Asia

Executive Summary Copper Demand Follows GDP Copper Demand Follows GDP Copper Demand Follows GDP European copper demand will increase on the back of still-accommodative monetary policy, coupled with a loosening of COVID-19-related gathering and mobility restrictions as the virus becomes endemic. Copper demand will be supported by the EU's need to diversify natural gas supplies in favor of increased LNG import capacity over the next 10 years, which will require incremental infrastructure investment. Increasing policy stimulus in China and government measures to increase lending to metals-intensive sectors – e.g., construction and grid infrastructure – will boost global copper demand. In the US, the Biden administration is backing a $550 billion bill to fund its renewable-energy buildout, which will result in higher demand for metals and steel over the next decade. Global copper supply growth will be restrained by local politics going forward, particularly in the Americas. Bottom Line: Copper prices have been grinding higher even as China maintains its zero-tolerance COVID-19 public health policy, and markets wait out the Russia-Ukraine standoff.  We are maintaining our forecast for COMEX copper to trade to $5.00/lb this year and $6.00/lb next year.  We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to miners and traders via the XME and PICK ETFs. Feature Ever since it hit its record high in May 2021, copper prices have been range-bound, despite tight market fundamentals and record low inventories in 3Q21, which, as it happens, have not significantly rebuilt since then (Chart 1, panel 1). This can be explained by weak global macro conditions since prices peaked, which have not been especially conducive to higher copper prices, particularly in Europe and China. Activity in these two markets accounting for ~ 60% and 11% of global refined copper demand, respectively, has had a stop-start aspect that has hindered full recovery to now. Chart 1Global Copper Inventories Remain Tight Global Copper Inventories Remain Tight Global Copper Inventories Remain Tight Chart 2Copper Demand Follows GDP Copper Demand Follows GDP Copper Demand Follows GDP As GDP in these regions rises, demand for copper will rise, as Chart 2 shows. Per our modelling, refined copper demand in China, the EU and the world are highly cointegrated with Nominal GDP estimates provided by the IMF. The coefficient associated with nominal GDP in all three instances is positive. Further, running Granger Causality tests indicate that past and present values of nominal GDP explain present refined copper demand values for all three entities. These results indicate that economic growth and refined copper demand have a positive long-run relationship. China’s zero-COVID tolerance policy and the property-market crisis there have restricted economic growth, activity and hence demand for the metal used heavily in construction and manufacturing. In Europe, lockdowns due to the Omicron variant restricted activity causing supply chain disruptions, which contributed to inflation. Now, Europe is relying on immunity among large shares of its population to keep economies open, as COVID-19 becomes endemic. Germany is loosening restrictions at a slower rate than its neighbors, as COVID still has not reached endemicity (Chart 3). Europe’s top manufacturer reportedly is expected to ease restrictions and increase economic activity by March-end. Chart 3New EU COVID-19 Cases Collapse Copper Will Grind Higher Copper Will Grind Higher Natural Gas Remains Critical To Europe Apart from COVID, elevated natural gas prices have and will continue to affect economic activity in Europe. These prices will only get more volatile as fears of a Russian invasion of Ukraine increase. In the short term, we do not expect Russia to cut off all gas supplies to the EU in case of an invasion.1 However, supplies going through Ukraine likely would be cut. Coupled with the region’s precariously low natgas inventory levels, this could fuel a gas price spike (Chart 4). Higher gas prices could lead to demand destruction, if, as occurred this winter, higher power-generating costs arising from higher natgas costs makes electricity too expensive to keep industrial processes like aluminum smelters up and running. In addition, another regional bidding war could incentivize more re-routing of LNG to Europe instead of Asia. This would reduce European prices, but could force Asian markets to raise their bids. Chart 4EU's Natgas Inventories Remain Critical Copper Will Grind Higher Copper Will Grind Higher Assuming gas prices do not remain significantly higher for the rest of the year, Europe will start seeing economic activity improve, and as our European Investment Strategy notes, PMIs will bottom out by the second quarter of this year. High immunity levels are allowing European nations to relax restrictions as it becomes apparent that COVID in the continent – at least in Western Europe – appears to be reaching endemicity. Importantly for base metals generally, and copper in particular, lower natgas prices will allow smelters and refining units to remain in service as electricity prices stabilize or even fall in the EU. During the pandemic, households – primarily in DM economies – built up significant levels of excess savings, particularly in Europe. The IMF reported that households in Europe have amassed nearly 1 trillion euros more in savings vs. normal levels over the last two years than if the pandemic had never occurred.2 While the entirety of excess savings will not be released as spending, even a portion of it will spur economic activity, once supply-chain issues are ironed out when the global economy reopens. China's Copper Demand Will Revive China’s property sector crisis last year was a major drag on economic growth. The Chinese government’s efforts to stabilize this sector seem to be paying off. China’s National Bureau of Statistics reported that for January housing prices in China’s first-tier cities reversed a month-on-month decline from December. The number of cities that saw home prices fall in January also was lower compared to December. Continued improvements in the property sector in China will be bullish for copper. Once macro hurdles related to COVID and high gas prices dissipate, and China’s property market stabilizes, economic activity will increase and copper demand will rebound (Chart 5). However, a timeline for this is difficult to handicap, given China's insistence – at least for now – on maintaining a zero-covid public-health policy. The zero-covid policy has resulted in sharply lower infection rates than the rest of the world, but, because it has not been accompanied by wide distribution of mRNA vaccines, immunity in the population is low. As global macro factors become conducive for copper, investors’ focus will switch to tight fundamentals in the copper market (Chart 6). Unlike the first half of 2021, copper’s high prices will be more sustained, given COVID’s current trajectory towards endemicity globally, and relatively higher immunity rates. Chart 5China's Demand Will Rebound Copper Will Grind Higher Copper Will Grind Higher Chart 6Coppers Tight Fundamentals Will Come Into Focus Again Coppers Tight Fundamentals Will Come Into Focus Again Coppers Tight Fundamentals Will Come Into Focus Again In addition, markets will have to factor in additional demand from the US that heretofore did not exist: The Biden administration is backing a $550 billion bill to fund renewable-energy development. More such funding can be expected in coming years as the US leans into decarbonization, and competes with the likes of the EU and China for limited base metals supplies. Supply Side Difficulties Mount Local governance is becoming increasingly critical to the supply side of base metals, no moreso than in the Americas – chiefly in Chile, Peru and, of late, the US., where the Biden administration recently shut down a Minnesota mining proposal in a major win for environmental groups.3 A number of these critical commodity-producing states in the Americas have elected – or are leaning toward – left-of-center candidates, some of whom are proposing fundamental changes in the laws and regulations governing resource extraction. Gabriel Boric, Chile’s new president, takes office in March. He has largely focused his campaign on the environment, human rights, and closer ties with other Latin American countries. Boric promotes a “turquoise” foreign policy, which includes “green” policies to combat climate change, and “blue” ones to protect oceans. He is likely to commit Chile, which accounts for ~ 30% of global copper mining, to participation in the Escazú Agreement, is being positioned to span the region.4 Of greatest import to the global metals and mining markets, Boric will push for a constitutional re-write affecting taxes on copper mining, decarbonization, Chile's water crisis and the nationalization of lithium mining. Chile's new constitution is expected to be put up for a vote by the end of 2022. In Peru, which accounts for ~ 10% of global copper output, President Pedro Castillo announced at the UN General Assembly that Peru would declare a "climate emergency," and promised to reach net-zero in Peru by 2050. Civil unrest in Peru directed at mining operations is becoming more widespread, as citizens become increasingly frustrated with pollution and poverty.5 Colombia is not a major metals producer, but it is a resource-based economy leaning left. In May it will hold its general elections to Congress and Presidency. The future president will have pressure on the ratification of the Escazú Agreement, fight against illegal mining, and work on the Amazon deforestation. Presently, a left-of-center candidate, Gustavo Petro, leads the polling, according to the latest December survey by the National Consulting Center.6 Petro is promising to stop approving oil exploration contracts to restructure Colombia's economy away from hydrocarbons, and plans to accelerate the transition towards renewable energy.7 In addition, Petro is trying to gather ideological allies across Latin America and the world to fight against climate change. He hopes Chile’s president-elect Gabriel Boric will be joining this alliance.8 Caution: Downside Risks Remain Apart from the Russia-Ukraine crisis discussed above, there are more headwinds to the bullish copper view. China’s zero-covid policy will lead to reduced activity in the world’s largest producer and consumer of refined copper. This will disrupt global supply chains and, along with high energy prices, spur global inflation, prolonging slow economic growth and activity. Central bank tightening globally – led by the Federal Reserve – will increase borrowing costs, reduce manufacturing, and act as a downside risk to copper, particularly if the Fed miscalculates and lifts rates too high too soon and sparks a USD rally. Finally, while DM economies have high vaccination rates, EM states do not have the same level of immunity (Chart 7). Europe exhibits this dichotomy in immunization rates between advanced and developing countries well. While most of Western Europe appears to be nearing endemicity and reopening, Omicron is spreading quickly into Eastern Europe, where immunity is low. As long as a majority of the global population is not vaccinated, COVID-19 mutations into more virulent and transmissive variants remain a major risk. Chart 7COVID-19 Remains A Risk Copper Will Grind Higher Copper Will Grind Higher Investment Implications Copper prices have been grinding higher even as China maintains its zero-tolerance COVID-19 public-health policy, and markets wait out the Russia-Ukraine standoff (Chart 8). As large economies continue to emerge from COVID-19-related disruptions demand for base metals can be expected to increase, particularly for copper. We are maintaining our forecast for COMEX copper to trade to $5.00/lb this year and $6.00/lb next year. We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to miners and traders via the XME and PICK ETFs. Chart 8Copper Continues To Grid Higher Copper Continues To Grid Higher Copper Continues To Grid Higher   Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish The US will expand its leading position as the EU-27's and UK's top liquified natural gas (LNG) supplier this year, in our view, although Qatar will provide stiff competition (Chart 9). In January, the EIA reported half of the Europe's LNG originated in the US. For all of 2021, 26% of Europe's LNG came from the US, while 24% came from Qatar and 20% came from Russia. We expect the Russia-Ukraine military standoff, which has the potential to become a kinetic engagement, will prompt Europe to diversify its natural gas supplies away from Russia to reduce its exposure to military and geopolitical pressure on its energy supplies. This also would apply, in our estimation, to pipeline supplies of natural gas from Russia, which shipped 10.7 Bcf/d to Europe in 2021 (vs. 11.8 Bcf and 14.8 Bcf/d in 2020 and 2019, respectively. Norway supplied 10.4 Bcf/d in 2019 and 2020, rising to 11.1 Bcf/d in 2021. We also would expect additional North Sea supplies to be developed to supply Europe in the wake of the current Russia-Ukraine tensions. Base Metals: Bullish Russia’s recognition of the two breakaway states of Donetsk and Luhansk People’s Republics (DPR and LPR), elicited US sanctions targeting Russian sovereign debt and its banking sector. The possibility of sanctions on Russian nickel and aluminum exports sent both metals to multi-year highs in LME trading. Russia constitutes around 6% and 9% of global primary aluminum and nickel ore supply, respectively. Precariously low inventory levels for both nickel and aluminum are inducing high price volatility. Year-over-year, global January LME aluminum and nickel stocks are 45% and 64% lower respectively. Precious Metals: Bullish Geopolitical uncertainty due to the Russia-Ukraine crisis and Western sanctions levied on Russia has pushed gold prices to levels not seen since its last bull run last year. While gold has risen, Bitcoin – once considered to be a safe-haven asset – has fallen on this uncertainty. Over the last two years, Bitcoin has been moving more in tandem with equity markets than with other safe-haven assets, as cryptocurrency has become more popular and central banks began large asset purchase programs in response to the pandemic (Chart 10). From beginning 2018 to end-2019 the coefficient measuring daily Bitcoin prices’ correlation with the S&P 500 index was ~0.31. From beginning 2020 to present day, this value has increased to ~ 0.86. Chart 9 Copper Will Grind Higher Copper Will Grind Higher Chart 10 Bitcoin Price Aligns With Gold Price And S&P 500 INDEX Bitcoin Price Aligns With Gold Price And S&P 500 INDEX     Footnotes 1     Please see our report from February 3, 2022 entitled Long-Term EU Gas Volatility Will Increase.  It is available as ces.bcaresearch.com. 2     Please see Europe’s Consumers are Sitting on 1 Trillion Euros in Pandemic Savings published by the International Monetary Fund on February 10, 2022. 3    Please see our report from on November 25, 2021 entitled Add Local Politics To Copper Supply Risks, and Biden administration kills Antofagasta's Minnesota copper project published by reuters.com on January 26, 2022. 4    Please see Chile Turns Left: The Foreign Policy Agenda of President Gabriel Boric, published by Australian Institute of Mining Affairs on January 28, 2022. 5    Please see China's MMG faces Peru whack-a-mole as mining protests splinter, published by reuters.com on February 16, 2022. 6    Please see Six Challenges Facing Colombia in 2022, published by Global Americas on January 6, 2022. 7     Please see Gustavo Petro, who leads polls in Colombia, seeks to create an anti-oil front published by Bloomberg on January 14, 2022. 8    Please see Colombia Presidential Favorite Gustavo Petro Wants to Form a Global Anti-Oil Bloc, published by Time on January 14, 2022. Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image

Executive Summary The Excess Return Of Corporate Bonds Is Driven By Corporate Profits The Excess Return Of Corporate Bonds Is Driven By Corporate Profits The Excess Return Of Corporate Bonds Is Driven By Corporate Profits Given that a sustainable business cycle acceleration in China is unlikely in the short term, onshore government bond yields will likely drop further. In the long run, odds are that Chinese government bond yields will drop below US Treasury yields. For domestic asset allocators, we continue to recommend overweighting government bonds over stocks for now. The excess return of corporate bonds is driven by the corporate profit cycle. On a volatility-adjusted basis, the total return on equities exceeds the excess return on corporate bonds during periods when economic growth is accelerating and underperforms during deceleration phases. Bottom Line: Given our view that a meaningful growth recovery in China will only be a theme for the second half of this year, onshore asset allocators should continue favoring corporate credit over stocks and government bonds over corporate bonds. The bear market in Chinese offshore corporate credit might be in its late stages but it is not yet over. Feature In this report we (1) elaborate on our outlook for Chinese government and corporate bonds and (2) offer a framework for understanding how asset allocation for fixed-income (government and corporate bonds) and multi-asset portfolios (comprised of fixed-income plus equities) should be implemented. Domestic Government Bonds Chart 1Chinese Bond Yields Have Bucked The Global Trend Chinese Bond Yields Have Bucked The Global Trend Chinese Bond Yields Have Bucked The Global Trend The risk-reward profile of Chinese domestic government bonds remains attractive. Chinese government bond yields have been declining,  bucking the global trend of surging government bond yields (Chart 1, top panel). Odds are that Chinese bond yields will drop further, both cyclically and structurally: In contrast with the Americas and Europe, China’s consumer price inflation has remained subdued. Its core, trimmed mean and headline inflation rates have remained low (Chart 2). The ongoing growth slump will cap core inflation in China at around 1%, allowing monetary authorities to lower interest rates further. Real bond yields in China remain well above those in the majority of DM (Chart 1, bottom panel). Hence, risk-free bonds in China offer value. As to the Chinese stimulus and business cycle, the recent pickup in Chinese credit numbers has been entirely due to local government bond issuance. After excluding local government bonds, credit growth and its impulse have not improved (Chart 3). While infrastructure spending will pick up in the coming months (given large special bond issuance), sentiment among consumers and private companies remains downbeat and local government budgets are severely impaired by the collapse in revenues from land sales. Hence, it will take some time before a boost in infrastructure activity lifts broader business and consumer sentiment such that a sustainable economic recovery can take hold. Chart 2Chinese Consumer Price Inflation Is Subdued Chinese Consumer Price Inflation Is Subdued Chinese Consumer Price Inflation Is Subdued Chart 3Recent Credit Improvement Is Entirely Due to Local Government Bond Issuance Recent Credit Improvement Is EntirelyDue to Local Government Bond Issuance Recent Credit Improvement Is EntirelyDue to Local Government Bond Issuance The special bond quota for Q1 stands at RMB 1.46 trillion and is equivalent to 28% of local government aggregate quarterly revenue. Even though the special bond issuance in Q1 is massive, it will be largely offset by the drop in local governments’ land sales revenue. The latter is shrinking and makes up more than 40% of local government aggregate revenues. In brief, strong headwinds from the property market in the form of shrinking land sales might counteract the increase from front-loaded special bond issuance in Q1 2022. As to real estate construction, funding for property developers is down dramatically from a year ago (Chart 4). In the absence of financing, real estate developers will shrink construction volumes in the months ahead. Chart 5Debt Service Burden For Chinese Enterprises And Households Is High Debt Service Burden For Chinese Enterprises And Household Is High Debt Service Burden For Chinese Enterprises And Household Is High Chart 4Property Completions Will Roll Over Property Completions Will Roll Over Property Completions Will Roll Over   Structurally, high enterprise and household debt levels in China amid slumping incomes mean that borrowing costs should drop to facilitate debt servicing. BIS estimates that debt service costs for the private sector (enterprises and households) in China are 21% of disposable income, much higher than in many other economies (Chart 5). Finally, China’s large and persistent current account surpluses mean that the nation is a major international creditor rather than a debtor. Thus, China does not need to offer high yields to attract foreign capital. Structurally speaking, foreign fixed-income inflows into Chinese domestic bonds will likely continue. Chart 6Credit Cycle And Government Bond Yields Credit Cycle And Government Bond Yields Credit Cycle And Government Bond Yields Bottom Line: Bond yields will likely drop further as a sustainable business cycle acceleration in China is unlikely in the short term. Chart 6 illustrates that the total social financing impulse leads bond yields by nine months and a cyclical bottom in yields will probably occur a few months from now. In the long run, Chinese government bonds yields will likely drop below US Treasury yields. Onshore Corporate Bonds The proper measure of corporate bond performance is excess return over similar government bonds (herein excess return). The basis for using excess return instead of total return for corporate bonds is because investors can attain government bond return by purchasing them outright. Essentially, investors prefer corporate bonds over government bonds because of credit spreads. Hence, a corporate bond performance assessment – whether in absolute terms or relative to other asset classes – should be based on excess return. In China, the excess return on onshore corporate bonds1 usually moves in tandem with the business cycle and government bond yields. In particular: The excess return of corporate bonds is positive during periods of growth acceleration and negative during slowdowns (Chart 7, top panel). The middle panel of Chart 7 illustrates that the excess return of corporate bonds correlates with analysts’ net EPS revisions for onshore listed companies. This confirms the above point that corporate bonds correlate with the profit/business cycle. Significantly, even though industrial profit growth is not yet negative (Chart 8, top panel), earnings in commodity-user industries have crashed (Chart 8, bottom panel).  This explains the negative excess return for onshore corporate bonds in the past 12 months. Chart 7The Excess Return Of Corporate Bonds Is Driven By Corporate Profits The Excess Return Of Corporate Bonds Is Driven By Corporate Profits The Excess Return Of Corporate Bonds Is Driven By Corporate Profits Chart 8Corporate Profit Cycle: Mind The Divergence Corporate Profit Cycle: Mind The Divergency Corporate Profit Cycle: Mind The Divergency Furthermore, the excess return of corporate bonds declines and rises with interest rate expectations (Chart 7, bottom panel). As the outlook for corporate profits remains sour, fixed-income investors should continue to favor government bonds over corporate bonds. Now, how do corporate bonds perform versus stocks? What drives their relative performance? To compare stock performance to corporate bond excess return, one should adjust for volatility. In other words, share prices are much more volatile than the excess return on corporate bonds. Hence, during risk-on periods equities always outperform corporate bonds and vice versa. Chart 9The Performance of Stocks over Corporate Bonds is Very Pro-Cyclical The Performance of Stocks over Corporate Bonds is Very Pro-Cyclical The Performance of Stocks over Corporate Bonds is Very Pro-Cyclical Chart 9 demonstrates that even on a volatility-adjusted basis, the total return on equities exceeds the excess return on corporate bonds during periods when economic growth is accelerating and underperforms during deceleration phases. In short, the performance of stocks over corporate bonds is very pro-cyclical. Bottom Line: The excess return of corporate bonds is driven by corporate revenue and profits rather than by interest rate expectations. Getting China’s business cycle right is critical to the allocation between government and corporate bonds in fixed-income portfolios and to the allocation between corporate bonds and equities in multi-asset portfolios. Given our view that a meaningful growth recovery in China will only be a theme in the second half of this year, onshore asset allocators should continue favoring corporate bonds over stocks and government bonds over corporate credit. Offshore Corporate Bonds What drives the excess return of Chinese USD corporate bonds in absolute terms as well as versus Chinese non-TMT investable stocks2 and onshore corporate bonds? Given that the offshore corporate bond universe is dominated by property developers, their excess return correlates with perceived risks to the mainland property market in general and the financial health of property developers in particular (Chart 10, top panel). Property developers are very overleveraged, their sales are shrinking and their financing has dried up. Yet, authorities are compelling them to complete construction of their pre-sold housing. Property developers will therefore continue to experience financial distress. Odds are that bond prices of corporate developers – both investment grade and high yield - will continue falling (Chart 10, middle and bottom panels). Chart 11Investable Stocks Vs. Offshore Corporate Credit: Volatility-Adjusted Performance Investable Stocks Vs. Offshore Coporate Credit: Volatility-Adjusted Performance Investable Stocks Vs. Offshore Coporate Credit: Volatility-Adjusted Performance Chart 10A Massive Bear Market In Offshore Corporate Bonds A Massive Bear Market In Offshore Corporate Bonds A Massive Bear Market In Offshore Corporate Bonds On a volatility-adjusted basis, non-TMT investable stocks outpace the excess return of offshore corporate bonds during periods of growth improvement and underperform during growth slowdowns (Chart 11, top panel). The same pattern holds true when it comes to the performance of offshore corporate bond versus the aggregate MSCI Investable equity index (including TMT stocks) (Chart 11, bottom panel). The credit cycle leads the business cycle and, thereby, it leads these financial market trends. Bottom Line: The bear market in Chinese offshore corporate credit might be in its late stages but it is not yet over. Chinese offshore corporate bonds will continue underperforming EM corporate bonds as well as Chinese onshore corporate bonds. Investment Recommendations Investors often read market signals across asset classes to gauge which market moves will persist and which ones will be short-lived.  In this regard, we have two observations for Chinese onshore markets: Chart 12Moving In Tandem Moving In Tandem Moving In Tandem The sustainability of an equity rally is higher when it is confirmed by rising excess returns of corporate bonds and rising government bond yields (Chart 12). Presently, there is no strong signal to switch from government bonds to either corporate bonds or stocks. Unfortunately, the yield curve in China does not correlate with its business cycle and, hence, cannot be used as a tool in macro analysis.  Our key investment conclusions are: For fixed-income investors, we continue to recommend receiving 10-year swap rates in China and for dedicated EM local currency bond managers to remain overweight China. The renminbi has been firm versus the US dollar despite a considerable narrowing in the interest rate differential between China and the US. In the long run, the real interest rate differential between China and the US will drive the exchange rate, and it will favor the RMB. While US real bond yields might rise relative to Chinese bond yields in the coming months, triggering a period of yuan softness, it will prove to be transitory. The basis is that the Federal Reserve is very sensitive to asset prices. As US share prices decline and corporate spreads widen, the central bank will eventually turn dovish and will lag behind the inflation curve. When a central bank falls behind the inflation curve, real rates stay low and its currency depreciates. Chart 13China’s Stock-to-Bond Ratio China"s Stock-to-Bond Ratio China"s Stock-to-Bond Ratio For domestic asset allocators, we continue to recommend favoring government bonds over stocks (Chart 13). Within fixed-income portfolios, investors should overweight government bonds over corporate bonds. Finally, corporate bonds will fare better than equities in the near term. In a few months there will be an opportunity to shift these positions.  More aggressive stimulus from authorities and aggressive property market relaxation measures will create conditions for an improvement in domestic demand. Finally, the risk-reward profile for offshore USD corporate bonds remains unattractive. Chinese offshore corporate credit will continue underperforming EM USD corporate credit as well as Chinese onshore corporate bonds.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1    Due to the lack of excess return data from the index provider (Bloomberg Barclays onshore bond indexes), we calculated the excess return on onshore corporate bonds as the ratio of the total return on the corporate bond index divided by the total return on the government bond index. This measure is not ideal as it does not account for duration mismatches between the corporate and government bond indexes. However, the key conclusions of this report will hold true for the duration-adjusted excess return not least because this framework is valid for financial markets in the US and Europe. 2    The reason to compare it to non-TMT (technology, media and telecommunication, i.e., Chinese tech and internet stocks) is that offshore corporate bond issuers are largely old economy industries.

We are booking profits on our short Baht/ long U.S. dollar trade instituted on March 25, 2021. The position has generated a 1.6% profit, including carry. We recommended to short the baht against the US dollar a year ago due to a shortfall in Thai tourism revenues. The baht was also too expensive in real terms given the macro-outlook back then. The currency has since weakened vis-à-vis the US dollar and is no longer expensive. In addition, Thai firms have been receiving a sizeable amount of foreign trade credit in recent months, which indicates higher exports in the medium term. The recent announcement of Thai authorities, following a remission in Omicron cases, to allow vaccinated international travelers from all countries to enter without quarantine measures has raised the probability of a considerable revival in tourism revenues. This is also positive for the currency. As such, the risk-reward benefit for staying short the baht is no longer there.     Bottom Line: Take profit on the short THB / long USD trade. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com

Executive Summary Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth The conditions for a major rally/outperformance in Malaysian equities are absent. Profits have been the primary driver of Malaysian equity prices historically, and the corporate earnings outlook is mediocre. Domestic demand is facing headwinds from tightening fiscal policy as well as from impaired credit channels.  Muted wage growth and deflating house prices are sapping consumer confidence. This will dent domestic demand going forward. This backdrop is bullish for bonds. Malaysian bonds offer value, as real bond yields are among the highest in Emerging Asia. The yield curve is far too steep given the growth and inflation outlook.  The Malaysian ringgit is cheap and has limited downside. Bottom Line: We recommend equity investors implement a neutral stance toward Malaysia in overall EM and Emerging Asian equity portfolios. Absolute return investors should avoid this bourse for now. Fixed-income investors, on the other hand, should stay overweight Malaysia in both EM domestic (local currency) and sovereign credit portfolios. In the rate markets, investors should continue receiving 10-year swap rates or bet on yield curve flattening. Feature Chart 1Malaysian Equity Underperformance May Be Late, But It’s Not Yet Time To Overweight Malaysian Equity Underperformance May Be Late, But It's Not Yet Time To Overweight Malaysian Equity Underperformance May Be Late, But It's Not Yet Time To Overweight Malaysian stocks are still in search of a stable bottom in absolute terms. Relative to their EM and Emerging Asian counterparts however, a bottom has been forming over the past year (Chart 1). So, could Malaysia’s prolonged underperformance be coming to an end?  Our analysis suggests caution. The underlying reasons behind this market’s substantial and protracted underperformance – dwindling earnings both in absolute terms and relative to its peers – are yet to show any signs of a reversal.  While cheap, the ringgit is also negatively impacted by the meager corporate profits generated by Malaysian firms. Investors would do well to stay neutral on this bourse for now in EM and Emerging Asian equity portfolios. Fixed income investors, however, should continue to stay overweight Malaysia in both EM domestic (local currency) and sovereign credit portfolios. Also, Malaysia’s yield curve is too steep and offers value given the sluggish cyclical growth outlook. It’s All About Profits Chart 2 shows that the bull and bear markets in Malaysian stocks have been all about the rise and fall in earnings per share (EPS). Stock multiples, the other possible driver of the equity prices, have been remarkably flat over the past two decades, with only brief periods of fluctuations around the GFC and COVID-19 pandemic. The same can be said about Malaysia’s relative performance vis-à-vis EM and Emerging Asian stocks. The trajectory of the relative stock performance was set by the relative earnings (Chart 3). Chart 3Malaysia’s Relative Performance Is Also Dictated By Relative Corporate Profits Malaysia's Relative Performance Is Also Dictated By Relative Corporate Profits Malaysia's Relative Performance Is Also Dictated By Relative Corporate Profits Chart 2Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth Thus, it is reasonable to expect that for this bourse to usher in a new bull market in absolute terms, Malaysian firms need to grow their earnings sustainably. And in order to outperform the rest of the EM stocks, Malaysian earnings need to grow at a faster clip than their peers. The question therefore is, are there signs of profit recovery in Malaysian companies in absolute and relative terms? The short answer is no. Bottom-up analysts do not expect any change in the downward trend in Malaysia’s relative profits over the coming 12 months. This outlook is corroborated by our macro analysis, as is outlined below. Sluggish Growth  Malaysian profits are languishing in large part because of subdued topline growth. While profit margins are returning to pre-pandemic levels – thanks to cost cutting – subdued sales are causing the corporate profits to stay low. Chart 4Malaysian Domestic Demand Is Subdued Malaysian Domestic Demand Is Subdued Malaysian Domestic Demand Is Subdued Malaysian gross output as of Q4 last year was barely at pre-pandemic levels. The weak recovery is most evident in the dismal level of capital investments. Gross fixed capital formations – in both real and nominal terms – are still a good 15% below their pre-pandemic levels (Chart 4, top two panels). Apathy among businesses in ramping up productive capacity indicates a lack of confidence in consumer demand going forward. Consumption is indeed weak: Unit sales for passenger vehicles continue to be sluggish, and commercial vehicle sales are not faring any better. Consumer sentiment has ticked down in the latest survey indicating retail sales might decelerate (Chart 4, bottom two panels) Consistently, industrial production in consumer goods-related industries is struggling to surpass previous highs, even though strong export demand has provided a fillip to sales. In more domestic-oriented industries such as construction goods, the weakness is palpable (Chart 5). Meanwhile, unemployment rates have fallen marginally, but are still higher than they were before the pandemic. As a result, wages remain subdued. The resulting weak household income is contributing to depressed consumption. With mediocre household income growth, demand for houses has also slowed meaningfully. This is reflected in dwindling property unit sales. The advent of the pandemic and the resulting loss of household income have further aggravated the situation. In fact, prices of certain types of dwelling units, such as semi-detached houses and high-rise apartments, are deflating outright (Chart 6, top panel). Falling house prices weigh on consumer sentiment and discourage future consumption. Chart 6Contracting House Prices Is Hurting Real Estate Sector And Denting Consumer Confidence Contracting House Prices Is Hurting Real Estate Sector And Denting Consumer Confidence Contracting House Prices Is Hurting Real Estate Sector And Denting Consumer Confidence Chart 5Weak Domestic Demand Is A Headwind To Industrial Production Weak Domestic Demand Is A Headwind To Industrial Production Weak Domestic Demand Is A Headwind To Industrial Production What’s more, the housing sector does not expect an early recovery in sales and prices either. This is evident in the very depressed level of new construction starts (Chart 6, bottom panel). As such, this sector is likely to remain a drag on Malaysia’s post-pandemic recovery. Fiscal And Credit Headwinds Going forward, the recovery will face other headwinds worth noting. One of them is a restrictive fiscal policy. This is because the “statutory debt” ceiling of the government – at 60% of GDP – has already been reached (Chart 7, top panel). This ceiling for statutory debts was fixed by lawmakers as part of a stimulus bill (COVID-19 Act) passed in 2020; and leaves little room for additional fiscal stimulus. Indeed, the IMF estimates that the ‘fiscal thrust’ this year will be negative at 2% of GDP (Chart 7, bottom panel). The country’s credit channel is also compromised. The reason is that Malaysian banks are still saddled with unresolved NPLs. These NPLs are a legacy of a very rapid expansion of bank loans following the GFC. In just five years (2009 -2014), bank credit doubled in nominal terms to 1500 billion ringgit or from 95% of GDP to 125% (Chart 8, top panel). Such fast deployment of credit was bound to cause significant misallocation of capital. And yet banks were averse to recognize impaired loans in any good measure. In fact, during the years of rapid credit growth, banks were recognizing ever fewer amounts in absolute terms as impaired loans. They were also setting aside ever lower amounts as loan loss provisions (Chart 8, second panel). Chart 7Fiscal Policy Will Stay Constrained As Statutory Debt Has Hit The Ceiling Fiscal Policy Will Stay Constrained As Statutory Debt Has Hit The Ceiling Fiscal Policy Will Stay Constrained As Statutory Debt Has Hit The Ceiling Chart 8Both Demand And Supply Of Bank Credit In Malaysia Remains Compromised Both Demand And Supply Of Bank Credit In Malaysia Remains Compromised Both Demand And Supply Of Bank Credit In Malaysia Remains Compromised While bad debt recognition and provisions have risen modestly over the past year, Malaysia’s reported NPL ratio remained under 1.5% of loans (Chart 8, third panel). Loan loss provisions have been equally meager. This indicates that banks’ balance sheets are far from clean. In reality, Malaysian borrowers never went through any deleveraging process following their last credit binge. The bank credit-to-GDP ratio remains at around the same level as it was in 2015 (125% of GDP). By comparison, during Malaysia’s previous deleveraging phase, bank credit was shed from 150% of GDP to 90% (1998 - 2008). Borrowers already saddled with large amounts of debt are much less likely to borrow more to invest and/or consume. This is therefore going to cap credit demand. Chart 9Banks Are Piling Up On Government Securities By Shunning Loans Banks Are Piling Up On Government Securities By Shunning Loans Banks Are Piling Up On Government Securities By Shunning Loans As for banks, an increase in impaired loans makes them reticent to engage in further lending. Instead, they seek to accumulate safer assets such as government bonds. In fact, this is what Malaysian banks have been doing. They have ramped up their holdings of government securities materially since 2015 at the expense of loans and advances (Chart 9, top panel).   After the pandemic-related slowdown in the economy, banks’ loan books are now probably more encumbered with impaired loans.  As such, banks are even less likely to ramp up their loan books in any major way. That will be yet another headwind to economic recovery (Chart 9, bottom panel).    Value In Fixed Income The headwinds to growth do not entail a bullish outlook for Malaysian equities. The outlook for Malaysian local currency bonds, however, is promising. A tightening fiscal policy amid weak domestic demand and subdued inflation is a bullish cocktail for domestic bonds. There is a good chance that Malaysian bond yields will roll over. At a minimum, they will rise less than most other EM countries or US Treasuries. Notably, Malaysia offers one of the highest real yields (nominal yield adjusted for core inflation) in Emerging Asia (Chart 10, top panel). Given the country’s mediocre growth outlook, odds are high that Malaysian local bonds will outperform their EM / Emerging Asian peers (Chart 10, bottom panel). Chart 10Malaysian Bonds Offer One Of The Best Values In Emerging Aisa Malaysian Bonds Offer One Of The Best Values In Emerging Asia Malaysian Bonds Offer One Of The Best Values In Emerging Asia Chart 11Steep Yield Curve Indicate Value In Bond Space; But Spell Trouble For Bank Stocks Steep Yield Curve Indicate Value In Bond Space; But Spell Trouble For Bank Stocks Steep Yield Curve Indicate Value In Bond Space; But Spell Trouble For Bank Stocks The Malaysian swap curve is also far too steep given the country’s macro backdrop. Going forward, the 10-year/1-year swap curve is set to flatten from its decade-steep level of 130 basis points (Chart 11, top panel). That means investors should continue receiving 10-year swap rates. On a related note, a fall in bond yields will not augur well for Malaysian stocks in general, and bank stocks in particular. The middle panel of Chart 11 shows that bank stocks struggle in absolute terms whenever bond yields decline. Incidentally, at 38% of total, banks are by far the largest sector in the MSCI Malaysia Index. And in recent months bank stocks have been propelling the Malaysian market (Chart 11, bottom panel). Should the bourse begin to miss the tailwind from rising bond yields, Malaysian equity performance will be hobbled.    Finally, investors should stay overweight in Malaysian sovereign credit. The country’s orthodox fiscal policy has accorded a defensive nature to this market. As such, periods of global risk-off witness Malaysian sovereign spreads fall relative to their EM counterparts, as they did in 2015 and again in 2020. In the months ahead, rising US inflation and a slowdown in Chinese property markets could cause another such period. That will lead Malaysian sovereign US dollar bonds to continue outperforming their EM peers. What’s With The Ringgit? Chart 12Malaysia Has Not Been Able To Benefit From A Cheap Currency Malaysia Has Not Been Able To Benefit From A Cheap Currency Malaysia Has Not Been Able To Benefit From A Cheap Currency The Malaysian currency is cheap, both in nominal and real terms (Chart 12, top panel). As such, it will likely be one of the most resilient currencies in EM this year. That said, the ringgit has been cheap for a while now (since 2015), and yet the Malaysian economy does not seem to have benefitted much all these years. The inability to take advantage of a cheap currency points to a fundamental malaise in the Malaysian economy: Loss of manufacturing competitiveness, as explained in our previous report on Malaysia. Perhaps equally worryingly, the country has not been able to attract much in the way of capital inflows. What this implies is that global investors did not find Malaysian assets attractive enough despite the benefits of a significantly cheaper currency (Chart 12, bottom panel). A major reason investors have not found the country attractive is because the return on capital on Malaysian assets has continued to deteriorate relative to the rest of the world. The upshot of the above is that, should Malaysian firms be able to improve their profits going forward, Malaysian stocks’ relative performance would get a boost from both higher relative earnings and a stronger currency. However, given the sluggish business cycle outlook as explained above, a sustainable rally in Malaysian stocks or currency is not imminent. Investment Conclusions Chart 13Malaysian Relative Stock Valuations Are On The Cheaper Side Malaysian Relative Stock Valuations Are On The Cheaper Side Malaysian Relative Stock Valuations Are On The Cheaper Side Equities: Malaysian stocks have cheapened. Both in terms of P/E ratio and P/book ratio, they are at the lower end of the spectrum relative to their EM counterparts (Chart 13). Yet, given the mediocre growth outlook, we recommend that dedicated EM and Emerging Asian equity portfolios stay neutral on this market for now. Absolute return investors should stay on the sidelines in view of the worsening risk outlook in global markets, and wait for a better entry point later in the year. For local asset allocators in Malaysia, it is too early to overweight stocks relative to bonds over a cyclical horizon. Even though the equity risk premium in general has been much higher since the advent of the pandemic, stocks have struggled to outperform bonds in a total return basis over the past two years. That will likely be the case for several more months given the country’s growth outlook and rising global risks. Fixed Income: Malaysian domestic bonds will outperform their overall EM / Emerging Asian peers. So will Malaysian sovereign credit. Fixed income investors should overweight them in their respective EM / Emerging Asian portfolios. In the rate markets, investors should continue receiving 10-year swap rates. Finally, Malaysian yield curves are set to flatten. Investors should position for a narrowing of the 10-year/1-year yield curve, which is at a decade-high level of 180 basis points. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com

Executive Summary China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 The pace of credit creation in January increased sharply over December. However, the jump was less than meets the eye compared with previous easing cycles and adjusted for seasonality. Our calculation suggests that a minimum of approximately RMB35 trillion of new credit, or a credit impulse that accounts for 29% of this year's nominal GDP, will be needed to stabilize the economy. January’s credit expansion falls short of the RMB35 trillion mark on a six-month annualized rate of change basis. Our model will provide a framework for investors to gauge whether the month-over-month credit expansion data is on track to meet our estimate of the required stimulus. Despite an improvement in January's credit growth from December, it is premature to update Chinese stocks (on- and off-shore) to overweight relative to global equities. Bottom Line: Approximately RMB35 trillion in newly increased credit this year will probably be needed to revive China’s domestic demand.  Any stimulus short of this goal would mean that investors should not increase their cyclical asset allocation of Chinese stocks in a global portfolio. Feature January’s credit data for China exceeded the market consensus. The aggregate total social financing (TSF) more than doubled in the first month of 2022 from December last year. However, on a year-over-year basis, the increase in January’s TSF was smaller than in previous easing cycles, such as in 2013, 2016 and 2019. Furthermore, underlying data in the TSF reflects a prolonged weak demand for bank loans from both the corporate and household sectors. While January’s uptick in credit expansion makes us slightly more optimistic about China’s policy support, economic recovery and equity performance in the next 6 to 12 months, we are not yet ready to upgrade our view. An estimated RMB35 trillion in newly increased credit this year will likely be necessary to revive flagging domestic demand. In the absence of seasonally adjusted TSF data in China, our framework will help investors determine whether incoming stimulus is on course to meet this objective. Interpreting January’s Credit Numbers Chart 1A Sharp Increase In Credit Creation In January A Sharp Increase In Credit Creation In January A Sharp Increase In Credit Creation In January January’s credit creation beat the market consensus to reach RMB6.17 trillion, pushed up by a seasonal boost and a frontloading of government bond issuance (Chart 1). However, the composition of the TSF data reflects an extended weakness in business and consumer credit demand. On the plus side, net government bond financing, including local government special purpose bonds, rose to RMB603 billion last month, more than twice the amount from January 2021 (Chart 1, bottom panel). Corporate bond issuance also picked up, reflecting cheaper market rates and more accommodative liquidity conditions (Chart 2). Furthermore, shadow credit (including trust loans, entrust loans and bank acceptance bills) also ticked up in January compared with a year ago. The increase in informal lending sends a tentative signal that policymakers may be willing to ease the regulatory pressure on shadow bank activities (Chart 3). Chart 2Corporate Financing Through Bond Issuance Also Increased Corporate Financing Through Bond Issuance Also Increased Corporate Financing Through Bond Issuance Also Increased Chart 3Shadow Banking Activity Ticked Up For The First Time In A Year Shadow Banking Activity Ticked Up For The First Time In A Year Shadow Banking Activity Ticked Up For The First Time In A Year Meanwhile, several factors suggest that the surge in January’s credit expansion may be less than what it appears to be at first glance. First, credit growth is always abnormally strong in January. Banks typically increase lending at the beginning of a year, seeking to expand their assets rapidly before administrative credit quotas kick in. In recent years loans made during the first month of a year accounted for about 17% - 20% of total bank credit generated for an entire year. Secondly, the credit flow in January, although higher than in January 2021, was weaker than in the first month of previous easing cycles. Credit impulse – measured by the 12-month change in TSF as a percentage of nominal GDP – only inched up by 0.6 percentage points of GDP in January this year from December, much weaker than that during the first month in previous easing cycles (Chart 4). TSF increased by RMB980 billion from January 2021, lower than the RMB1.5 trillion year-on-year jump in 2019 and the RMB1.4 trillion boost in 2016 (Chart 4, bottom panel). Chart 4The Magnitude Of Increase In January’s Credit Impulse Less Than Meets The Eye Takeaways From January’s Credit Data Takeaways From January’s Credit Data Chart 5Corporate Demand For Bank Credit Remains Soft Corporate Demand For Bank Credit Remains Soft Corporate Demand For Bank Credit Remains Soft Furthermore, China’s households and private businesses have significantly lagged in their responses to recent policy easing measures and their demand for credit remained soft in January (Chart 5). Bank credit in both short and longer terms to households were lower than a year earlier due to downbeat consumer sentiment (Chart 6A and 6B). Chart 6AConsumption Was Unseasonably Weak During Chinese New Year Consumption Was Unseasonably Weak During Chinese New Year Consumption Was Unseasonably Weak During Chinese New Year Chart 6BHouseholds' Propensity To Consume Continues Trending Down Households' Propensity To Consume Continues Trending Down Households' Propensity To Consume Continues Trending Down How Much Stimulus Is Necessary? Our calculation suggests that China will probably need to create approximately RMB35 trillion in new credit, or 29% of GDP in credit impulse, over the course of this year to avoid a contraction in corporate earnings. In our previous reports, we argued that the state of the economy today is in a slightly better shape than the deep deflationary period in 2014/15, but the magnitude of the property market contraction is comparable to that seven years ago. Chart 7 illustrates our approach, which uses a model of Chinese investable earnings growth. The model is designed to predict the likelihood of a serious contraction in investable earnings in the coming 12 months. It includes variables on credit, manufacturing new orders and forward earnings momentum. The chart shows that the flow of TSF as a share of GDP needs to reach a minimum of 28.5% in order that the probability of a major earnings contraction falls below 50%. The size of the credit impulse necessary is 2 percentage points higher than that achieved last year, but still lower than the scope of the stimulus rolled out in 2016. Assuming an 8% growth rate in nominal GDP in 2022, the credit flow that should to be originated this year would be about RMB35 trillion, as illustrated in Chart 8. The chart also shows that this amount would exceed a previous high in credit flow reached in late-2020. Chart 7China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession Chart 8China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 China Needs To Create RMB35 Trillion In Credit In 2022 Based on a 3-month annualized rate of change, January’s credit growth appears that it will achieve the RMB35 trillion mark. However, the jump in TSF largely reflects a one-month leap in frontloaded local government bond issuance and it is not certain if private credit will accelerate in the months ahead. For now, we contend the stimulus have been insufficiently provided during the past six months (Chart 8, bottom panel). Chance Of A Stimulus Overshoot? We will closely monitor whether the month-to-month pace of credit growth is consistent with the scope of the reflationary policy response required to revive China’s domestic demand. Despite a sharp improvement in January’s headline credit number, we view the policy signal from January’s credit data as neutral. China’s unique cyclical patterns and the lack of official seasonally adjusted data make monthly credit figures difficult to interpret. Charts 9 and 10 represent an approach that we previously introduced to help gauge whether the pace of credit creation is on track to meet the stimulus called for to stabilize the economy. Chart 9Jan Credit Growth Looked To Be Stronger Than A “Half-Strength” Credit Cycle… Takeaways From January’s Credit Data Takeaways From January’s Credit Data Chart 10…But It Is Too Early To Conclude It Is In Line With What Is Needed Takeaways From January’s Credit Data Takeaways From January’s Credit Data The charts show an average cumulative amount of TSF as the year advances, along with a ±0.5 standard deviation, based on data from 2010 to 2021. The thick black line in both charts shows the progress in new credit creation this year, assuming an 8% annual nominal GDP growth rate. Chart 9 shows the cumulative progress in credit, assuming a 27% new credit-to-GDP ratio for the year, whereas Chart 10 assumes 30%. The 27% ratio scenario shown in Chart 9, which is slightly higher than the magnitude of stimulus in 2019, would correspond to a very measured credit expansion. If the thick black line continues to trend within this range, it would suggest that policymakers are reluctant to allow credit growth to surge. Consequently, global investors should continue an underweight stance on Chinese stocks. In contrast, Chart 10 represents a 30% rate of TSF as a share of this year’s GDP; this would be the adequate stimulus needed for a recovery in domestic demand. A cumulative amount of TSF that trends within or above this range would provide more confidence that a credit overshoot similar to 2015/16 and 2020 would occur.   Investment Conclusions It is premature to upgrade Chinese stocks to an overweight cyclical stance (i.e. over 6-12 months) within a global portfolio. For now, we recommend investors stay only tactically overweight in Chinese investable equities versus the global benchmark, given their cheap relative valuations. Meanwhile, the increase in January’s TSF, while registering an improvement relative to previous months, does not signal that the pace of credit growth will be strong enough to overcome the negative ramifications of the ongoing deceleration in housing market activity. Therefore, in view of policymakers’ steadfast desire to avoid another major credit overshoot, our cyclical recommendation to underweight Chinese stocks remains unchanged.   Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations

Executive Summary Chinese Onshore Stock Prices And Earnings Are Set To Deteriorate Chinese Onshore Stock Prices And Earnings Are Set To Deteriorate Chinese Onshore Stock Prices And Earnings Are Set To Deteriorate Macro fundamentals indicate that for the time being there is no basis to overweight Chinese onshore stocks (in both absolute terms and relative to global stocks) given the outlook for profit growth contraction in 1H22. We are reluctant to shift our stance on Chinese domestic stocks to overweight in the next 6 to 12 months due to the following non-trivial risks: a subdued recovery in China’s economic activity, a deceleration in fiscal impulse in 2H22, a re-focus on reducing carbon emissions, as well as higher US bond yields and tighter global liquidity conditions.  Despite a sharp drop in January, valuations in Chinese onshore stocks are still neutral in absolute terms, and only slightly cheaper than global stocks. As such, Chinese onshore stocks offer little valuation buffer in the wake of any negative surprises. Bottom Line: We maintain our underweight stance on Chinese onshore stocks (in both absolute terms and relative to global equities) due to non-trivial risks in the coming year. Feature China’s stock markets was very weak in the first month of 2022. The domestic equity market tumbled by 8% in January, while the offshore market dropped by 3%. We discussed our view on Chinese investable stocks in last week’s report and recommended that investors go long on investable value stocks versus growth stocks. This week’s report focuses on the onshore market. While we expect the economy to stabilize by mid-year on the back of increased policy support, we are reluctant to move to a cyclical overweight in the next 6 to 12 months, in both absolute terms and relative to their global peers. Near-term challenges in economic fundamentals will continue to weigh on Chinese domestic stocks. Over a cyclical time frame, the main risks to a bullish view on Chinese stocks are fourfold: a potentially subdued economic recovery; a sharp deceleration in fiscal impulse in the second half of the year; a re-acceleration in de-carbonization efforts; as well as higher bonds yields in the US and tighter global financial conditions. Chinese onshore stocks are not as deeply discounted as their offshore peers and, therefore, are less able to counter any negative surprises. Macroeconomics Matter Chart 1Weak Economic Fundamentals Undermine Stock Performance Weak Economic Fundamentals Undermine Stock Performance Weak Economic Fundamentals Undermine Stock Performance China’s economic fundamentals still drive corporate earnings and the country’s domestic stock performance, despite an escalation in monetary policy easing (Chart 1). Current macro fundamentals do not provide a legitimate support for investors to overweight Chinese stocks. The domestic stock market’s rocky start to 2022 underscores extremely fragile sentiment and heightened anxiety among investors. Credit growth bottomed in October last year but has not shown any signs of a strong rebound. Corporate demand for credit remains in the doldrums while turmoil in the housing market has disincentivized households from taking mortgages (Chart 2). The real economy, which in previous business cycles lagged credit growth by about six to nine months, has not responded to policy easing measures. Housing market indicators in January deteriorated further (Chart 3). Moreover, the nation’s counter-COVID measures have disrupted a recovery in the service sector and private consumption. Chart 2Demand For Loans Remains Weak Demand For Loans Remains Weak Demand For Loans Remains Weak Chart 3Housing Sales Weakened Further In January Housing Sales Weakened Further In January Housing Sales Weakened Further In January Chart 4Chinese Onshore Stock EPS Is Set To Deteriorate Chinese Onshore Stock EPS Is Set To Deteriorate Chinese Onshore Stock EPS Is Set To Deteriorate The financial market is forward looking and macro policies have become more market friendly. However, Chart 4 suggests that China's onshore corporate profits are set to deteriorate in the coming six months or so, and investors will likely react negatively to any further weakness in China’s measures of economic activity. Bottom Line: At the moment, China’s domestic economic fundamentals do not support an overweight stance in Chinese stocks. Mindful Of Cyclical Risks Chinese authorities have prioritized stimulating growth through countercyclical measures in 2022. However, we are reluctant to move to a cyclical overweight stance because we see four significant risks to turning bullish towards Chinese stocks (in both absolute and relative terms) in the next 6 to 12 months. These scenarios not only threaten the performance of Chinese stocks relative to global equities but could also prevent Chinese stocks’ absolute performance from trending higher. A subdued recovery in China’s economic activity. When policymakers wait too long to decisively stimulate the economy, business and consumer sentiment as well as the economy can remain downbeat for a prolonged period. For example, in the 2014/15 business cycle, monetary policy started to ease in early 2015, but policymakers hesitated to back down from supply-side reforms. As a result, the economy did not bottom until Q1 2016. Business activity and the financial markets reached their lows only after the authorities opened the “flood irrigation” to the economy by massively stimulating the housing sector (Chart 5). Arguably China’s economy is in a better shape now than in 2014/15 and the ongoing economic slowdown is not the result of a four-year downtrend in industrial activity as was the case prior to 2015’s economic slump (Chart 6). The drop in the A-share market in January was nothing compared with the turmoil in the financial markets seven years ago. Chart 5Economic Activity Picked Up In Q1 2016 Following A Massive Stimulus Economic Activity Picked Up In Q1 2016 Following A Massive Stimulus Economic Activity Picked Up In Q1 2016 Following A Massive Stimulus Chart 6China's Economy In General Is In A Better Shape Now Than In 2014/15... China's Economy In General Is In A Better Shape Now Than In 2014/15... China's Economy In General Is In A Better Shape Now Than In 2014/15... ​​​​​​​ On the other hand, the housing market, which is estimated to account for about 29% of China’s economy, is currently decelerating at the same pace as in 2014/15. Growth in home sales and new projects dropped to their 2015 lows, while real estate inventories are comparable to the 2015 highs (Chart 7). Furthermore, property developers and consumers are even more indebted than during the 2014/15 cycle (Chart 8). Chart 7...But Downward Momentum In Property Market Comparable To 2015 ...But Downward Momentum In Property Market Comparable To 2015 ...But Downward Momentum In Property Market Comparable To 2015 ​​​​​​ Chart 8Chinese Real Estate Developers And Households Are More Leveraged Now Than In 2015 Chinese Real Estate Developers And Households Are More Leveraged Now Than In 2015 Chinese Real Estate Developers And Households Are More Leveraged Now Than In 2015 Chart 9Policymakers Will Have To Allow Significant Re-leveraging To Revive The Housing Market Policymakers Will Have To Allow Significant Re-leveraging To Revive The Housing Market Policymakers Will Have To Allow Significant Re-leveraging To Revive The Housing Market As noted in a previous report, unless regulators are willing to initiate more aggressive policy boosts as in 2015/16, the ongoing easing measures will not be sufficient to revive sentiment in the property market. Thus, the property market downtrend will likely extend through 2022 (Chart 9). The IMF recently revised its 2022 growth projection for China from 5.6% to 4.8%. It attributed the sharp downgrade to China’s protracted financial stress in the housing sector and pandemic-induced disruptions related to a zero-tolerance COVID-19 policy. A sub-5% economic expansion in 2022, although still an improvement from the 4.5% average annual rate in 2H21, is subdued and below China’s potential growth. Such a weak economic recovery will weigh on investor sentiment towards Chinese stocks in the coming year. A deceleration in fiscal impulse in 2H22. The impulse in fiscal stimulus - without any intervention - will fall sharply in the second half of the year. The Ministry Of Finance has approved a quota of RMB1.46 trillion in local government special purpose bonds (SPBs), which accounts for more than one-third of the yearly SPB quota, to be issued in Q1 this year. Chart 10Large Amount Of Local Government Debts Due In 2H22 Chinese Onshore Stocks: How Much Upside? Chinese Onshore Stocks: How Much Upside? However, the frontloading of SPBs also means that the fiscal impulse will slow significantly in 2H22. Our geopolitical strategists have noted that a total of RMB2.7 trillion worth of local government bonds (LGB) will reach maturity this year, with RMB2.2 trillion coming due after June 2022 (Chart 10). The number of maturing LGBs in 2H22 will be only slightly smaller than those in all of 2021; in 2021 42% of LGBs issued were re-financing bonds to pay off existing local government debts, undermining real fiscal support for the economy. Furthermore, authorities have not loosened their grip on implicit local government debts (Chart 11). These so-called shadow banking debts through local government financing vehicles (LGFVs) are an important source of funding for investments in infrastructure projects. If the central government does not reverse its efforts to curb hidden debts while explicit fiscal stimulus also wanes, then we will likely see a sharp deceleration in fiscal support in 2H22. Lastly, we think Chinese policymakers are still serious about preventing “flood irrigation” type of stimulus, and will not opt for it unless the economic slowdown is much sharper. In Q1 2019 stock prices jumped sharply, boosted by an above-expectation pace of local government SPB issuance and credit expansion. However, following the public spat between Premier Li Keqiang and the PBoC over whether the January 2019 credit spike represented “flood irrigation-style” stimulus, policymakers quickly scaled back credit expansion in Q2 and onshore stock prices ended the year 5% lower than in Q1 (Chart 12).  Chart 11Authorities Have Kept Tight Grip On Shadow Banking Activity Authorities Have Kept Tight Grip On Shadow Banking Activity Authorities Have Kept Tight Grip On Shadow Banking Activity Chart 12Policymakers Scaled Back Stimulus And Took The Wind Out Of Onshore Stocks In 2019 Policymakers Scaled Back Stimulus And Took The Wind Out Of Onshore Stocks In 2019 Policymakers Scaled Back Stimulus And Took The Wind Out Of Onshore Stocks In 2019 Carbon emission reduction targets are still viable. In the current 14th Five-Year Plan (2021-2025), the cumulative targets reduction in energy consumption intensity is 13.5%.1 Last year’s energy crisis slowed the de-carbonization process and energy consumption intensity fell by 2.7% in 2021, missing the official annual target of 3%. To meet the de-carbonization target by 2025, energy consumption intensity will have to be lowered by at least 2.7% per year in the next four years. If energy- and carbon-intensive infrastructure activity picks up sharply in 1H22, then policymakers will have to renew their vigilance to constrain carbon-intensive activities later this year. The de-carbonization target has become a key parameter for assessing the performance of local governments, and meeting de-carbonization targets is particularly important given the rotation of local officials will be completed in late 2022. Furthermore, the initiative to reduce energy intensity reflects China’s commitment to move to a green economy. Given the important political events in both China and the US in the fall of 2022, meeting the annual de-carbonization target will be an important projection of China’s international image and will likely play a role in US-China negotiations. Chart 13Prior To The Pandemic, Chinese Stocks Had Little Correlation With US Treasury Yields Prior To The Pandemic, Chinese Stocks Had Little Correlation With US Treasury Yields Prior To The Pandemic, Chinese Stocks Had Little Correlation With US Treasury Yields Higher bond yields in the US and tighter global liquidity conditions. Historically, Chinese onshore stocks have exhibited a loose cyclical correlation with US government bond yields (Chart 13). Nonetheless, if US bond yields rise more than global investors expect and to a level that is economically restrictive, then capital expenditures and household consumption in the US will weaken. This, in turn, will weigh down global trade and Chinese exports of manufactured goods.   Against the backdrop of escalating US bond yields, Chinese onshore stocks may passively outperform their US counterparts because China’s A-share market is heavily weighted in value stocks. However, A-share prices in absolute terms will not be immune to heightened volatility in the global financial markets.   The risk-off sentiment across global bourses will discourage portfolio flows into emerging economies including China. On a monthly basis, foreign portfolio net inflows account for less than 1% of the onshore equity market trading volume, but in recent years foreign portfolio inflows have increasingly influenced China’s onshore market sentiment and prices (Chart 14). China’s domestic household savings will not provide much support to stock prices this year. Chinese households have increasingly invested in the domestic equity market in the past few years, given that the authorities have been vigilant in containing price inflation in the property market.2 While we think Chinese consumers will continue rotating investment from property to financial market, household savings growth has fallen sharply since mid-2021, which means there have been less available funds to invest in the stock market (Chart 15). ​​​​​​​ Chart 15Chinese Households' Quickly Diminishing Dry Powder Chinese Households' Quickly Diminishing Dry Powder Chinese Households' Quickly Diminishing Dry Powder Chart 14Foreign Investors Have Become More Influential In The Chinese Onshore Market Foreign Investors Have Become More Influential In The Chinese Onshore Market Foreign Investors Have Become More Influential In The Chinese Onshore Market   Bottom Line: For the time being, the significant risks described above make us reluctant to turn bullish on Chinese stocks in both absolute and relative terms. Investment Conclusions There are few upsides related to Chinese onshore stocks in the next 6 to 12 months. However, there are two risks to our underweight stance on Chinese onshore stocks: First, we cannot rule out the possibility that Chinese policymakers will go “all in” for economic stability and allow a significant credit overshoot. In this scenario, a strong pickup in credit growth will produce a rebound in profit growth and support share prices in absolute terms and relative to global equities. Secondly, recent gyrations in global financial markets, coupled with China’s sluggish domestic economy, have triggered shakeouts in the onshore equity markets. The pullback in stock prices has helped to shed some excesses in Chinese stock valuations. Chart 16In Very Optimistic Scenario Chinese Stocks Would Have Some Upside Potential Vs. Global In Very Optimistic Scenario Chinese Stocks Would Have Some Upside Potential Vs. Global In Very Optimistic Scenario Chinese Stocks Would Have Some Upside Potential Vs. Global If the stimulus in the next 6 to 12 months returns Chinese corporate profit growth to their 2021 peaks, then Chinese stock prices (in absolute terms) will also approach or go back to their early-2021 highs. Chart 16 highlights that reverting to these levels would imply a return of about 10-15% for domestic stocks in both absolute and relative price terms. We think China’s potential to command a higher multiple than global stocks is capped, barring a major structural improvement in earnings growth. However, Chart 16 (bottom panel) shows that Chinese onshore stocks at their height early last year were still cheaper than their global counterparts. Therefore, in a scenario where Beijing does “whatever it takes” to stimulate its economy, we will have no strong reasons to argue against a return of domestic forward multiples and a strong earnings growth back to levels seen in early-2021. Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1     Energy consumption intensity refers to energy consumption per unit of GDP. 2     There was a sharp jump in demand in 2020 for investment products from households; mutual funds in China raised money at a record pace, bringing in over 2 trillion yuan ($308 billion), which is more than the total amount in the previous four years. Strategic Themes Cyclical Recommendations Tactical Recommendations