this rally and outperformance continue? The rally in the KOSPI has been due to two factors: (1) improving global growth in general and surging demand for semiconductors in particular; and (2) unprecedented domestic retail investor buying of stocks. We explore both these factors in detail below. Global Growth Tailwinds The global economic recovery will continue. With the US about to adopt another round of massive fiscal stimulus and Chinese policymakers’ cautious approach to tightening, global trade will remain robust for now. Chinese purchases account for 24% of Korean exports, the US for 17% and the EU for 10%. Importantly, due to substantial fiscal transfers to households, US demand for consumer goods will remain extremely strong, benefiting Korean exporters as a result. DRAM semiconductor prices and producers’ revenues are rising and are pointing towards more upside in share prices of their producers - Samsung and Hynix (Chart 2). Chart 1The KOSPI: Absolute And Relative Performance Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Chart 2Rising DRAM Prices Are Bullish For Korean Semi Stocks Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making   In a nutshell, the well-publicized semiconductor shortages in the global auto industry suggests that producers’ forward order books are full. Retail Investor Euphoria Chart 3Retail Investors Drove The Rally In Korean Stocks In The Past Year Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Apart from the apparent global recovery, another major force that has been propelling Korean share prices is individual investors’ rush to buy stocks (Chart 3). Notably, retail investors bought stocks last March when foreign and domestic institutional investors were offloading their holdings. In a nutshell, were it not for local individual investors’ providing a bid for equities during the crash last March, the KOSPI index would have plummeted much more than it ultimately did. This is true for almost all bourses worldwide. Are retail investors about to withdraw from the stock market? If yes, does it mark the end of this stock market rally? There are several measures that point to built-up excesses in the equity market in general and retail investor participation in particular. Since last March, margin loans have surged 3.5-fold in absolute terms and have risen from 0.7% to 1.2% of broad equity market cap with the latter expanding tremendously (Chart 4). Consistent with the retail equity frenzy, trading volumes on the stock exchange have surged 1.5-fold (Chart 5). Chart 4Korea: Surging Margin Loans For Equity Purchases Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Chart 5Skyrocketing Stock Trading Volume Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making   Korea’s broad equity market capitalization has reached an all-time high relative to both nominal GDP, broad money supply and household deposits (Chart 6). Overall, Korean equity prices have been driven by retail investor speculation that has created considerable excesses in the stock market. However, we cannot rule out the odds that this rally will persist and a genuine equity bubble will form. It will eventually burst, but it might get bigger beforehand. The main reason to expect the retail equity mania to last longer is the massive quantity of retail investors’ cash at brokerage accounts, ostensibly waiting to be invested. Chart 7 denotes that individual investor account balances at brokerage houses have swelled by about 2-fold since last March and now stand at KRW 65 trillion, equal to almost 4% of market cap. Chart 6Equity Market Capitalization In Perspective Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Chart 7Individual Investors Still Have A Lot Of Dry Powder Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making   This cash on the sidelines, along with foreign investors who have not meaningfully participated in this equity rally, holds the potential to push share prices much higher. What about Korean equity valuations? Is there a historical bubble that can serve as a roadmap? Korean equities are richly valued: the forward P/E ratio is the highest in past 22 years (Chart 8). Besides, in manias driven by retail investors, valuation is not a constraint for higher prices. Finally, Korean stocks experienced a full-fledged mania and bubble in the late 1980s alongside the Japanese equity bubble. Chart 9 displays the overlay of the current rally with the one in the late 1980s in Korea. Based on this profile, share prices could rise further. Chart 8Equity Multiples Are Elevated Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Chart 9Korean Stocks Now And During The Late 1980s Bubble Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making   Bottom Line: Korean stocks have been in a retail-investor driven mania. Rational and fundamental analysis are rendered useless during a financial mania. Odds of an equity overshoot are considerable. The Structural Outlook Can the economy grow fast in the long run, justifying current and potentially higher equity multiples? We have several considerations on Korea’s structural outlook: The Korean manufacturing industry is extremely competitive, and it will remain a major global production hub. Consistently, export-oriented companies with comparative advantages will flourish, unless the currency appreciates considerably. Hence, precluding the won’s appreciation relative to its main competitors’ currencies is critical to the profitability of Korean exporters that make up a substantial chunk of this bourse. Although Korea’s export prices are rising in US dollar terms, they are deflating in local currency terms (Chart 10). This augments the importance of exchange rates for the profitability of exporters. In fact, the currency is presently not cheap. According to the real effective exchange rate based on unit labor costs, the won is modestly overvalued while the Japanese yen is undervalued (Chart 11). Chart 10Korean Exporters Are Experiencing Falling Prices In Local Currency Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Chart 11The Won Is Not Cheap Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making   Regarding domestic demand, the outlook is uninspiring. The share of consumer spending has been declining precipitously while the share of government spending has been rising, albeit from a low level (Chart 12). The good news is that public debt stands at a mere 41% of GDP meaning the government can keep increasing its spending. Exports’ share of GDP remains substantial at around 40%. Finally, Korea’s potential GDP growth has been, and will continue, trending lower. Chart 13 illustrates that the working age population is forecast to shrink at an accelerated rate in the foreseeable future. This will reduce potential GDP growth from 1.7% to 1% by the end of this decade (Chart 14, bottom panel). Chart 12Structure Of Korean GDP Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Chart 13Korea's Potential Growth Rate Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making     Chart 14Korea Has The World's Lowest Fertility Rate Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making In sum, the main constraint on Korea’s potential growth is low fertility. Chart 14 reveals Korea’s fertility at 1.1 to be the lowest in the world, along with Taiwan’s. Bottom Line: Apart from competitive export industries, the structural growth outlook for domestic demand is very poor and does not justify elevated equity multiples. In turn, the export sector’s competitiveness rests on the exchange rate. The Korean won’s large appreciation versus the currencies of its competitors will hurt exporters’ profitability or reduce their market share. In short, uninterrupted share price and currency appreciation are not sustainable in the long run. Investment Recommendations We upgraded Korean stocks to overweight relative to the EM equity benchmark on November 5, 2020 and this overweight remains intact. For absolute-return investors, odds of an overshoot in Korean stocks are considerable with retail investors’ cash on the sidelines waiting to be deployed and pent-up demand from foreign investors. Manias are not over until they are over. We are booking gains on our long-standing position in Korean local rates. We have been receiving 10-year Korean swap rates since May 2011 as a bet on weaker growth and disinflationary trends in the global economy. We now see a higher risk of inflation, especially in regard to the US. Provided US bond yields largely drive Korean yields, we are taking profits on this strategy. This position has generated a gain of 280 basis points (Chart 15). The currency could correct in the near-term if the US dollar stages a countertrend rebound but the cyclical outlook for the won is positive. The Korean won appreciates when the nation’s export prices rise and vice versa (Chart 16). Chart 15Book Profits On Korean 10-Year Swap Rate Position Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Chart 16The Won Will Be Supported If Export Prices Continue Rising Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Chart 17KRW Is Facing Technical Resistance Korean Equities: A Bubble In The Making Korean Equities: A Bubble In The Making Technically, the KRW is facing an important resistance versus the USD (Chart 17). As a part of our broader currency strategy, we have been shorting the KRW along with other EM currencies versus an equal-weighted basket of the euro, CHF and JPY. We will close this trade in the near term on any potential US dollar rebound. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Vanessa Wong Ee Shan Research Associate vanessaw@bcaresearch.com Footnotes

Dear client, On behalf of the China Investment Strategy team, I would like to wish you a very happy, healthy, and prosperous Chinese New Year of the Ox (Bull)! Gong Xi Fa Chai, Jing Sima, China Strategist   Highlights A projected 8% increase in China’s real GDP for 2021 will not be an acceleration from the V-shaped economic recovery from the second half of last year. Excluding an exceptionally strong year-over-year economic expansion in Q1, the average growth in the rest of this year will be slower than in 2H20, which implies China’s economic growth momentum has already passed its peak. On a quarter-over-quarter basis, an expected 18% annual growth in Q1 would mean that China’s economic growth momentum has moderated from Q4 last year. Chinese policymakers are not in a hurry to press the stimulus accelerator again, with good reason. Commodity and risk-asset prices will be the most vulnerable to a weakened demand growth.   Feature China’s real GDP is expected to grow by more than 8% this year, which would be a significant improvement over last year’s 2.3%.1 However, it is misleading to compare this year’s growth with that of 2020 as a whole. The first three months of this year will undergo an exceptionally high year-on-year growth (YoY) rate due to the deep contraction experienced in Q1 last year. An 8% annual growth for 2021 would imply that the rate of economic expansion in the rest of this year will be slower than the sharp recovery in 2H20.  From a policy perspective, an 8% real GDP growth in 2021 implies an average rate of 5% over the 2020-2021 period, within the long-term growth range targeted in China’s 14th Five-Year Plan - this removes policymakers’ incentives to further stimulate the economy. The annual National People's Congress (NPC) in early March should provide clues about the government's growth priorities and policy directions. If policymakers set 2021’s real GDP growth target at around 8%, our interpretation is that Chinese leaders are not looking to accelerate growth beyond where it ended in 2020. Major equity indexes are already richly valued. A moderating growth momentum from China will weigh on commodity and risk asset prices, both in China and globally.  We reiterate our view that downside risks are high in the near term; the market could take the easing demand growth from China as a reason for a long overdue correction. A Perspective On Growth In 2021 Investors should put this year’s GDP growth projections into perspective given last year’s distortions in China’s economic conditions and data. On a YoY basis, data in the first quarter this year will be artificially boosted due to the deep contraction in Q1 last year. The market consensus is that Q1 2021 will register an 18% YoY rate of real GDP expansion. If we assume the economy can expand by 8% this year over 2020, then the YoY GDP growth rates in the rest of this year will average less than 6%. This would be below the 6.5% YoY rate in the fourth quarter of 2020 – meaning that on a YoY basis, China’s growth momentum has peaked (Chart 1). Importantly, sequential growth, such as month-over-month (MoM) and quarter-over-quarter (QoQ), drives the financial markets. On a QoQ basis, Q1 business activities are typically weaker due to the Chinese New Year. However, when we compare the rate of QoQ slowdown in Q1 this year with previous years, an 18% YoY increase would mean China’s output in the first three months of 2021 would be one of the worst in the past 20 years (Chart 2).  Chart 1Q1 GDP Growth Will Be Artificially Boosted, On A YoY Basis Q1 GDP Growth Will Be Artificially Boosted, On A YoY Basis Q1 GDP Growth Will Be Artificially Boosted, On A YoY Basis Chart 2…But Will Be On The Weaker Side, On A QoQ Basis Understanding China’s Growth Arithmetic For 2021 Understanding China’s Growth Arithmetic For 2021 The moderating growth momentum in Q1 this year was already reflected in high-frequency data in January. Most major components in last week’s PMI surveys in both the manufacturing and service sectors had larger setbacks than in January of previous years. Prices in major commodities as well as the Baltic Dry Index softened (Chart 3). Cyclical sector stocks in China’s onshore market, which is highly sensitive to domestic economic policies, have halted their outperformance relative to defensive stocks (Chart 4).  Chart 3Chinese Economic Growth May Be Showing Signs Of Moderation Chinese Economic Growth May Be Showing Signs Of Moderation Chinese Economic Growth May Be Showing Signs Of Moderation Chart 4Outperformance In Onshore Cyclical Stocks Is Rolling Over Outperformance In Onshore Cyclical Stocks Is Rolling Over Outperformance In Onshore Cyclical Stocks Is Rolling Over Furthermore, it is useful to look past the growth outliers in the previous four quarters to gain insight into the status of China’s business cycle. On a two-year smoothed term, an 8% annual output growth in 2021 would represent a continuation of China’s downward economic growth trend (Chart 5). Chart 5This Years Rebound In Headline GDP Growth Does Not Alter Chinas Structural Downtrend This Years Rebound In Headline GDP Growth Does Not Alter Chinas Structural Downtrend This Years Rebound In Headline GDP Growth Does Not Alter Chinas Structural Downtrend Bottom Line:  It is misleading to consider an 8% YoY real GDP growth rate in 2021 as an acceleration in China’s economic recovery. On a quarterly basis, Q1 will undergo a moderation in growth momentum. The economy in the rest of the year will remain on a downward growth trend. No Rush To Stimulate Anew If Q1 growth turns out to be weaker than the market anticipates, then will Beijing continue to dial back stimulus? Or, will it become concerned about the underlying fragility in the economy and provide more support? So far, all signs point to a continuation of a stimulus pullback. Chart 6Tighter Monetary Conditions are Starting To Bite the Economy Tighter Monetary Conditions are Starting To Bite the Economy Tighter Monetary Conditions are Starting To Bite the Economy The resurgence of domestic COVID-19 cases contributed significantly to January’s shaky demand. However, tighter monetary conditions in 2H20 are likely another reason for the growth moderation (Chart 6). Here are some factors that may have prompted Chinese authorities to stay on track to scale back stimulus: Policymakers appear to consider the massive fiscal stimulus last year overdone. In contrast with the previous two years, local governments are not issuing special-purpose bonds (SPBs) before the NPC sets its quota in early March. China’s broader fiscal budgetary deficit widened to 11% of GDP in 2020 from 6% in 2019. Local governments issued nearly 70% more SPBs in 2020 than in the previous year (Chart 7). SPBs are mostly used for investing in infrastructure projects and last year’s fiscal support along with substantial credit expansion helped to speed up infrastructure investment. However, towards the end of last year local governments reportedly experienced a shortage in profitable investment projects and thus, parked more than 400 billion yuan of proceeds from last year’s SPB issuance at the central bank (Chart 8). This will likely convince the central government to reduce the SPB quota by a large margin this year. Chart 7Fiscal Stimulus Last Year May Be Overdone Fiscal Stimulus Last Year May Be Overdone Fiscal Stimulus Last Year May Be Overdone Chart 8Local Governments Reportedly Ran Out Of Profitable Infrastructure Projects To Invest Last Year Local Governments Reportedly Ran Out Of Profitable Infrastructure Projects To Invest Last Year Local Governments Reportedly Ran Out Of Profitable Infrastructure Projects To Invest Last Year In addition, government revenues in 2020 were surprisingly strong and spending was well below budgeted annual expenditures, resulting in 2.5 trillion yuan in idle funds (Chart 9). Based on China’s fiscal budget laws, any unspent funds from the previous year will be carried over to the next year. In other words, the 2.5 trillion yuan will contribute to fiscal deficit reduction this year and are not extra savings that can be distributed.  In addition, asset price bubbles are a perennial concern. Land sales and housing demand for top-tier cities roared back last year due to cheap loans and a relaxed policy environment (Chart 10). In our opinion, Chinese leaders allowed the real estate market to temporarily heat up last year to avoid a deep economic recession. As the economy recovered to its pre-pandemic level by late 2020, policymakers have sharply reduced their tolerance for the booming housing market and substantially tightened restrictions in the real estate sector. Chart 9Unspent Fiscal Stimulus Checks Do Not Lead To Higher Government Spending Next Year Unspent Fiscal Stimulus Checks Do Not Lead To Higher Government Spending Next Year Unspent Fiscal Stimulus Checks Do Not Lead To Higher Government Spending Next Year Chart 10Housing Market Heats Up Again Housing Market Heats Up Again Housing Market Heats Up Again The domestic labor market has been surprisingly resilient, removing the leadership’s political constraints and incentives to further stimulate the economy.  Labor market conditions and household income are improving. The gap between household disposable income and spending growth has narrowed, the unemployment rate is back to its pre-pandemic level and consumer confidence has rebounded (Chart 11). More importantly, China’s labor market in urban areas is tightening again, with migrant workers receiving higher pay than prior to the pandemic (Chart 12).  Chart 11Labor Market Is On The Mend Labor Market Is On The Mend Labor Market Is On The Mend Chart 12China’s Urban Labor Market Is Tightening Again Understanding China’s Growth Arithmetic For 2021 Understanding China’s Growth Arithmetic For 2021 Bottom Line: Growth rates will moderate, but policymakers will wait for more evidence of a pronounced slowdown in economic conditions before they ease policies. Concerns about financial risks and excesses in the property market entail authorities to allow stimulus of 2020 to relapse. It will take a much deeper slowdown in the business cycle before easing is re-introduced. Investment Implications Our baseline view indicates that credit growth will decelerate by two to three percentage points in 2021 from 2020, and the local government SPB quota will drop by 10%. The projected pullbacks on stimulus are small and more measured than the last policy tightening cycle in 2017/18. Nevertheless, a smaller stimulus and tighter policy environment will consequently lead to moderating growth momentum in China’s domestic economy and demand, particularly in the second half of this year.   Chart 13How Far Can Chinas Inventory Restocking Cycle Go Without More Policy Tailwinds How Far Can Chinas Inventory Restocking Cycle Go Without More Policy Tailwinds How Far Can Chinas Inventory Restocking Cycle Go Without More Policy Tailwinds Commodity prices may be at high risk of easing demand. The strong rebound in China’s commodity imports in 2H20 was not only due to a recovery in domestic consumption, but also inventory restocking from an extremely low level. Chart 13 shows that the change in China’s industrial inventories relative to exports has risen substantially from a two-year contraction. Going forward, the pace of inventory accumulation will slow following a weaker policy tailwind and growth momentum, which will weigh on the demand for and prices of key industrial raw materials. Corporate profits should continue to recover, albeit at a slower rate than in 2H20. At the same time, risks are tilted to the downside, and policy initiatives should be closely monitored going forward. As such, we maintain a cautious view on Chinese stocks.    Jing Sima China Strategist jings@bcaresearch.com   Footnote: 1     IMF World Economic Outlook and World Bank Global Outlook, January 2021   Footnotes Cyclical Investment Stance Equity Sector Recommendations

Highlights Indian private sector banks have shown a remarkable improvement in their operating efficiency and have largely cleansed their balance sheets. Further, they have plenty of room to grow as they will continue to grab market share from public sector banks. Investors should go long Indian banks and short EM banks. EM equity portfolios should upgrade the Indian bourse from neutral to overweight. Feature Indian bank stocks have been the star performers among emerging markets banks over the past 20 years (Chart 1). They have consistently outperformed the broader Indian markets too, except in 2020 (Chart 2). What led to such a sustained outperformance? And more importantly, are Indian banks still a buy? Chart 1Indian Bank Stocks Have Been The Star Performer Among EM Banks Are Indian Banks A Buy? Are Indian Banks A Buy? Chart 2Indian Banks: 2020 Underperformance Is Reversing Are Indian Banks A Buy? Are Indian Banks A Buy?   Changing Landscape Our research indicates that listed Indian banks have displayed remarkable improvement in their operating efficiencies in the past 15 years. Lately, they have also cleansed their balance sheets meaningfully. Before we delve deeper into the drivers of their outperformance and prospects, we need to be aware of the changing structure in the Indian banking sector, and the disconnect it has created between banks’ assets versus banks’ market capitalization. Even though India’s public sector (PSU) banks have been steadily losing their market share to private ones over the past three decades, they still dominate the Indian banking scene with a 60% slice in terms of assets and loans. Private sector banks’ market share is a third of the total, with the rest belonging to foreign banks and smaller local banks. Yet, Indian bank stock indexes are comprised predominantly of private sector banks. For example, they make up 95% of India’s MSCI bank index1 – a share that has risen rapidly over the past decades. India’s bank stock performance, therefore, has been largely a reflection of its private sector banks. Robust Operating Efficiency Chart 3Indian Private Banks Have Shown Remarkable Operating Efficiency... Are Indian Banks A Buy? Are Indian Banks A Buy? In terms of operational efficiency, Indian private sector banks have shown significant improvement over the past 20 years. Their operating profit-to-assets ratio went up from around 2% in 2000 to 2.8% currently (Chart 3, top panel). On the flip side, PSU banks’ operating profits have dwindled to 1.6% of their assets. The improving performance of private sector banks also boosted India’s bank stock indexes as they continued to have ever larger weights therein. This remarkable divergence between the operating profits of public and private banks has been caused by several factors:  Private sector banks have been more aggressive than PSU banks in terms of the assets they accumulated, as well as in their management of asset-liability mismatch. This has helped them generate significantly higher net interest income relative to their assets (Chart 3, middle panel). Over the past several years, private sector banks have ramped up their loan book (higher-yielding) while trimming their investments portfolio (lower-yielding government paper). The opposite has happened with PSU banks (Chart 4, top panel). As a result, private banks’ interest income relative to their assets has risen more than that of PSU banks. In their loan portfolio, private banks maintained a higher share of term loans relative to working capital loans (Chart 4, bottom panel). Term loans often entail higher yield as they typically lock-in funds for a longer period than do working capital loans. But term loans also need to be funded by longer duration liabilities to avoid asset-liability mismatch. These liabilities are typically term deposits. Since term deposits cost more than demand or savings deposits, it’s important to balance the term liabilities with term assets. Private sector banks have mobilized term deposits in line with their needs to finance their term loans (Chart 5, top panel). PSU banks, on the other hand, have had much more (higher-cost) term deposits compared to their term loans. Chart 4...Supported By Prudent Asset-Liability Management... Are Indian Banks A Buy? Are Indian Banks A Buy? Chart 5...That Yielded Higher Cost-Adjusted Return On Loans... Are Indian Banks A Buy? Are Indian Banks A Buy?   This is one of the reasons why the profitability of banks loans for private banks, after adjusting for funding costs, has been superior to that of PSU banks (Chart 5, bottom panel). Private banks have also made a stronger foray into the world of unsecured loans (Chart 6). These are typically credit card loans and personal lines of credit. Since unsecured loans usually earn a higher rate of interest, this strategy has worked in favor of boosting their net interest margins. Finally, private banks have always had significantly more non-interest income (i.e., fee-based income). This has helped improve their operating profits meaningfully (Chart 3, bottom panel). Notably, in terms of employee cost and other operating costs, private sector banks do not do any better than PSU banks. In fact, the operating expenditure as a percentage of assets has always been higher for private banks than for PSU banks (Chart 7). This divergence has mainly been due to a difference in employee compensation expenditure. Chart 6...And An Aggressive Credit Strategy Are Indian Banks A Buy? Are Indian Banks A Buy? Chart 7Private Banks' High Operating Cost Was More Than Offset By A Higher Operating Income Are Indian Banks A Buy? Are Indian Banks A Buy?   Put differently, the “operating efficiency” of private sector banks stems from their built-in business model, in which they take slightly more business risks than their PSU counterparts. But in the process, private banks earn significantly more operating income than PSU banks. This more than offsets their relatively higher operating expenditure resulting in higher operating profitability (Chart 3, top panel). Crucially, private sector banks have steadily taken market share from PSU banks in all four types of loans: agricultural, industrial, services, and personal loans (Chart 8). Their loan book is also quite balanced, with no excessive exposures to any type of borrowers (Chart 9). Yet, their presence in the economy is proliferating at a fast clip. It’s no wonder then that their stock prices have commanded a steady premium over their PSU counterparts. They also gradually displaced the latter in India’s stock market indexes. Chart 8Private Banks Are Grabbing Market Shares In All Areas... Are Indian Banks A Buy? Are Indian Banks A Buy? Chart 9...But They Are Not Over-Exposed To Any One Type Of Loans Are Indian Banks A Buy? Are Indian Banks A Buy?   The Saga Of NPLs And Provisions The diverging operating profits of public and private sector banks got more accentuated when it came to net profits. The reason is a much higher share of bad loans among PSU banks. This forced PSU banks to make higher loan loss provisions, which weighed on their net profits (Chart 10). One development that aggravated PSU banks’ market share and NPL woes is the rising trend of disintermediation by corporate borrowers. Large industrial sector borrowers have been increasingly relying on corporate bond markets for their financing needs instead of bank credit. Indeed, disintermediation of large industrial loans is the main reason why overall bank credit in India has decelerated so much recently. Excluding this sector, bank credit growth has been quite decent (Chart 11). Chart 10Private Banks' Robust Operating Margins Let Them Make Aggressive NPL Provisions Are Indian Banks A Buy? Are Indian Banks A Buy? Chart 11PSU Banks Got Disproportionately Hurt By Decelerating Industrial Loans Are Indian Banks A Buy? Are Indian Banks A Buy?   Chart 12 shows that the amounts raised by corporates via local debt issuance has far outstripped the incremental bank credit to the industrial sector in the past.  One incentive for large firms to issue debt instead of taking on more credit is that corporate bond yields for top borrowers (AAA and AA rated) have been lower than the prime lending rates of banks. With bond markets maturing in India, corporates are increasingly taking advantage of the situation (Chart 13). Chart 12Large Industrial Firms Shunned Bank Credit In Favor Of Debt Issuance... Are Indian Banks A Buy? Are Indian Banks A Buy? Chart 13...As Financing Cost Via Debt Issuance Became Increasingly More Attractive Are Indian Banks A Buy? Are Indian Banks A Buy?   This general shift in credit markets caught PSU banks off-guard. Since almost 90% of all industrial loans were from PSU banks at the beginning of the past decade (Chart 8), the disintermediation process hurt them disproportionately compared to private banks. PSU banks are also now stuck with an ever higher share of old, ageing industrial loans in their books. Older loans are more prone to turning into NPLs as compared to fresh, newly issued loans. This is one of the reasons why the NPL ratio has been higher for PSU banks. Private sector banks, on the other hand, have had a relatively higher share of their loan book in personal and services sector loans. These loans have traditionally been much less prone to turning sour. RBI’s data shows that the stressed loans in the personal loans sector have remained around 2% for the past several years while that of industrial loans hovered in double digits (Chart 14). This is another reason why private sector banks faced relatively lower NPL problems over the years.  The top panel of Chart 15 shows the gross NPL ratios of both public and private sector banks. The middle panel shows the yearly provisions they made as a share of their total loans. Chart 14Industrial Loans Have A High Propensity To Become NPL; Personal Loans Low Are Indian Banks A Buy? Are Indian Banks A Buy? Chart 15Private Banks' Copious NPL Provisioning Led To Lower Net NPL Are Indian Banks A Buy? Are Indian Banks A Buy? Chart 16In Past Decade Private Banks Have Provisioned For Half Of Their Average Loan Book! Are Indian Banks A Buy? Are Indian Banks A Buy? Evidently, over the years private banks have made nearly as much provisions (as a % of loans) as their PSU counterparts, even though the former has had much less gross NPLs. This is why private banks’ balance sheets are cleaner now, i.e., they have less net NPLs (Chart 15, bottom panel). Notably, these data also indicate that private sector banks have set aside a mammoth INR 5.5 trillion as cumulative provisions over the past ten years. This would be equivalent to 55% of their average gross loans outstanding that existed over a five-year period between 2010 and 2014 (both years inclusive) (Chart 16). Since most of these provisions have since been used up to write-off bad loans, one could estimate that around half of the loans that existed in the early 2010s have since been written off. The same figure for PSU banks would be INR 14 trillion, and about a third of their average loans between 2010 and 2014 have already been provisioned for. These figures are all as of March 2020, i.e., before the pandemic kicked in. This entails that Indian banks’ balance sheets, especially those of private sector banks, were largely clean going into the pandemic. The reported net NPL ratio of 1.5% for private sector banks as of March 2020 is therefore a credible figure. The Pandemic And Its Aftermath Banks’ NPLs will surely rise as the negative ramifications of the prolonged country-wide lockdown becomes clearer in the months ahead. That said, the RBI and banks have taken several prudential measures to minimize the fallout: During the pandemic, the RBI (and later the Supreme Court) had allowed a loan moratorium period from March to August 2020. Borrowers needed not to pay any instalment or interest for loans during that period, and their loans would still not be downgraded to NPLs. What’s more, for loans up to INR 20 million (all small, medium and micro enterprises, and personal loans), the borrowers won’t have to pay the foregone instalments after the moratorium period is over. They won’t have to pay even the incremental interest that will have accrued on their loans as their principal balance stayed higher for six months than if they would have continued making repayments. The federal government has agreed to pay for the incremental interest, which has mitigated the loss of profitability for banks on these loans. Thus, most borrowers are unlikely to face sudden, additional debt servicing burdens after the moratorium period is over. This would help in avoiding more accounts from turning bad. Banks, at the same time, did make separate provisions – whenever instalments or interests remained overdue during the pandemic – as if no moratorium was in place. As such, banks have already taken the hit in their income statements for any slippage in their loan books. Excluding the moratorium-period new NPLs and provisions, private sector banks’ regular stock of provisions stood at 80% of their gross NPLs as of September 2020. For some listed private banks, the figure was well over 100%. For PSU banks, this figure was 70.5% as of last September. Hence, the bottom line is that in the absence of further pandemic and lockdown-related growth slumps, the private sector banks’ NPL profile is quite benign. To assess the future impact on banks’ NPL and capital adequacy, the RBI conducted a stress test in January this year: As per their projections (not forecast), in the worst case scenario where GDP would grow only at 3.8% in the six months from April to September 2021 (against the IMF’s base line projection of 11.5% growth in April 2021 to March 2022), the gross NPL ratio of PSU banks could rise from 9.7% in September 2020 to 17.6% a year later. For private sector banks, it could rise from 4.6% to 8.8%.  In that case, assuming that banks will set aside another 4% of loans as provisions this year (as they did last year), net NPLs for PSU banks will rise from 2.9% to 6.8%, but that of private banks will remain largely unchanged at 1.2%. Since private banks dominate the bank stock index, there will be a muted negative ramification on stock prices, if any, on account of such a pessimistic scenario of a new wave of NPLs.   Investment Conclusions Indian private sector banks have had plenty of tailwinds: high net interest margins and profitability, good asset-liability management, and exposure to good-quality credit. Besides, they have been aggressive in the provisioning of their NPLs. More importantly, going forward, these banks have plenty of room to grow. Their market share is still relatively small, and India’s bank credit to-GDP ratio is also relatively low at 55% of GDP. Including corporate bonds, total borrowings of non-financial, non-government sectors are still not high at 72% of GDP (Chart 11, bottom panel). Post-pandemic, once India’s economy gets back in the groove, these banks are very well placed to exploit the opportunity over a sustained period. This warrants a bullish view on Indian private sector banks: While their valuation remains expensive, they have fallen somewhat compared to the past several years. Given their balance sheets are now much cleaner than they were in the recent past, they offer a better risk-reward profile (Chart 17). A good harvest and lingering domestic demand weakness will keep inflation in check in India. This also means that the RBI is unlikely to raise rates anytime soon. Periods of low inflation and no monetary tightening are beneficial for both banks and borrowers. Indeed, bank stocks usually do well, both in absolute terms and relative to overall markets, whenever inflation is under control (Chart 18). Chart 17Bank Valuations Are Better Than In Recent Years Given Balance Sheets Are Cleaner Are Indian Banks A Buy? Are Indian Banks A Buy? Chart 18Muted Inflation And Lower Policy Rates Are Supportive Of Bank Stocks Are Indian Banks A Buy? Are Indian Banks A Buy?   Investors should go long Indian banks and short EM banks. We recommend dedicated EM equity portfolios to use the latest relapse in India’s relative equity performance to upgrade the country's allocation from neutral to overweight (Chart 19). India’s yield curve remains steep with the ten-year swap rate 120 basis points above the policy rate. Indian local currency government bonds offer value relative to both US and EM bonds. The spread of India’s GBI bond index over the same duration of US and EM local currency bonds are 570 and 150 basis points respectively. Investors should stay on with our recommendation to receive ten-year swap rates. Finally, the rupee is likely to stay well bid thanks to a strong balance of payments – which was boosted by copious capital flows (Chart 20). A potential rebound in the US dollar could produce a mild setback in the rupee. However, this currency will outperform the majority of EM exchange rates. Chart 19Upgrade Indian Stocks To Overweight In An EM Portfolio Are Indian Banks A Buy? Are Indian Banks A Buy? Chart 20A Strong Balance Of Payment Is Supportive Of Indian Rupee Are Indian Banks A Buy? Are Indian Banks A Buy?   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Box 1 A Note On India’s Agriculture Reforms We published a report on India’s Agricultural reforms on November 19, 2020 where we elaborated on why this law was very important for India’s structural outlook. As we contended therein, it’s a highly politically sensitive issue. Expectedly, it was met with political resistance from a few political parties and a section of farmers. Just to provide some context to the agitations, out of the 500 million agricultural workers in India, only about 50 thousand or so large farmers from a particular region in India are protesting. While these protesters have significant political clout, they can hardly be called representative of all farmers. As to the reason for these protests, the new law will upend the monopoly and vested interests of many large farmers who benefitted from the current system for decades. Even though the reforms will usher in private capital, improving overall farm productivity, they will also introduce competition in procurement and distribution. The latter will certainly hurt many large farmers who practically run the current “mandi” system (designated marketplaces where farmers sell their produce). It’s still uncertain how this will play out. As many as 11 rounds of discussions between the farmers’ representatives and the government failed to sort out the issue. Meanwhile, the Supreme Court intervened and formed a committee to look into the matter over the next six weeks, but the protesting farmers have refused to accept its involvement and forthcoming ruling. The government’s offer to put the act on hold for the next 12-18 months while discussion continues has also been refused by the farmers. The protesters’ sole demand is a complete repeal of the law. Our best guess is, eventually, there will be some modification in the most contentious parts of the new laws, and the roll out will probably be delayed by a year or so. In any case, we will keep you updated. Footnotes 1 The MSCI India Financials index makes up 27% of the broader MSCI India index, and the MSCI India Banks index makes up 20%. The latter is dominated by private sector banks with 19% weights, and figure in only one PSU bank, the State Bank of India (SBI), which has an index weight of 1%. However, SBI’s assets or deposits are still higher than the rest of the index constituents (all private sector banks) combined.

Highlights Chart 1China's PMIs Dropped In January China Macro And Market Review China Macro And Market Review January’s official PMI suggests that China’s economic recovery started the year on a weaker note. While both manufacturing and non-manufacturing PMIs remain in expansionary territory, the moderation was larger than in previous Januarys, which implies that more than seasonal factors were at play (Chart 1). The lockdowns in January due to a resurgence of COVID-19 cases in China are distorting business activities. Moreover, travel restrictions imposed for the upcoming Lunar New Year (LNY) will profoundly affect household consumption and the service sector in February and perhaps into March. Chinese stock prices, on the other hand, registered gains in January in both onshore and offshore markets. As noted in last week’s report, Chinese stocks face downside risks in the near term and we recommend that investors turn cautious. Economic and profit growth may disappoint in the first quarter, against a tightening policy backdrop. Feature Monetary Policy Normalization Remains On Track In the past three weeks, the PBoC drained short-term liquidity on a net basis from the interbank system. This action reversed market expectations in earlier January that the central bank would start to loosen monetary stance. Chart 2Chinas Monetary Policy Unlikely To Change Course When The Economy Strengthens Chinas Monetary Policy Unlikely To Change Course When The Economy Strengthens Chinas Monetary Policy Unlikely To Change Course When The Economy Strengthens The soft patch in China’s first-quarter economic recovery may prompt the PBoC to temporarily slow the pace of interest rate tightening, but it is unlikely that policymakers will reverse their policy normalization over the next 6 to 12 months (Chart 2). The authorities have been increasingly concerned about asset price inflation. In our view, near-term policy shifts will be tied to asset prices rather than consumer prices. The PBoC stated that its policymaking will be data dependent, but it may not succumb to a marginally slower recovery, particularly if the weakness proves to be transitory. Moreover, the unprecedented growth contraction from Q1 last year will boost economic data in the first three months of this year due to a low base effect. This year’s monetary policy could be reminiscent of 2019 when the PBoC frequently adjusted the short-term interbank rate (i.e. 1- to 7-days) while keeping the longer rate (3-month repo rate) mostly trendless throughout the year (Chart 3). In this scenario, China's 10-year government bond yield will not rise by as much as in 2017-2018 (Chart 4). Without a substantial improvement in profit growth, however, a slower rise in bond yields will be only marginally positive for Chinese stocks (Chart 4, bottom panel).  Chart 3Policy Normalization Remains On Track Policy Normalization Remains On Track Policy Normalization Remains On Track Chart 4Smaller Bond Yield Hikes Are Marginally Positive For Chinese Stocks Smaller Bond Yield Hikes Are Marginally Positive For Chinese Stocks Smaller Bond Yield Hikes Are Marginally Positive For Chinese Stocks   Corporations May Not Deliver Strong Profit Growth In 2021 Chart 5An Impressive Profit Recovery Supported The Stock Rally In 2H20 An Impressive Profit Recovery Supported The Stock Rally In 2H20 An Impressive Profit Recovery Supported The Stock Rally In 2H20 The newly released industrial profits data showed a sharp rebound in growth this past December, with the annual profit up by 4.1% over 2019. An impressive recovery in profit growth in the second half of last year helped to drive up Chinese stock prices (Chart 5). However, the magnitude of the rally in stock prices has been much more substantial than implied by the underlying profit growth. Industrial profits have barely recovered to their 2018 levels, while A shares have jumped by 40% in the past two years (Chart 5, bottom panel). Moreover, the strong recovery in profit growth may not be sustainable in 2021. While sales revenues may pick up even more this year, operating costs will likely increase, which would compress corporate profit margins (Chart 6). Lower operating costs from last year’s cheaper financing and growth-support policies, such as tax cuts and loan payment deferrals, helped to widen corporate profit margins. China’s social security contribution exemption and reduction policy reduced the cost burden of enterprises by 1.5 trillion yuan in 2020. Moreover, cheaper global commodity and oil prices in earlier 2020 also lowered China’s industrial input prices (Chart 7). Chart 6Increasing Operation Costs May Weigh On Industrial Profit Margins Increasing Operation Costs May Weigh On Industrial Profit Margins Increasing Operation Costs May Weigh On Industrial Profit Margins Chart 7Input Prices Have Risen Faster Than Output Prices Input Prices Have Risen Faster Than Output Prices Input Prices Have Risen Faster Than Output Prices Chart 8Product Inventories And Account Receivables Have Not Fully Recovered Product Inventories And Account Receivables Have Not Fully Recovered Product Inventories And Account Receivables Have Not Fully Recovered The normalization of policy rates and bond yields along with the rebound in commodity prices will weigh on industrial profit margins and profit growth this year. Furthermore, some cost-reduction benefits will be rolled back: policymakers have announced an end to the social security contribution waiver for corporations in 2021.  However, they will extend the reduction of unemployment insurance from the end of April 2021 to April 2022. It is still unclear whether China will grant the same scale of corporate tax relief this year as it did in 2020. We note that industrial inventory turnover has not recovered to its pre-pandemic level, finished product inventories remain high, and accounts receivable payments are taking longer to reach businesses compared with 2019. All these factors highlight a lack of vigor in the industrial sector’s recovery (Chart 8).  Travel Restrictions Will Dampen Q1 Economic Growth Chart 9A New Wave Of COVID-19 Cases In China A New Wave Of COVID-19 Cases In China A New Wave Of COVID-19 Cases In China New travel restrictions may cause some short-term distortion in China’s aggregate economy in the first quarter. China announced inter-provincial travel constraints for the LNY, effective between January 28 and March 8, due to a resurgence of COVID-19 cases in Beijing and the northern provinces (Chart 9). Local authorities urged migrant workers to stay in their work places and not return to their hometowns. According to the Ministry of Transport, it is estimated that around 50% of migrant workers will remain in place during the LNY. Manufacturing production (secondary industry) may increase slightly because workers will take fewer vacation days during the LNY. Nevertheless, the positive effect will be more than offset by large losses from consumption and tourism (tertiary industry). Reduced consumption from holiday travel, restaurant dining, offline shopping and services will overwhelm online retail sales of goods and services. All these factors will negatively impact Q1 GDP because tertiary industry accounts for around 55% of China’s GDP, a much larger slice than secondary industry1  (Chart 10).    January’s PMI shows that after narrowing in the past six months, the gap between production (supply) and new orders (demand) sub-indexes widened again in January (Chart 11). We expect the travel restrictions to exacerbate the goods oversupply in February and perhaps even into March. Chart 10New Travel Restrictions Will Have A Negative Impact On Q1 GDP New Travel Restrictions Will Have A Negative Impact On Q1 GDP New Travel Restrictions Will Have A Negative Impact On Q1 GDP Chart 11Goods Oversupply May Last Through Q1 Goods Oversupply May Last Through Q1 Goods Oversupply May Last Through Q1 Lingering Deflationary Pressures While headline CPI moved back into inflationary territory in December, mainly driven by food price increases, core CPI has fallen to its lowest level since late 2010 (Chart 12). Prices for some key consumer goods and services remain firmly in deflation and they may deteriorate further in Q1 due to a high price base during last year’s LNY. Chart 12Lingering Deflationary Pressures On Consumer Prices Lingering Deflationary Pressures On Consumer Prices Lingering Deflationary Pressures On Consumer Prices Chart 13PPI Will Likely Turn Positive In Q1 Due To Low Base Effect PPI Will Likely Turn Positive In Q1 Due To Low Base Effect PPI Will Likely Turn Positive In Q1 Due To Low Base Effect Chart 14A Stronger RMB Will Exacerbate Deflationary Pressures A Stronger RMB Will Exacerbate Deflationary Pressures A Stronger RMB Will Exacerbate Deflationary Pressures PPI deflation has eased and will probably turn positive in Q1 this year, supported by an expansionary business cycle and a low base (Chart 13). However, the risk of deflation may resurface in the second half of the year as stimulus effects subside. As such, China’s corporate profit growth will again face downward pressure, which would be exacerbated by a stronger RMB and rising real interest rate (Chart 14). Shipping Disruptions Should Be Transitory China’s export sector remains strong, benefiting from improving global demand and strength in China’s manufacturing supply chains. The drop in January’s PMI export new orders sub-index was mainly seasonal and could be due to the recent pandemic-related logistical disruptions and bottlenecks at ports (Chart 15).  The recent massive jump in freight costs reflects these one-off factors and bouts of inflation this year due to disruptions in logistics, which will likely prove to be transitory (Chart 16). Chart 15Exports Should Remain Robust Through 1H21 Exports Should Remain Robust Through 1H21 Exports Should Remain Robust Through 1H21 Chart 16A Jump In Freight Costs is Probably Transitory A Jump In Freight Costs is Probably Transitory A Jump In Freight Costs is Probably Transitory Real Estate Sector Under Stricter Scrutiny Housing demand and prices in top-tier cities picked up again in December despite rising mortgage rates and more restrictive bank lending to the real estate sector (Chart 17). In our view, the rebound in floor space started will be short-lived, and the gap between floor space started and completed will continue to converge (Chart 18). Real estate developers face stricter borrowing regulations and the rate of expansion of new projects will slow this year due to shrinking land transfers in 2020. Still, real estate developers will continue to finish their existing projects and promote new home sales. Therefore, on a net basis, we expect real estate investment and construction activities to remain stable in the first half of 2021.  Chart 17Housing Demand In First Tier Cities Climbed Again In December Housing Demand In First Tier Cities Climbed Again In December Housing Demand In First Tier Cities Climbed Again In December Chart 18A Rebound In Floor Space Started May Be Short lived A Rebound In Floor Space Started May Be Short lived A Rebound In Floor Space Started May Be Short lived Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1China’s secondary industry is mainly comprised of mining, manufacturing, the production and supply of electricity, gas and water, and construction. The tertiary industry refers to traffic, storage and mail businesses, information transfer, computer services and software, wholesale and retail trade, accommodation and food, finance, and other services. Cyclical Investment Stance Equity Sector Recommendations