China

Highlights Global oil demand will remain betwixt and between recovery and relapse through 3Q21, as stronger DM consumer spending and increasing mobility wrestles with persistent concerns over COVID-19-induced lockdowns in Latin America and Asia. These concerns will be allayed as vaccines become more widely distributed, and fears of renewed lockdowns – and their associated demand destruction – recede.  Going by US experience – which can be tracked on a weekly basis – as consumer spending rises in the wake of relaxed restrictions on once-routine social interactions, fuel demand will follow suit (Chart of the Week). OPEC 2.0 likely will agree to return ~ 400k b/d monthly to the market over the course of the next year and a hal. For 2021, we raised our average forecast to $70/bbl, and our 2H21 expectation to $74/bbl. For 2022 and 2023, we expect Brent to average $75 and $78/bbl. These estimates are highly sensitive to demand expectations, particularly re containment of COVID-19. Feature For every bit of good news related to the economic recovery from the COVID-19 pandemic, there is a cautionary note. Most prominently, reports of increasing demand for refined oil products like diesel fuel and gasoline in re-opening DM economies are almost immediately offset by fresh news of renewed lockdowns, re-infections in highly vaccinated populations, and fears a new mutant strain of the coronavirus will emerge (Chart 2).1 In this latter grouping, EM economies feature prominently, although Australia this week extended its lockdown following a flare-up in COVID-19 cases. Chart of the WeekUS Product Demand Revives As Economy Reopens US Product Demand Revives As Economy Reopens US Product Demand Revives As Economy Reopens Chart 2COVID-19 Infection And Death Rates Keep Markets On Edge Demand Dictates Oil Price Expectations Demand Dictates Oil Price Expectations Our expectation on the demand side is unchanged from last month – 2021 oil demand will grow ~ 5.4mm b/d vs. 2020 levels, while 2022 and 2023 consumption will grow 4.1 and 1.6mm b/d, respectively (Chart 3). These estimates reflect the slowing of global GDP growth over the 2021-23 interval, which can be seen in the IMF's and World Bank's GDP estimates, which we use to drive our demand forecasts.2 Weekly data from the US seen in the Chart of the Week provide a hint of what can be expected as DM and EM economies re-open in the wake of relaxed restrictions on once-routine social interactions. Demand for refined products – e.g., gasoline, diesel fuel and jet fuel – will recover, but at uneven rates over the next 2-3 years. The US EIA notes the recovery in diesel demand, which is included in "Distillates" in the chart above, has been faster and stronger than that of gasoline and jet fuel. This is largely because it reflects the lesser damage done to freight movement and activities like mining and manufacturing. The EIA expects 4Q21 US distillate demand to come in 100k b/d above 4Q19 levels at 4.2mm b/d, and to hit an all-time record of 4.3mm b/d next year. US gasoline demand is not expected to surpass 2019 levels this year or next, in the EIA's forecast. This is partly due to improved fuel efficiencies in automobiles – vehicle-miles travelled are expected to rise to ~ 9mm miles/day in the US, which will be slightly higher than 2019's level. Jet fuel demand in the US is expected to return to 2019 levels next year, coming in at 1.7mm b/d. Chart 3Global Oil Demand Forecast Remains Steady Global Oil Demand Forecast Remains Steady Global Oil Demand Forecast Remains Steady Quantifying Demand Risks We use the recent uptick in COVID-19 cases as the backdrop for modelling demand-destruction scenarios in this month’s oil balances (Chart 2). We consider different scenarios of potential demand destruction caused by the resurgence in the pandemic (Table 1). Last year, demand fell by 9% on average, which we take to be the extreme down move over an entire year. In our simulations, we do not expect demand to fall as drastically this time. Table 1Demand-Destruction Scenario Outcomes Demand Dictates Oil Price Expectations Demand Dictates Oil Price Expectations We modelled two scenarios – a 5% drop in demand (our low-demand-destruction scenario) and an 8% drop in demand (our high-demand-destruction scenario). A demand drop of a maximum of 2% made nearly no difference to prices, and so, we did not include it in our analysis. In both cases, demand starts to fall by September and reaches its lowest point in October 2021. We adjusted changes to demand in the same proportion as changes in demand in 2020, before making estimates converge to our base-case by end-2022. The estimates of price series are noticeably distinct during the period of the simulation (Chart 4). Starting in 2023, the low-demand-destruction prices and base-case prices nearly converge, as do their inventory levels. Prices and inventory levels in the high-demand-destruction case remain lower than the base-case during the rest of the forecast sample. OPEC 2.0 and world oil supply were kept constant in these scenarios. World oil supply is calculated as the sum of OPEC 2.0 and Non-OPEC 2.0 supply. Non-OPEC 2.0 can be broken down into the US, and Non-OPEC 2.0, Ex-US countries. Examples of these suppliers are the UK, Canada, China, and Brazil. OPEC 2.0 can be broken down into Core-OPEC 2.0 and the cohort we call "The Other Guys," which cannot increase production. Core-OPEC 2.0 includes suppliers we believe have excess spare capacity and can inexpensively increase supply quickly. Chart 4Brent Forecasts Rise As Global Economy Recovers COVID-19 Demand Destruction Scenarios Brent Forecasts Rise As Global Economy Recovers COVID-19 Demand Destruction Scenarios Brent Forecasts Rise As Global Economy Recovers COVID-19 Demand Destruction Scenarios OPEC 2.0 Remains In Control We continue to expect the OPEC 2.0 producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia to maintain its so-far-successful production policy, which has kept the level of supply below demand through most of the COVID-19 pandemic (Chart 5). This allowed OECD inventories to fall below their pre-COVID range, despite a 9% loss of global demand last year (Chart 6). We expect this discipline to continue and for OPEC 2.0 to continue restoring its market share (Table 2). Chart 5OPEC 2.0 Production Policy Kept Supply Below Demand OPEC 2.0 Production Policy Kept Supply Below Demand OPEC 2.0 Production Policy Kept Supply Below Demand Chart 6...And Drove OECD Inventories Down ...And Drove OECD Inventories Down ...And Drove OECD Inventories Down Table 2BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Demand Dictates Oil Price Expectations Demand Dictates Oil Price Expectations Our expectation last week the KSA-UAE production-baseline impasse will be short-lived remains intact. We expect supply to be increased after this month at a rate of 400k b/d a month into 2022, per the deal most members of the coalition signed on to prior to the disagreement between the longtime GCC allies. This would, as the IEA notes, largely restore OPEC 2.0's spare capacity accumulated via production cutbacks during the pandemic of ~ 6-7mm b/d by the end of 2022 (Chart 7). It should be remembered that most of OPEC 2.0's spare capacity is held by Gulf Cooperation Council (GCC) states, which includes the UAE. The UAE's official baseline production number (i.e., its October 2018 production level) likely will be increased to 3.65mm b/d from 3.2mm b/d, and its output in 2H21 and 2022 likely will be adjusted upwards. As one of the few OPEC 2.0 members that actually has invested in higher production and can increase output meaningfully, it would, like KSA, benefit from providing barrels out of this spare capacity.3 Chart 7OPEC 2.0 Spare Capacity Will Return Demand Dictates Oil Price Expectations Demand Dictates Oil Price Expectations As we noted last week, we do not think this impasse was a harbinger of a breakdown in OPEC 2.0's so-far-successful production-management strategy. In our view, this impasse was a preview of how negotiations among states with the capacity to raise production will agree to allocate supply in a market starved for capital in the future. This is particularly relevant as US shale producers continue to focus on providing competitive returns to their shareholders, which will limit supply growth to that which can be done profitably. We see the "price-taking cohort" – i.e., those producers outside OPEC 2.0 exemplified by the US shale-oil producers – remaining focused on maintaining competitive margins and shareholder priorities. This means maintaining and growing dividends, and returning capital to shareholders will have priority as the world transitions to a low-carbon business model (Chart 8).4 For 2021, we raised our average forecast to $70/bbl on the back of higher prices lifting the year-to-date average so far, and our 2H21 expectation to $74/bbl. For 2022 and 2023, we expect Brent to average $75 and $78/bbl (Chart 9). These estimates are highly sensitive to demand expectations, which, in turn, depend on the global success in containing and minimizing COVID-19 demand destruction, as we have shown above. Chart 8US Shale Producers Focus On Margins US Shale Producers Focus On Margins US Shale Producers Focus On Margins Chart 9Raising Our Forecast Slightly Raising Our Forecast Slightly Raising Our Forecast Slightly Investment Implications In our assessment of the risks to our views in last week's report, we noted one of the unintended consequences of the unplanned and uncoordinated rush to a so-called net-zero future will be an improvement in the competitive position of oil and gas. This is somewhat counterintuitive, but the logic goes like this: The accelerated phase-out of conventional hydrocarbon energy sources brought about policy, regulatory and legal imperatives already is reducing oil and gas capex allocations within the price-taking cohort exemplified by US shale-oil producers. This also will restrict capital flows to EM states with heavy resource endowments and little capital to develop them. Our strong-conviction call on oil, gas and base metals is premised on our view that renewables and their supporting grids cannot be developed and deployed quickly enough to make up for the energy that will be foregone as a result of these policies. Capex for the metals miners has been parsimonious, and brownfield projects continue to dominate. Greenfield projects can take more than a decade to develop, and there are few in the pipeline now as the world heads into its all-out renewables push. In a world where conventional energy production is being forced lower via legislation, regulation, shareholder and legal decisions, higher prices will ensue even if demand stays flat or falls: If supply is falling, market forces will lift oil and gas prices – and the equities of the firms producing them – higher. As for metals like copper and their producers, if supply is unable to keep up with demand, prices of the commodities and the equities of the firms producing them will be forced to go higher.5 This call underpins our long S&P GSCI and COMT ETF commodity recommendations, and our long MSCI Global Metals & Mining Producers ETF (PICK) recommendation. We will look for opportunities to get long oil and gas producer exposure via ETFs as well, given our view on oil and metals spans the next 5-10 years.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish The US EIA expects growth in large-scale solar capacity will exceed the increase in wind generation for the first time ever in 2021-22. The EIA forecasts 33 GW of solar PV capacity will be added to the US grid this year and next, with small-scale solar PV increasing ~ 5 GW/yr. The EIA expects wind generation to increase 23 GW in 2021-22. The EIA attributed the slow-down in wind development to the expiration of a $0.025/kWH production tax credit at the end of 2020. Taken together, solar and wind generation will account for 15% of total US electricity output by the end of 2022, according to the EIA. Nuclear power will account for slightly less than 20% of US generation in 2021-22, while hydro will fall to less than 7% owing to severe drought in the western US. At the other end of the generation spectrum, coal will account for ~ 24% of generation this year, as it takes back incremental market share from natural gas, and ~ 22% of generation in 2022. Base Metals: Bullish Iron ore prices continue to trade above $215/MT in China, even as demand is expected to slow in 2H21. Supply additions from Brazil, which ships higher quality 65% Fe ore, have been slower than expected, which is supporting prices (Chart 10). Separately, the Chinese government's auction of refined copper earlier this month cleared the market at $10,500/MT, or ~ $4.76/lb. Spot copper has been trading on either side of $4.30/lb this month, which indicates the Chinese market remains well bid. Precious Metals: Bullish The 13-year record jump in the US Consumer Price Index reported this week for the month of June is bullish for gold, as it produced weaker real rates and sparked demand for inflation hedges. Fed Chair Powell continued to stick to the view that the recent rise in inflation is transitory. The Fed’s dovish outlook will support gold prices and likely will lead to a weaker US dollar, as it reduces the possibility that US interest rates will rise soon. A falling USD will further bolster gold prices (Chart 11). Chart 10 BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI)RECOVERING BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI)RECOVERING Chart 11 Gold Prices Going Down Gold Prices Going Down     Footnotes 1     We highlighted this risk in last week's report, Assessing Risks To Our Commodity Views, which is available at ces.bcaresearch.com. Two events – in the Seychelles and Chile, where the majority of the populations were inoculated – highlight re-infection risk. Re-infections in Indonesia along with lockdowns following the spread of the so-called COVID-19 Delta variant also are drawing attention. Please see Euro 2020 final in UK stokes fears of spread of Delta variant, published by The Straits Times on July 11, 2021. The news service notes that in addition to the threats super-spreader sporting events in Europe present, "The rapid spread of the Delta variant across Asia, Africa and Latin America is exposing crucial vaccine supply shortages for some of the world's poorest and most vulnerable populations. Those two factors are also threatening the global economic recovery from the pandemic, Group of 20 finance ministers warned on Saturday." 2     Please see the recently published IMF World Economic Outlook Reports and the World Bank Global Economic Prospects. 3    If, as we suspect, KSA and the UAE are playing a long game – i.e., a 20-30-year game – this spare capacity will become more valuable as investment capex into oil production globally slows. Please see The $200 billion annual value of OPEC’s spare capacity to the global economy published by kapsarc.org on July 17, 2018. 4    Please see Bloomberg's interview with bp's CEO Bernard Looney at Banks Need ‘Radical Transparency,’ Citi Exec Says: Summit Update, which aired on July 13, 2021. In addition to focusing on margins and returns, the company – like its peers among the majors – also is aiming to reduce oil production by 20% by 2025 and 40% by 2030. 5    This turn of events is being dramatically played out in the coal markets, where the supply of metallurgical coals is falling as demand increases. Please see Coal Prices Hit Decade High Despite Efforts to Wean the World Off Carbon published by wsj.com on June 25, 2021.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Image

Highlights It is too early to conclude that the PBoC’s surprise rate cut last Friday to its reserve requirement ratio (RRR) marks the beginning of another policy easing cycle.  Historically it took more than a single RRR reduction to lower interest rates and to boost credit growth. Overall economic conditions do not yet suggest that Chinese policymakers will initiate a broad-based policy easing to spur demand. The end-of-July Politburo meeting will shed more light on whether there is a decisive turn in China’s overall policy stance. In previous cycles, consecutive RRR cuts led to bond market rallies, but were not good leading indicators for equities, which have been more closely correlated with cyclical swings in credit and business cycle. We recommend patience. Chinese onshore stocks are richly valued and their prices can still correct in Q3 when corporate profits and economic growth slow further. Feature The speed and magnitude of the PBoC’s 50-basis point trim in its RRR rate last week exceeded market expectations. The RRR rate drop, combined with June’s better-than-expected credit data, sparked speculation that China’s macroeconomic policy had shifted to an easier mode. A single RRR cut does not indicate that another policy easing cycle is underway. Rather, the PBoC’s intention is to prevent rising demand for liquidity in 2H21 from significantly pushing up interest rates. In addition, we do not expect that the credit impulse will decisively turn around until later this year. We will remain alert to any signs of additional policy easing, particularly because policymakers will face more pressure to maintain trend growth next year. The July Politburo meeting may provide more information on the direction of Chinese macro policy going forward. Meanwhile, investors should stay the course. In previous cycles there were long lags between the first RRR cut and sustained rallies in China’s onshore stock markets. We will continue to maintain an underweight stance towards Chinese stocks through the next three months, given that economic data and corporate profits will likely weaken further in Q3. Surprise, Surprise! The PBoC lowered the RRR rate only two days after the State Council mentioned the possibility, which exceeded the consensus. Historically, the PBoC has always made more than one RRR reduction during easing cycles, separated by about three months. Are more RRR cuts pending and does the initial decrease mark the beginning of another policy easing cycle? It is too early to conclude that a broad-based easing cycle has started, for the following reasons: First, economic fundamentals do not suggest an urgent need for policy easing. The economy is softening, but it is softening from a very elevated level (Chart 1). Importantly, production is weakening at a faster pace than demand and partially due to COVID-related idiosyncrasies. This supply-side issue cannot be solved by monetary easing.  For example, the production subcomponent of the manufacturing PMI fell in June while new orders increased (Chart 2). Since its trough in April last year, the gap between new orders and production has consistently narrowed for 11 of the past 15 months, highlighting that the demand-side recovery has been outpacing the supply-side. The recent resurgence in COVID-19 cases and local lockdowns in Guangdong province, which is China’s manufacturing and export powerhouse, may have curbed June’s manufacturing production and new export orders. Global supply shortages in raw materials and chips also add to the sluggishness in manufacturing production. Chart 1Chinese Economy Is Slowing, But Not Too Slow Chinese Economy Is Slowing, But Not Too Slow Chinese Economy Is Slowing, But Not Too Slow Chart 2Demand Not As Soft Compared With Production Demand Not As Soft Compared With Production Demand Not As Soft Compared With Production Similarly, China’s service PMI slipped notably in June and has closely tracked the country’s domestic COVID-19 situation. The decline is an issue that policy easing and boosting demand will not solve (Chart 3). Secondly, global supply chains are still impaired and commodity prices remain elevated. Even though China’s PPI on a year-over-year basis rolled over in June, it is at its highest level since 2008 (Chart 4). As such, spurring demand through monetary easing would only exacerbate inflationary pressures among producers. Chart 3Slow Recovery In Services Largely Due To Lingering COVID Effects Slow Recovery In Services Largely Due To Lingering COVID Effects Slow Recovery In Services Largely Due To Lingering COVID Effects Chart 4Producer Prices Remain Elevated Producer Prices Remain Elevated Producer Prices Remain Elevated Apart from COVID-related disruptions, the weakness in China’s economy this year has been driven by slower growth in infrastructure and real estate investment due to tightened regulatory oversights that were put in place late last year (Chart 5). Construction PMI declined sharply from its peak in March and both excavator sales and loader sales have plummeted since Q1 this year (Chart 5, bottom panel). However, regulatory tightening towards the housing market and infrastructure projects remain firmly in place, suggesting that policymakers are not looking to stimulate the old economy sectors to support growth. Lastly, despite weaker home sales, housing prices in tier-one cities continue to escalate (Chart 6). The rising prices will keep authorities vigilant about excessive liquidity in the market.    Chart 5It Has Been Chinese Policymakers' Intention To Slow The 'Old Economy' Sectors It Has Been Chinese Policymakers' Intention To Slow The 'Old Economy' Sectors It Has Been Chinese Policymakers' Intention To Slow The 'Old Economy' Sectors Chart 6Housing Market Mania Remains Authorities' Pressure Point Housing Market Mania Remains Authorities' Pressure Point Housing Market Mania Remains Authorities' Pressure Point Bottom Line: Supply-demand dynamics in the global economy and China’s domestic inflationary pressures suggest that it is premature to assume that the RRR cut marks the beginning of another policy easing cycle.  Why Now? Chart 7More 'Pain' Needed For Broad Easing More 'Pain' Needed For Broad Easing More 'Pain' Needed For Broad Easing The drop in the RRR highlights the PBoC’s determination to maintain a low interest-rate environment without any further easing, and does not indicate that the central bank has shifted its current policy setting framework. The PBoC has been reactive rather than proactive in the past as it typically waits for severe signs of economic weakness before broadly relaxing its policy (Chart 7). The PBoC cited two main reasons for the RRR cut. One is to ease liquidity pressures of small to medium enterprises (SMEs), which have been struggling with rising input prices and subdued output prices (Chart 8). This motive is consistent with the PBoC’s monetary position so far this year –the central bank has kept rates at historical low levels while scaling back credit creation (Chart 9).   Chart 8SMEs Under Elevated Pricing Stress SMEs Under Elevated Pricing Stress SMEs Under Elevated Pricing Stress Chart 9The PBoC Has Kept Rates At Historic Low Levels The PBoC Has Kept Rates At Historic Low Levels The PBoC Has Kept Rates At Historic Low Levels Demand for liquidity will rise meaningfully in the second half of the year due to an acceleration in local government bond issuance and the large number of expiring medium-term lending facility (MLF) loans and bonds. The liquidity gap could significantly push up interbank and market-based interest rates without the central bank’s intervention. The amount of maturing MLF and government bonds could be more than RMB1 trillion in July. Thus, the 50bp RRR cut, which the PBoC indicates will free up about RMB1 trillion of liquidity to the banking system, will ensure that interest rates remain stable. Chart 10Bank Lending Rates Have Not Declined With Policy Rates Bank Lending Rates Have Not Declined With Policy Rates Bank Lending Rates Have Not Declined With Policy Rates The PBoC also stated that it intends to keep down financing costs for both banks and SMEs. The statement is vague, but the PBoC may mean it plans to guide bank lending rates lower for SMEs and, at the same time, provide banks (particularly smaller banks) with enough liquidity to encourage lending to those enterprises. To achieve this goal, a broad-based RRR cut would be more effective than other monetary policy tools, such as open-market operations or MLF injections, which normally benefit large commercial banks more than their smaller counterparts. While interbank rates have been sliding since Q4 last year, the weighted average lending rates moved sideways and even ticked up slightly this year (Chart 10). As of Q1 2021, more than half of bank loans charged higher interest rates than the loan prime rate (LPR), highlighting a distribution matrix unfavorable to SMEs (Chart 11). Loan demand from SMEs, as shown in the PBoC survey, peaked much earlier and tumbled more rapidly than their large peers (Chart 12). Chart 11SMEs Face Rising Input And Funding Costs China’s Monetary Policy: Easy, But Not Easing China’s Monetary Policy: Easy, But Not Easing Chart 12Waning SMEs' Demand For Bank Credit Waning SMEs' Demand For Bank Credit Waning SMEs' Demand For Bank Credit Lowering lending rates for SMEs is usually at the cost of the banks by bearing higher default risks and lower profits. A RRR reduction, coupled with recent changes in banks’ deposit rate pricing mechanisms,1 are measures that can potentially reduce the banks’ liability costs. Bottom Line: The PBoC is using a RRR cut to avoid a sudden jump in interest rates from their low levels in 1H21, and to reduce funding costs for the SMEs and banks. What About Credit Growth? Chart 13Credit Numbers In June Beat Market Expectations Credit Numbers In June Beat Market Expectations Credit Numbers In June Beat Market Expectations Credit numbers beat the market’s expectations in June. Both credit growth and impulse rose slightly after a fast deceleration in much of 1H21 (Chart 13). We continue to expect the credit impulse to hover at a low level throughout Q3. Local government bond issuance will pick up in 2H21, but the acceleration will not necessarily lead to a reversal in credit growth (Chart 14). On a year-over-year basis, high base during Q3 last year will depress credit growth and impulse in the next three months. Moreover, in the past couple years, on average local government bonds account for only about 18% of annual total social financing. As such, the pace of bank loan expansion would need to substantially accelerate to reverse the slowdown in credit growth in the next three months. In previous cycles, on average it took more than one RRR cut and about two quarters for credit growth to turn around (Chart 15). Therefore, even if monetary policy is on an easing path, we expect credit growth to pick up in Q4 at the earliest. Chart 14LG Bonds Only A Small Part Of Total Credit Creation China’s Monetary Policy: Easy, But Not Easing China’s Monetary Policy: Easy, But Not Easing Chart 15Credit Growth Lags RRR Cuts By About Two Quarters Credit Growth Lags RRR Cuts By About Two Quarters Credit Growth Lags RRR Cuts By About Two Quarters Furthermore, policymakers are unlikely to deviate from targeting credit growth in line with nominal GDP this year. Based on our estimate, the target suggests that the overall credit impulse relative to 2020 will be negative this year (Chart 16). Chart 16Negative Credit Impulse In 2021 Relative To 2020 Negative Credit Impulse In 2021 Relative To 2020 Negative Credit Impulse In 2021 Relative To 2020 Chart 17The Credit Structure, Rather Than Volume, Will Improve In 2H21 The Credit Structure, Rather Than Volume, Will Improve In 2H21 The Credit Structure, Rather Than Volume, Will Improve In 2H21   Meanwhile, we think that the PBoC will focus on improving the structure of credit creation by continuing to encourage medium- to long-term lending, while scaling back shadow banking and short-term loans (Chart 17). Corporate bond financing improved slightly in June. However, room for further improvement in corporate bond issuance is small this year, given tightened financing reglations on local government financing vehicles. Downside potential for corporate bond yields is also limited in 2H21, when the economy slows and corporate bond default risks are rising (Chart 18).  Given elevated housing prices and tightened regulations to contain the property sector’s leverage, bank lending to real estate developers and mortgages will continue to trend down in the foreseeable future, regardless the direction of interest rates (Chart 19). Chart 18Limited Upsides For Corporate Bond Issuance In 2H21 Limited Upsides For Corporate Bond Issuance In 2H21 Limited Upsides For Corporate Bond Issuance In 2H21 Chart 19Bank Loans To Property Market Unlikely To Pick Up In 2H21 Bank Loans To Property Market Unlikely To Pick Up In 2H21 Bank Loans To Property Market Unlikely To Pick Up In 2H21 Bottom Line: Regardless changes in monetary policy, credit growth will not decisively bottom until later this year. Investment Implications Chart 20Chinese Stock Prices Failed To Break Out Chinese Stock Prices Failed To Break Out Chinese Stock Prices Failed To Break Out Chinese stocks in both onshore and offshore equity markets failed to reverse their trend of underperformance relative to global stocks (Chart 20). Investors should be patient in upgrading their allocation to Chinese stocks from underweight to overweight, in both absolute terms and within a global equity portfolio.  Historically, there has been a long lag between an initial RRR trim and a trough in Chinese onshore stock prices (Chart 21). Although prices moved up along with RRR cut announcements in the past, the price upticks were short lived. Stock prices in previous cycles troughed when the credit impulse and/or the economy bottomed. Given our view that a single RRR decrease does not indicate a broad-based policy easing and the credit impulse is unlikely to pick up until later this year, investors should wait for more price setbacks in Q3 before favoring Chinese stocks again.  Chart 21Long Lags Between First RRR Cut And Stock Market Troughs Long Lags Between First RRR Cut And Stock Market Troughs Long Lags Between First RRR Cut And Stock Market Troughs We are slightly more optimistic than last month about Chinese bonds because the RRR cut has reduced the possibility for any substantial rise in interest rates in 2H21. However, we maintain a cautious view on Chinese government and corporate bonds in Q3. In previous cycles, onshore bond yields often fluctuated sideways or even climbed a bit following the first RRR reduction. It often took several RRR drops, more policy easing signals and sure signs of economic weakening for the bond market to enter a tradable bull run (Chart 22). Therefore, we recommend investors stay on the sidelines for a better entry price point. Chart 22It Takes More Than One RRR Cut To Start A Bond Market Bull Run It Takes More Than One RRR Cut To Start A Bond Market Bull Run It Takes More Than One RRR Cut To Start A Bond Market Bull Run It is also unrealistic to expect the RRR cut will lead to significant and sustained devaluation in the RMB relative to the US dollar. We expect the dollar index to rebound somewhat in Q3 on the back of positive US employment data surprises which will push US bond yields higher. However, following previous RRR cuts, the RMB had sizeable depreciations only when geopolitical events (the US-China trade war in 2018/19) or drastic central bank intervention (the August 2015 de-pegging from the USD) coincided with the RRR cuts. These scenarios are not likely to play out in the next six months (Chart 23). As such, we maintain our view that the CNY will slightly weaken against the USD in Q3 but will end the year at around 6.4. Chart 23Expect Muted And Short-Lived Movements In The USDCNY From A Single RRR Cut Expect Muted And Short-Lived Movements In The USDCNY From A Single RRR Cut Expect Muted And Short-Lived Movements In The USDCNY From A Single RRR Cut   Jing Sima China Strategist jings@bcaresearch.com Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Footnotes 1The reform changes the way banks calculate and offer deposit rates. The upper limit is set on their deposit interest rates by adding basis points to the central bank’s benchmark deposit rates, rather than multiplying the benchmark rates by a specific number. Exclusive: Banks Prepare to Lower Deposit Rates as Rate Cap Reform Takes Effect (caixinglobal.com) Cyclical Investment Stance Equity Sector Recommendations

Feature Since the end of the first quarter, the decline in Treasury yields has been the most important trend in global financial markets. It has contributed to the return of the outperformance of growth stocks relative to value stocks, the underperformance of Eurozone equities relative to the S&P 500, and the tepid results of cyclicals relative to defensive equities. This decline in yields is a temporary phenomenon, because the global economy continues to re-open and inventory levels remain so low that further restocking is in the cards. The cyclical picture is not without blemish; COVID-19 variants remain a concern. However, if these risks were to materialize into another delayed re-opening, then further reflationary efforts by both monetary and fiscal authorities would buoy financial markets. The greatest near-term worry for the global economy and markets comes from China. The Chinese credit impulse is slowing markedly and fiscal support has yet to come to the rescue. This phenomenon is the main reason why this publication maintains a cautious tactical stance on Eurozone cyclical stocks, even if we believe these sectors have ample scope to outperform over the remainder of the business cycle. As a corollary, we believe that yields will likely remain within range this summer and Eurozone benchmarks will lag behind the US. This week, we review key charts, organized by theme, highlighting some of these key concepts. As an aside, none covers inflation. Even if the balance of evidence suggests that any sharp increase in Eurozone inflation will be temporary, the proof will only become more visible by early 2022. The Opening Is On Track… The pace of vaccination across the major Eurozone economies has picked up meaningfully since the spring. Consequently, the number of doses distributed per capita is rapidly approaching that of the US, even as it still lags behind that of the UK (Chart 1). As a result of this improvement, the stringency of lockdown measures is declining, which is allowing European mobility to recover (Chart 2). While this phenomenon is evident around the world, EM still lag in terms of vaccination rates. However, the Global Health Innovation Center at Duke University expects 10 billion vaccine doses to be produced by the year’s end, which will be enough to inoculate most (if not all) the vulnerable people in the world by early 2022. Consequently, the re-opening of the economy will remain a potent tailwind behind global growth for three or four more quarters. Chart 1Vaccination Progress... Vaccination Progress... Vaccination Progress... Chart 2...Leads To Greater Activity ...Leads To Greater Activity ...Leads To Greater Activity   … But Near-Term Headwinds Remain The re-opening of the global economy will allow growth to stay well above trend for the upcoming 12 months, at least. Global industrial activity could nonetheless decelerate this summer. Input costs have risen. The two most important ones, oil and interest rates, are already consistent with a peak in the US ISM manufacturing and the global PMI (Chart 3). In this context, the decelerating Chinese credit impulse is concerning (Chart 4) because it portends a hit to global trade and industrial activity. The effect of this slowdown should be most evident in the third and fourth quarters of 2021. However, it will be temporary because Beijing only wants credit to grow in line with GDP, rather than an outright deleveraging. Thus, the credit impulse will stabilize before the year’s end, which will allow the positive effect of the global re-opening to be fully experienced once again. Chart 3Rising Input Costs... Rising Input Costs... Rising Input Costs... Chart 4...And China's Credit Slowdown Matter ...And China's Credit Slowdown Matter ...And China's Credit Slowdown Matter   Domestic Tailwind In Europe Despite the extreme sensitivity of the European economy to the global business cycle, Europe should continue to produce positive surprises. The supports to the domestic economy are strong. The NGEU funds means that Europe will suffer one of the smallest fiscal drag among G-10 nations next year. Moreover, the re-opening will support household income and allow the positive effect of the increase in the money supply to buoy consumption (Chart 5). Finally, rising consumer confidence, and the ebbing propensity to save will reinforce the tailwinds behind consumption (Chart 6). Chart 5Europe's Domestic Activity Europe's Domestic Activity Europe's Domestic Activity Chart 6...Will Improve Further ...Will Improve Further ...Will Improve Further   Higher Bond Yields Are Coming… The environment continues to support higher yields. Our BCA Pipeline Inflation Indicator is surging, which historically translates into higher global borrowing costs (Chart 7). Most importantly, our Nominal Cyclical Spending Proxy remains very robust, which normally leads to rising yields (Chart 8). While US inflation expectations at the short end of the curve already fully reflect current inflationary pressures, the 5-year/5-year forward inflation breakeven rates will have additional upside. Moreover, the term premium and real rates remain depressed, and policy normalization will cause these variables to climb higher over time. Chart 7Higher Yields Will Come... Higher Yields Will Come... Higher Yields Will Come... Chart 8...Later This Year ...Later This Year ...Later This Year   … But Not This Summer It could take some time before the bearish backdrop for bonds results in higher bond yields. First, bonds have yet to purge fully their oversold status created by the 125 basis-point surge that took place between August 2020 and March 2021 (Chart 9). This vulnerability is even more salient in an environment in which the Chinese credit impulse is decelerating. As Chart 10 illustrates, a slowing total social financing number reliably leads to bond rallies. While the chart looks dire for bond bears, it must be placed in context, in which global fiscal policy remains accommodative considering the decline in the private sector savings rate and in which Advanced Economies’ capex will stay strong. Thus, instead of betting on a large swoon in yields in the coming quarters, we expect US yields to remain stuck between 1.20% and 1.70% for a few more months before they resume their upward path once the Chinese economy stabilizes. Chart 9But Bonds Are Still Oversold... But Bonds Are Still Oversold... But Bonds Are Still Oversold... Chart 10...And Fundamentals Cap Yields For Now ...And Fundamentals Cap Yields For Now ...And Fundamentals Cap Yields For Now   A Positive Cyclical Backdrop For The Euro The near-term forces suggest that the euro will remain range bound over the summer, between 1.16 and 1.23. EUR/USD is a pro-cyclical pair, and so the near-term lack of upside to global growth will act as a temporary ceiling on this currency. Nonetheless, the 18-month outlook continues to favor the common currency. Investors have shed Eurozone exposure for more than 10 years and are structurally underweight this region (Chart 11). Hence, EUR/USD should benefit from any positive reassessment of the growth path in the Euro Area compared to that of the US. Additionally, the euro benefits from a structural current account surplus compared to the USD, which translates into a positive basic balance of payments (Chart 12). In an environment in which US real interest rates are low in relation to foreign ones and in which the Fed wants to maintain accommodative monetary conditions to achieve maximum employment, the capital account balance is unlikely to come to the rescue of the dollar. In this context, EUR/USD still possesses significant cyclical upside and is likely to move back above 1.30 by the year’s end of 2022. Chart 11Investors Underweight Eurozone Assets... Investors Underweight Eurozone Assets... Investors Underweight Eurozone Assets... Chart 12...And The BoP Favors The Euro ...And The BoP Favors The Euro ...And The BoP Favors The Euro   The Bull Market In Global Stocks Is Not Over The cyclical outlook for equities remains supportive. To begin with, in most years, equities eke out positive returns, as long as a recession is not around the corner; we do not expect a recession anytime soon. Moreover, while the balance of valuation risk and monetary accommodation is not as supportive of stocks as it was last year, it is not pointing to an imminent deep pullback either (Chart 13). The equity risk premium echoes this message. Our ERP measure adjusts for the expected growth rate of earnings as well as the lack of stationarity of the ERP. According to this indicator, equities are not an urgent buy, but they are not at risk of a bear market either (Chart 14). This combination does not prevent corrections, but it suggests that pullbacks of 10% are to be bought. Chart 13Equities Are Not A Screaming Buy... Equities Are Not A Screaming Buy... Equities Are Not A Screaming Buy... Chart 14...Nor A Screaming Sell ...Nor A Screaming Sell ...Nor A Screaming Sell   Europe’s Structural Underperformance Is Intact… Eurozone stocks have been underperforming their US counterparts since the GFC. As Chart 15 highlights, this subpar performance reflects the decline in European EPS relative to US ones. There is very little case to be made for this underperformance to end on a structural basis. Europe remains saddled with an excessive capital stock and ageing assets. This combination is weighing on European profit margins and RoE (Chart 16). To put an end to this structural underperformance, either European firms will have to consolidate within each industry (allowing cuts to the excess capital stock, to increase concentration, and to boost profit margins) or the regulatory burden must rise in the US to curtail rates of returns in relation to European levels. Chart 15Europe's Underperformance... Europe's Underperformance... Europe's Underperformance... Chart 16...Reflects Profitability Problems ...Reflects Profitability Problems ...Reflects Profitability Problems   …But The Window For A Cyclical Outperformance Remains Open Despite a challenging structural backdrop, European equities have a window to outperform US stocks, similar to the outperformance of Japan from 1999 to 2006, which only marked a pause within a prolonged relative bear market. European stocks beat their US counterparts when global yields rise (Chart 17). This is because European benchmarks underweight growth stocks relative to US markets. The effect of higher yields on the relative performance of the Euro Area is not limited to the impact of higher discount rates. Yields rise when global economic activity is above trend. As Chart 18 highlights, robust readings of our Global Growth Indicator correlate with an outperformance of the EPS of value stocks compared to growth equities. Thus, when rates rise, Europe should enjoy both a period of re-rating relative to the US and stronger profits. Chart 17Yields Drive European Stocks... Yields Drive European Stocks... Yields Drive European Stocks... Chart 18...And So Does Global Growth ...And So Does Global Growth ...And So Does Global Growth   Positives For Euro Area Financials Like the broad European market, the financials’ fluctuations are linked to interest rates. Moreover, Euro Area banks also move in line with EUR/USD (Chart 19). As a result, our positive view on both yields and the euro for the next 18 months or so should translate into an outperformance of financials in Europe. Additionally, European banks are inexpensive, embedding not just depressed long-term growth expectations, but also a wide risk premium. Europe’s structural problems mean that investors are correct to expect poor earnings growth from the region’s banks. However, the risk premium is overdone. Eurozone banks are much safer than they were 10 years ago. Banks now sport significantly higher Tier 1 capital adequacy ratios and NPLs have shrunk considerably (Chart 20). Moreover, governmental supports and credit guarantees implemented during the pandemic should limit the upside to NPL in the coming quarters. Finally, the so-called doom-loop that used to bind government and bank solvency together is not as problematic as it once was, because the ECB is a willing buyer of government paper and the NGEU programs create the embryo of fiscal risk sharing that limit these dynamics. As a result, investors should overweight this sector for the next 18 months. Chart 19Financials Have A Window To Shine... Financials Have A Window To Shine... Financials Have A Window To Shine... Chart 20...And Are Less Risky ...And Are Less Risky ...And Are Less Risky   A Tactical Hedge Our worries about the impact on the global economy of the Chinese credit slowdown are likely to prompt some downside in European cyclical equities relative to defensive ones. Moreover, cyclicals are still significantly overbought relative to defensives, while our relative Combined Mechanical Valuation Indicator confirms the near-term threat (Chart 21). A high-octane vehicle to play this tactical underperformance of cyclicals relative to defensives is to buy Euro Area telecom stocks relative to consumer discretionary equities. Not only are the discretionary stocks massively overbought and expensive relative to telecoms (Chart 22), they also offer a lower RoE. This backdrop makes the short discretionary / long telecoms bet a great hedge for portfolios with a pro-cyclical bias over one- to two-year horizons.  Chart 21Cyclicals Are Tactically Vulnerable... Cyclicals Are Tactically Vulnerable... Cyclicals Are Tactically Vulnerable... Chart 22...But This Risk Can Be Hedged Away ...But This Risk Can Be Hedged Away ...But This Risk Can Be Hedged Away   Currency Performance Currency Performance Summer Charts Summer Charts Fixed Income Performance Government Bonds Summer Charts Summer Charts Corporate Bonds Summer Charts Summer Charts Equity Performance Major Stock Indices Summer Charts Summer Charts Geographic Performance Summer Charts Summer Charts Sector Performance Summer Charts Summer Charts  

Highlights Three distinct forces are likely to make South Asia’s geopolitical risks increasingly relevant to global investors. First, India’s tensions with China stem from China’s growing foreign policy assertiveness and India’s shift away from traditional neutrality toward aligning with the US and its allies. This creates a security dilemma in South Asia, just as in East Asia. Second, India’s economy is sputtering in the wake of the COVID-19 pandemic, adding fuel to nationalism and populism in advance of a series of important elections. India will stimulate the economy but it could also become more reactive on the international scene. Third, the US is withdrawing from Afghanistan and negotiating a deal with Iran in an effort to reduce the US military presence in the Middle East and South Asia. This will create a scramble for influence across both regions and a power vacuum in Afghanistan that is highly likely to yield negative surprises for India and its neighbors. Traditionally geopolitical risks in South Asia have a limited impact on markets. India’s growth slowdown and forthcoming fiscal stimulus are more relevant for investors. However, a sharp rise in geopolitical risk would undermine India’s structural advantages as the West diversifies away from China. Stay short Indian banks. Feature Geopolitical risks in South Asia are slowly but surely rising. India-Pakistan and China-India are well-known “conflict-dyads” or pairings. Historically, these two sets have been fighting each other over their fuzzy Himalayan border with limited global financial market consequences. But now fundamental changes are afoot that are altering the geopolitical setting in the region. Specifically, the coming together of three distinct forces could trigger a significant geopolitical event in South Asia. The three forces are as follow: Force #1: Sino-Indian Tensions Get Real About a year ago, Indian and Chinese troops clashed in Ladakh, a disputed territory in the Kashmir region. Following these clashes China reduced its military presence in the Pangong Tso area but its presence in some neighboring areas remains meaningful. Besides the troop build-up along India’s eastern border, China is building more air combat infrastructure in its India-facing western theatre. China’s major air bases have historically been concentrated in China’s eastern region, away from the Indian border (Map 1). Consequently, India has historically enjoyed an advantage in airpower. But China appears to be working to mitigate this disadvantage. Map 1Most Of China’s Major Aviation Units Are Located Away From India South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown Owing to China’s increased military focus along the Sino-India border, India’s threat perception of China has undergone a fundamental change in recent years. Notably, India has diverted some of its key army units away from its western Indo-Pak border towards its eastern border with China. India could now have nearly 200,000 troops deployed along its border with China, which would mark a 40% increase from last year.1 Turning attention to the Indo-Pak border, India’s problems with Pakistan appear under control for now. This is owing to the ceasefire agreement that was renewed by the two countries in February 2021. However, this peace cannot possibly be expected to last. This is mainly because core problems between the two countries (like Pakistan’s support of militant proxies and India’s control over Kashmir) remain unaddressed. History too suggests that bouts of peace between the two warring neighbors rarely last long. These bouts usually end abruptly when a terrorist attack takes place in India. With both political turbulence and economic distress in Pakistan rising, the fragile ceasefire between India and Pakistan could be upended over the next six months. In fact, two events over the last week point to the fragility of the ceasefire: Two drones carrying explosives entered an Indian air force station located in Jammu and Kashmir (i.e. a northern territory that India recently reorganized, to Pakistan’s chagrin). Even as no casualties were reported, this attack marks a turning point for terrorist activity in India as this was the first-time terrorists used drones to enter an Indian military base. Hours later, another drone attack struck an Indian base at the Ratnuchak-Kaluchak army station, the site of a major terrorist attack in 2002. Chart 1China, Pakistan And India Cumulatively Added 41 Nuclear Warheads Over 2020 South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown Given that the ceasefire was agreed recently, any further increase in terrorist activity in India over the next six months would suggest that a more substantial breakdown in relations is nigh. Distinct from these recent tensions, China’s troop deployment along India’s eastern arm and Pakistan’s presence along India’s western arm creates a strategic “pincer” that increasingly threatens India. India is naturally concerned. China and Pakistan are allies who have been working closely on projects including the strategic China-Pakistan Economic Corridor (CPEC). The CPEC is a collection of infrastructure projects in Pakistan that includes the development of a port in Gwadar where a future presence of the People's Liberation Army Navy (PLAN) is envisaged. Gwadar has the potential of providing China land-based access to the Indian Ocean. Trust in the South Asian region is clearly running low. Distinct from troop build-ups and drone-attacks, China, Pakistan, and India cumulatively added more than 40 nuclear warheads over the last year (Chart 1). China is reputed to be engaged in an even larger increase in its nuclear arsenal than the data show.2 From a structural perspective, too, geopolitical risks in the South Asian peninsula are bound to keep rising. When it comes to the conflicting Indo-Pak dyad, India’s geopolitical power has been rising relative to that of Pakistan in the 2000s. However, the geopolitical muscle of the Sino-Pak alliance is much greater than that of India on a standalone basis (Chart 2). Chart 2India Has Aligned With The QUAD To Counter The Sino-Pak Alliance South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown China’s active involvement in South Asia is responsible for driving India’s increasing desire to abandon its historical foreign policy stance of non-alignment. India’s membership in the Quadrilateral Security Dialogue (also known as the QUAD, whose other members include the US, Japan, and Australia) bears testimony to India’s active effort to develop closer relations with the US and its allies (Chart 2). India’s alignment with the US is deepening China’s and Pakistan’s distrust of India. Conventional and nuclear military deterrence should prevent full-scale war. But the regional balance is increasingly fluid which means geopolitical risks will slowly but surely rise in South Asia over the coming year and years. Force #2: A Growth Slowdown Alongside India’s Loaded Election Calendar The pandemic has hit the economies of South Asia particularly hard. South Asia historically maintained higher real GDP growth rates relative to Emerging Markets (EMs). But in 2021, this region’s growth rate is set to be lower than that of EM peers (Chart 3). History is replete with examples of a rise in economic distress triggering geopolitical events. South Asia is characterized by unusually low per capita incomes (Chart 4) and the latest slowdown could exacerbate the risk of both social unrest and geopolitical incidents materialising. Chart 3South Asian Economies Have Been Hit Hard By The Pandemic South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown Chart 4South Asia Is Characterized By Very Low Per Capita Incomes South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown To complicate matters a busy state elections calendar is coming up in India. Elections will be due in seven Indian states in 2022. These states account for about 25% of India’s population. State elections due in 2022 will amount to a high-stakes political battle. During state elections in 2021, the ruling Bharatiya Janata Party (BJP) was the incumbent in only one of the five states. In 2022, the BJP is the incumbent party in most of the states that are due for elections, which means it has the advantage but also has a lot to lose, especially in a post-pandemic environment. Elections kick off in the crucial state of Uttar Pradesh next February. Last time this state faced elections Prime Minister Narendra Modi was willing to go to great lengths to boost his popularity ahead of time. Specifically, he upset the nation with a large-scale and unprecedented de-monetization program. Given the busy state election calendar in 2022, we expect the BJP-led central government to focus on policy actions that can improve its support among Indian voters. Two policies in particular are likely to come through: Fiscal Stimulus Measures To Provide Economic Relief: India has refrained from administering a large post-pandemic stimulus thus far. As per budget estimates, the Indian central government’s total expenditure in FY22 is set to increase only by 1% on a year-on-year basis. But the expenditure-side restraint shown by India’s central government could change. With elections and a pandemic (which has now claimed over 400,000 lives in India), the central government could consider a meaningful increase in spending closer to February 2022. Map 2Northern India Views Pakistan Even More Unfavorably Than Rest Of India South Asia: A Slowdown And A Showdown South Asia: A Slowdown And A Showdown India’s Finance Minister already announced a fiscal stimulus package of $85 billion (amounting to 2.8% of GDP) earlier this week. Whilst this stimulus entails limited fresh spending (amounting to about 0.6% of India’s GDP), we would not be surprised if the government follows it up with more spending closer to February 2022. Assertive Foreign Policy To Ward-Off Unfriendly Neighbors: India’s northern states are known to harbor unfavorable views of Pakistan (Map 2). The roots of this phenomenon can be traced to geography and the bloody civil strife of 1947 that was triggered by the partition of British-ruled India into the two independent dominions of India and Pakistan. Given the north’s unfavorable views of Pakistan and given looming elections, Indian policy makers may be forced to adopt a far more aggressive foreign policy response, to any terrorist strikes from Pakistan or territorial incursions by China. This kind of response was observed most recently ahead of the Indian General Elections in April-May 2019. An Indian military convoy was attacked by a suicide-bomber in early February 2019 and a Pakistan-based terrorist group claimed responsibility. A fortnight later the Indian air force launched unexpected airstrikes across the Line of Control which were then followed by the Pakistan air force conducting air strikes in Jammu and Kashmir. While the next round of Pakistani and Indian general elections is not due until 2023 and 2024, respectively, it is worth noting that of the seven state elections due in India in 2022, four are in the north (Uttar Pradesh, Punjab, Uttarakhand, and Himachal Pradesh). Force #3: Power Vacuum In Afghanistan The final reason to be wary of the South Asian geopolitical dynamic is the change in US policy: both the Iran nuclear deal expected in August and the impending withdrawal from Afghanistan in September. The US public has now elected three presidents on the demand that foreign wars be reduced. In the wake of Trump and populism the political establishment is now responding. Therefore Biden will ultimately implement both the Iran deal and the Afghan withdrawal regardless of delays or hang-ups. But then he will have to do damage control. In the case of Iran, a last-minute flare-up of conflict in the region is likely this summer, as the US, Israel, Saudi Arabia, and Iran underscore their red lines before the US and Iran settle down to a deal. Indeed it is already happening, with recent US attacks against Iran-backed Shia militias in Syria and Iraq. A major incident would push up oil prices, which is negative for India. But the endgame, an Iranian economic opening, is positive for India, since it imports oil and has had close relations with Iran historically. In the case of Afghanistan, the US exit will activate latent terrorist forces. It will also create a scramble for influence over this landlocked country that could lead to negative surprises across the region. The first principle of the peace agreement between the US and Afghanistan states that the latter will make all efforts to ensure that Afghan soil is not used to further terrorist activity. However, the enforceability of such a guarantee is next to impossible. Notably, the US withdrawal from Afghanistan will revive the Taliban’s influence in the region. This poses major risks for India, which has a long history of being targeted by Afghani terrorist groups. The Taliban played a critical role in the release of terrorists into Pakistan following the hijacking of an Indian Airlines flight in 1999. Furthermore, the Haqqani network, which has pledged allegiance to the Taliban, has attacked Indian assets in the past. Any attack on India deriving from the power vacuum in Afghanistan would upset the precarious regional balance. Whilst there are no immediate triggers for Afghani groups to launch a terrorist attack in India, the US withdrawal will trigger a tectonic shift in the region. Negative surprises emanating from Afghanistan should be expected. Investment Conclusions Chart 5Indian Banks Appear To Have Factored In All Positives Indian Banks Appear To Have Factored In All Positives Indian Banks Appear To Have Factored In All Positives We reiterate the need to pare exposure to Indian assets on a tactical basis. India’s growth engine is likely to misfire over the second half of the Indian financial year. Macroeconomic headwinds pose the chief risk for investors, but major geopolitical changes could act as a negative catalyst in the current context. So we urge clients to stay short Indian Banks (Chart 5). Financials account for the lion’s share of India’s benchmark index (26% weight). India could opt for an unexpected expansion in its fiscal deficit soon. Whilst we continue to watch fiscal dynamics closely, we expect the fiscal expansion to materialize closer to February 2022 when India’s most populous state (i.e. Uttar Pradesh) will undergo elections. Over the long run, India’s sense of insecurity will escalate in the context of a more assertive China, stronger Sino-Pakistani ties, and a power vacuum in Afghanistan. For that reason, New Delhi will continue to shed its neutrality and improve relations with the US-led coalition of democratic countries, with an aim to balance China. This process will feed China’s insecurity of being surrounded and contained by a hegemonic American system. This security dilemma is a source of South Asian geopolitical risk that will become more globally relevant over time. China’s conflict with the US and western world should create incentives for India to attract trade and investment. However, its ability to do so will be contingent upon domestic political factors and regional geopolitical factors.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Sudhi Ranjan Sen, ‘India Shifts 50,000 Troops to China Border in Historic Move’, Bloomberg, June 28, 2021, bloomberg.com. 2 Joby Warrick, “China is building more than 100 missile silos in its western desert, analysts say,” Washington Post, June 30, 2021, washingtonpost.com.